Reality Bites

Like it or not, the era of cheap crude is over…expensive oil is here to stay. And Puru Saxena’s research shows that the supply and demand of crude is seriously out of balance. Read on…

Hurricane Katrina ripped through the Gulf of Mexico causing oil prices to reach another record-high of $70 a barrel.

Over the past seven years, crude oil prices have risen almost seven-fold! In December 1998, crude traded at roughly $10.5 per barrel and recently it recorded an all-time high, over $70 per barrel.

What is amusing though is that during the entire course of this massive advance, the majority of analysts, politicians and OPEC officials have consistently called for a top in the oil price! So far, the experts have been proven wrong.

In the meantime however, oil has continued to surge. The problem for the establishment is that the price of oil is dictated not by officials, but by supply and demand. It is this dynamic that is now pointing towards a significantly higher oil price.

Oil Price Surge: The 1970’s Surge

The last time crude oil prices went through the roof was in the 1970’s. In late 1973, there was political unrest in the Middle East and the result was an oil embargo imposed by OPEC. This caused oil prices to soar from $2 a barrel earlier in the year to over $10 a barrel in December 1973. The oil crisis stunned the world and America was caught totally off-guard. The Iranian Revolution in 1980, when Iranian oil production came to a standstill, followed this event. Due to this further disruption in supply, oil prices exploded higher and recorded their all-time high at roughly $40 per barrel. Adjusting for inflation (in today’s dollars), oil had in fact peaked at $90 a barrel in 1980!

So, it is worth noting today that it was largely supply which caused oil prices to rise twenty-fold in the 1970’s.

In the early 70’s, American oil production was peaking, a fact which was largely unknown at that time. A legendary scientist by the name of King Hubbert had predicted in 1956 that the United States would peak as an oil producer during this time. Back then the experts did not take Hubbert seriously. After all, America had been the largest oil producer for the past 100 years. In 1970, American oil production hit a record-high of 9.6 million barrels of oil per day. Academics dismissed Hubbert as a whacky scientist, not realizing that 1970 was indeed the year when oil production peaked in the United States! By the end of that decade, America was replaced by Saudi Arabia as the world’s largest producer of oil – and it has stayed this way ever since.

Now, let us return to the current situation. Why has oil surged – and where is it likely to go in the years ahead? For this, let us turn to the primary drivers – supply and demand.

Supply is extremely tight, OPEC is already pumping close to capacity and most of the major oil provinces are well past their peak output. It is a known fact that once major oil fields hit peak output, their production rates decline significantly. Such fields are then able to produce oil for years to come, but at a greatly reduced rate.

The last major oil provinces were discovered between 1967-68 in Alaska, The North Sea and Siberia. Alaska peaked in the 1990’s, and its peak output was two million barrels per day. It now produces 900,000 barrels per day. The North Sea peaked in 1999 at 6 million barrels per day. Current production is down by 25%. Siberia peaked at ten million barrels per day. At present, it produces five million barrels per day. As mentioned earlier, America peaked in 1970-71 and current output is only a shadow of its record-high. Furthermore, according to Chinese and Mexican officials, their own biggest oil fields Daqing and Cantarell respectively are also close to their peak output. The ensuing decline from these two fields alone will create a shortfall of 1.8 million barrels per day!

Oil price Surge: Dependent on the Saudis

Let’s face it; our world now depends heavily on Saudi oil. The Saudis claim that they have 260 billion barrels of proven oil reserves and their oil fields are capable of pumping 15-20 million barrels of oil per day. But, will the Saudis be able to deliver when oil demand rises in the years ahead? For the answer, let us examine the Saudi claims.

Up until 1979, the Saudi oil company "ARAMCO" was owned by major foreign oil companies. In 1979, just before Saudi Arabia removed the foreign interest and nationalized ARAMCO, a final audit of Saudi oil reserves was conducted. The study revealed that Saudi Arabia had 110 billion barrels of proven oil reserves. Then, in the mid-1980’s, soon after ARAMCO was nationalized, Saudi proven oil reserves miraculously jumped by 150% to 260 billion barrels! Nobody knew how this happened and it is highly questionable, considering that the last major Saudi oil field was discovered in 1968! How the Saudis manage to boost their proven reserves by 150 billion barrels since taking over ARAMCO is still a mystery. To complicate matters further, for the past 25 years, Saudi proven reserves have remained constant at 260 billion barrels. How can Saudi reserves stay the same at 260 billion barrels when it has pumped almost 60 billion barrels of oil since 1980? This is one question, which begs an answer.

