Show me the Oil!

Are the days of cheap oil over? The question hogged the business headlines for much of 2005 and the issue was brought to the fore again with Matthew Simmons' new book. But Mr Simmons' hypothesis of a "peak oil" theory isn't novel. Geophysicist Marion King Hubbert was probably the first to voice similar concerns in 1956 when he controversially predicted that world oil production would peak in 2000.

To literally drill down to the root of the pricing equation, a systematic approach to examining the determinants of price, oil's demand and supply, is necessary.

The Demand
Let's start with demand. The North America region of USA and Canada is responsible for about 33% of the world's energy consumption. Currently, Asia is placed second; guzzling about 25%. But with Asia housing the world giants of China and India, it is expected that Asia will double its energy needs while demand in the US will increase by about 25% by 2020. Already, consumption in a rapidly industrializing China has rapidly outstripped its domestic production levels as the former increases exponentially. In fact, China became a net importer of oil in 1993. In India's case, it has already been a net importer for the past decade.

For years, engineers and scientists have touted the viability of alternative sources of energy which, when they come on stream, should reduce the demand for oil. However, it is not particularly clear that clean and safe alternatives such as solar, wind energies have proven to be commercially viable and may be produced on a mass scale. Even when they do, the question of time comes in for these technologies cannot be mass produced over night at a cheap price to penetrate and replace products which oil power. As with all products, the initial prices of such advances are expected to be high as firms need to recoup their R&D expenditures.

Instead, what I suspect has increased is the number of drivers who zip around with larger capacity cars (think SUVs which guzzle oil) and increased flights following the proliferation of cheap air travel. While budget air travel is common in Europe and USA, it is only starting to take root in certain parts of Asia. With increasing affluence levels, it is expected that Asians' appetite for automobiles and air travel will increase.

The Supply
What about supply then? Is it on the wane? The largest oil exporter is Saudi Arabia who churns out over 8 million barrels each day. The Saudis have claimed that there is a fair bit of reserves in their fields. As pointed out by several "peak oil" proponents, the numbers have not been independently audited, thereby raising questions on their authenticity. And because OPEC's current export quotas are pegged to the levels of members' reserves, there appears to be perverse incentive to artificially inflate the claims. Coupled by the fact that there are no great discoveries of oil fields for the last 35 years internationally, the nagging suggestion that oil is depleting simply cannot go away.

It is ironic that much of the oil exporters are located in the Middle East region where many states share a love-hate and yet symbiotic relationship with the West. From the religious angle, this geographical region embed potential flashpoints. The rise of certain pockets of Islamic extremists, whose views are certainly not representative of the larger Islamic community, is worrying for it threatens to polarize nations. As things stand, tension between the West and Islam probably sits on a tight balance and pushing the wrong buttons repeatedly won't do matters any good - think the current situation in Europe (Denmark).

Other than the Saudis, the Iranians (4th largest exporter) also chip in by exporting about 2.5 million barrels a day. But the Iranians have ruffled the feathers of some super-powers by insisting on pursuing nuclear enrichment work, arguably for energy purposes only. One wonders whether there will come a day when tensions between the Muslims and the West deteriorate to the point in that oil will be used as a weapon? Is there a risk of the oil tap being turned off as a form of retaliation? Risk has no religion but religion has risk.

In recent years, I have traveled to the Middle East. Skyscrapers are abound in Dubai. Qatar is rapidly modernizing and Bahrain has embarked on an ambitious billion dollar project to construct a US$2 billion financial harbor on largely reclaimed land. These ambitious projects are undoubtedly fuelled by their oil wealth and these states seem intent on developing an alternative pillar in their economies. The conspiracy theorist in me cannot help but wonder whether the increased urgency to devote increased attention to growing an alternative sector in financial services stems from knowledge that oil supplies may run out? Indeed, some quarters venture that Dubai's oil may dry out in as early as 2010. Recently, it got increasingly worrisome when the industry newsletter Petroleum Intelligence Weekly ran an expose suggesting that Kuwait had overestimated its oil reserves.

With limited domestic supplies, China has turned its sights overseas for more. As the old saying goes, "actions speak louder than words". China has gone out of its way to cultivate good relations with oil producers in their bid to secure their oil supply. Without the ideological baggage that besiege Western nations, Beijing has demonstrated that it is prepared to close deals with countries which the West may shun due to human rights or ethical reasons. Case in point: The Chinese has secured a multi billion stake in a Nigerian offshore oil field. It has also done a deal with Petro Kazakhstan and has secured rights to prospect and import in Algeria. Also, have we conveniently forgotten that CNOOC attempted to purchase a stake in a US oil corporation in 2005?

Whilst the supply picture for oil appears bleak, there have been suggestions that there may be substantial oil deposits under Canada. The reports could well be true but the issue here, from what I gather, is that extracting them will not be a piece of cake. Apparently, the oil deposits are fused with sand. Thus, extracting them will be a technological feat. Just as technology served up the diamond drill bit to enable deep sea drilling, it is likely that the day will come to allow the extraction from oil from difficult deposits or far flung corners. But the issue could well be that the world has to tolerate inflated oil prices before the day arrives.

Let's also not discount the supply chain bottleneck which could cause oil prices to spike. When was the last major oil refinery built in USA? I believe it was several years ago and no new capacity has come abroad on existing ones. Essentially a bottleneck situation could arise if any of the refineries should fail due to a terrorist attack or be affected by a natural disaster. Scenarios not entirely impossible with the heightened security concerns internationally and the increased frequency of hurricanes affecting USA (think Katrina).

The Positioning
The demand and supply scenarios are set out very starkly above. So what's the lowdown? Will there be inflationary pressures? The recent Fed statement, the last presided over by Mr Greenspan, suggested that core inflation remained manageable. But is core inflation, which exclude oil figures, truly reflective? Should the nightmarish scenarios for oil pan out, there could well be an oil led inflation. And history suggests that equities do not perform when prices of commodities such as oil surge [Link to previous post on market cycles].

A critical appraisal of the holdings in one's portfolio may be necessary. In particular, it may pay to be more cautious towards the raw materials used by the companies which one invests in. For example, plastic OEM manufacturers which have no pricing power may see their margins squeezed if oil prices spiral. Prices of oil by-products such as plastic resins could escalate and erode margins of manufacturers of plastic thin films too.

Many macroeconomic predictions have gone awry. The above demand and supply analysis could have been overly pessimistic and I am no petroleum expert. Despite the grave uncertainly in the oil picture, it is clear that to increase the probabilities of being successful in investing will require a sound grasp of one's circle of competence and purchasing only in attractively priced companies within it. Understanding your companies inside out and outside in, knowing how high prices of oil will affect it, could well make the difference between holding a sinker or a multi-bagger in one's portfolio.