Next, let us closely examine Saudi Arabia’s oil production capacity, which seems to have mystified the world. The majority of people believe that Saudi Arabia can keep supplying the world with endless quantities of crude oil. In fact, the reality may be very different. Not many people realize that over 90% of Saudi oil comes from only six oilfields, which were all discovered before the 1970’s. So, all these fields are now extremely old, and experts argue that they are now well past their prime. Ghawar oilfield is the super -giant and has provided 55-60% of Saudi oil over the past five decades! According to experts like Matthew Simmons, Ghawar is past its peak already and likely to enter into a major decline.

Some analysts argue that oil supplies are infinite and Russia has found a way to pump oil from previously untapped oil reserves. If this is true, why is oil trading over $60 per barrel? Surely, prices would have collapsed on this good news.

Global demand for oil is another story altogether. Paris-based International Energy Agency (IEA) estimates that in the fourth quarter of this year, demand will hit 86 million barrels per day, a record-high.

Asian demand for oil is rising fast and is expected to double within the next 8-10 years. Over time, we can expect the emerging economies to consume a lot more oil than the industrial world – a fact that can’t be disputed due to the sheer population numbers in developing countries. What will happen when the Asian demand for oil doubles to almost 40 million barrels a day in a few years time? Where will these extra 20 million barrels come from? This excess demand will most probably be tackled not by increased supply, but by significantly higher prices.

Regards,

Puru Saxena
for The Daily Reckoning

September 27, 2005

Puru Saxena is the editor and publisher of Money Matters, an economic and financial publication.

An investment adviser based in Hong Kong, he is a regular guest on CNBC, BBC World, Bloomberg TV & Radio, NDTV, RTHK Radio 3 and writes for several newspapers and financial journals.

The Andes are still there…gleaming. But we are seeing them from a different angle. We have come north to Salta province.

An airline strike left us stranded at the airport in San Rafael. There were no hotel rooms left in the city either; we had to go on. We considered driving, but it is a 12-hour drive from San Rafael to Salta. After hours of telephoning and negotiating, we were finally able to find a small plane to take our group onwards. None of us had to be anywhere special, so we took the whole thing in high spirits.

Of course, spirits have played a big role in this trip. We live on a diet of cheap beef and cheap wine. Both are as good as any we’ve ever had and leave us with the impression that we are having a good time, even when things go wrong.

Everything is cheap in Argentina. Yesterday, we had lunch on the verandah of a restaurant in the little town of Angustaca. A party of 12 ate steaks and pork cutlets, French fries and salad – lavaged down with coke and bottled water. The bill came to $27 for the whole group. First, we thought the waitress had made a mistake; we demanded a recount. The math was checked, but failed to raise the total.

We were flabbergasted at the price and charmed by the location. It is an oasis in a spectacular desert of strange rock formations and meandering streams. There, we looked at a wine estate bigger than an American county. It was 50,000 hectares, or about 150,000 acres. Nobody knows for sure. Most of the land is out in the hills…dry, dry hills…hills as parched as Death Valley. The rest is a fertile bottomland that looks a bit like the best parts of Italy – with Lombardy poplars bordering streams of water – and a vineyard that produces as much as half-a-million litres of wine. This property is for sale for less than, say, the typical house in San Diego County.

The buildings were put up more than a century ago. The winery itself was built in 1870. As near as we could tell, no maintenance has been done since. Chunks of adobe are falling out of the walls. You can see the bright desert sun up through holes in the roof. If Sergio Leone were to make any more spaghetti westerns, he could choose no better site. We half expected to see a man with a poncho and a cigar.

"Everyone thinks about Patagonia," said our Argentine real estate expert. "Ted Turner and Lucian Benetton made it famous. But Salta is really a better buy. It’s more interesting. More varied. You get more for your money."

Salta is startlingly beautiful. It is Arizona…New Mexico…Montana…and nearly Tennessee. It has varied rainfall, extremely varied altitude, and is practically empty. There are vineyards, cattle ranches, fruit orchards, high mountains, and even jungle. It has spaces so wide open and desolate you think you are on the moon. Unlike the American west, Argentina’s wide-open spaces tend to be owned by private individuals rather than the federal government. And since there is so much of it, you get a lot for you money.

Argentina has seen its share of trouble. At the turn of the 20th century it was considered one of the richest countries in the world – ranked number six in the world. Many thought it would soon be number one. Good English families, already feeling the pinch of a waning empire, hoped to marry their daughters off to an Argentine with a polo field. "As rich as an Argentine," was a popular expression.

You can see the residue of this period still. In Buenos Aires, many of the buildings put up at the end of the last century or the beginning of this one are as attractive as any in Paris. Out in the countryside, rich planters built mini-palaces.

But anything that can be wrought by the hand of man can be twisted and misshapen, too. In the 1930s, a wave of populism passed over the world like a solar flare. The normal patterns of a civilized society were disrupted by world improvers with a socialist bent. In France, Leon Blum stirred the masses to larceny. In America, Franklin Roosevelt packed the New Deal with democratic claptrap. In Italy and Germany, opportunists put socialism in jackboots and made it more popular than adultery. And in Argentina, Juan Peron started his own Populist Party – the Peronistas.

All of them did damage to their economies and their societies. Italy and Germany were so thoroughly beaten down they had no choice but to recover. But the Peronistas plagued Argentina until the 1970s.

Their successors – military dictators and elected bumblers – have misruled ever since, including a few backed by the Peronistas, who remain an important force in Argentine politics.

Two low points of the post-Peronista period were the Falklands war with England in 1982, and the inflation of the late 80s.

"By that time," said our local expert, "Argentines had grown a little cynical about politics. I know it was a big deal in the rest of the world, but we hardly noticed. We were watching an important soccer tournament at about the same time."

And the inflation?

"It was amazing," continued our source. "Prices rose about 1,000% a year. I got married in ’88. I remember it well. We were given a price for our wedding in the morning and in the afternoon it was much higher. Then it got worse…not inflation, but the economy. After the peso was tied to the dollar, our exports were so expensive; everyone was going out of business. The middle class was practically wiped out."

War…inflation…financial destruction…Argentina has seen it all. Its people are hip to trouble…resilient and resourceful. When you buy a property in the country, you will find the price quoted in U.S. dollars, but calibrated to a cynical Argentine market. Here, people do not expect property to go up 20% every year. They do not anticipate that next year will always be better than the last or that some sucker with money in his pocket will always come along just when you need a loan.

Argentines have little faith in their own currency, but much faith in ours.

This is likely to change. Stay tuned, dear reader.

More news from our friends at The Rude Awakening:

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Eric Fry, reporting from New York City…

"About three years ago, your editor paid a visit to Rancho Santana, a beautiful beachfront development in Nicaragua. He fell in love…with the property, that is…not with any members of the local populace."

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Bill Bonner, back in Argentina with more random opinions, thoughts, and experiences…

*** "Looking at property is a little like looking at women," said an Argentine realtor, "sometimes they look a lot better from a distance."

We have spent the last few days looking at various things. Our bet is that the world is turning. In the last century, the United States became a big winner; Argentina turned itself into a big loser. Here we refer only to money, which is, after all, our beat. Americans got rich in the 20th century; Argentines got poor. You can hire a good farm-worker for a full day and pay him only $10. In America, the rate is at least five times higher.

But the world didn’t stop turning at the end of the 20th century. The sun still rises in the morning and sets in the evening – here in Salta province as in San Diego or Wichita. The Argentines are smart. They are educated. They are immigrants from Europe. They have banks and the Internet. They have a country that is big, beautiful and rich. Why should they remain poor forever? Or, why should Americans remain rich?

Are the best opportunities in a country that is rich, or one that might get rich? If you want to invest in a factory, you might be better off in China or Malaysia. If you want to buy land, you might be better off in Argentina. We don’t know that that is the case, but we’re here to find out.

*** What we’ve found so far is that Argentina has an immense amount of land, spectacular climate and scenery, and it seems reasonably cheap. We looked at another farm of 20,000 acres this morning, about an hour from the town of Salta, which has a population of 800,000. The land is rich and well-watered. It has timber – including an ancient cedar bigger than any we have ever seen – thousands of cattle, huge reservoirs, 3,000 pigs, pheasants, thousands of acres of alfalfa, and an impressive new 5-bedroom house. It’s priced at $3 million.

"Not much more than those little houses down on the Chesapeake bay," said an old friend. "In Galesville, you can’t touch anything on the water for less than about $1.2 million. And these are tiny little houses on tiny little lots. When we were growing up, the only person in Galesville who had any money at all was the undertaker. Now, they’re all millionaires. But that whole area around Washington has gone crazy.

"But that’s why were down here. I don’t know what is going to happen, but it makes sense to me to sell some of what I have up there and put a little money down here."