26/03/2008 - 22:00

A simple case of supply and demand

26/03/2008 - 22:00

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I wonder if there are any readers who have not yet heard about the impending peak of global oil production.

I wonder if there are any readers who have not yet heard about the impending peak of global oil production.

Put up your hands if you think that the supply of a finite resource such as oil will continue to rise for ever, and if so, go and stand at the back of the room.

Just as each individual oil well builds production to a peak, delivers at a plateau level for a short period and then, depending on the quality and size of its reservoir and physical characteristics of the oil, begins to decline at a rate of between 4 per cent and 20 per cent a year, so the entire oilfield will build to peak production from many wells, plateau and fall.

This production profile can be safely and accurately extrapolated to an entire sedimentary basin, containing oilfields such as the Gippsland Basin and provinces of many basins, such as the North Sea and ultimately to the entire planet.

By all accounts, over the past 100 odd years, the modern world has consumed about a trillion barrels of oil, or about half of the easily extractable oil that was ever laid down over time.

At its current rate of extraction, global reserves of oil are being depleted at a rate of about 3.2 per cent per annum and it is worthwhile to know that the discovery of new oilfields has fallen increasingly below the rate of extraction for more than 25 years.

Consumption is currently 31.6 billion barrels of oil a year, but geologists are only able to find about 5 billion barrels each year.

In future columns, Briefcase will examine the implications of a peaking oil production and, in fact, the peaking of production for other minerals, such as gold, for which global production has been in decline since 2001.

In reality, it is not the peaking of oil production that we should be concerned with, but rather the subsequent decline in production.

Oil is a highly useful fuel with a high energy content whose uses pervade modern life.

Oil sits behind virtually everything we use and consume, from fuel for cars, buses, trucks and ships that transport commodities to markets or goods to the shop, to pesticides and fertilisers to boost global food production and on to textiles, plastics, cosmetics, bitumen for roads and a zillion other things we use daily.

The big questions we need to ask are, how will we cope with an oil price of $300 or $1,000 per barrel and what substitutes or new technologies can replace oil? Equally critical – if, as Briefcase calculates, the availability of oil is going to decline beyond 2010 – is the question of how rapidly these solutions will be available?

•••

The price of money, or if you prefer, interest rates, stayed far too low for the three or four years following the events of September 2001 in the US.

The economy of the US and, more recently, global economies are now suffering the after-effects of the US Federal Reserve Bank’s response to those terrorist attacks.

In an attempt to prop up financial markets and bolster consumer spending, US inter-bank interest rates were reduced to 1 per cent in the aftermath of an attack on New York’s World Trade Centre in September 2001.

An extended period of zero or even negative real interest rates in the US has resulted in damage to its economy and financial system, which has now brought Wall Street to its knees under the weight of too much, poorly allocated debt and the action of leverage upon leverage in fancy financial products.

The panic attack by the US Federal Reserve Bank, which has recently dropped interest rates in a dramatic fashion, looks like repeating the dose so the damage, especially in the US, will be long lasting.

When the World Trade Centre fell, everyone knew that global politics and even economics had changed forever, but the unintended consequence of the attack could not have been predicted at the time.

Interestingly, some of the biggest losers from the current US financial turmoil are Arab-based funds, which have been long-term major investors in the US financial market through bonds and also as owners of its banking shares.

Knee-jerk reactions to the US financial crisis by the US government and the Federal Reserve appear to be bandaid solutions to a systemic problem that remains unresolved by tinkering with interest rates.

Briefcase believes the outlook remains for a weakening US dollar.

Gold has overcome the $US1,000 per ounce hurdle before making a tactical retreat, but should go higher on the back of a weaker US currency and a flight to alternative assets.

The oil price appears to have broken its short-term up trend and is likely to trade back towards $US85/bbl by May, as the northern spring weather reduces demand for heating oil and weaker economic growth, or fears of weaker growth, dampen speculative activity.

The Aussie dollar could well move to parity or above by mid 2008, but inevitably the Aussie, which has a strong correlation to Australia’s terms of trade, will weaken against third party currencies as commodity prices move lower during the second half of 2008 as worries rise about the level of industrial activity moving into 2009.

As Briefcase says, there is always more than one cockroach, so I continue to expect that we will witness more stress on Wall Street, which is likely to flow on to other markets around the world.

•••

It is instructional to remember that, after the stock market crash of late 1987, metal prices remained strong, peaking in 1989 ahead of a recession in 1990-91.

While commodities are currently viewed as a saviour for Australia, their eventual return to more normal price levels, under the influence of weaker global economic growth, will also bring a touch of reality to our market and the Aussie dollar.

In the final counting, Australia is riding a wave originating in China by dealing with a portfolio of unsustainable assets.

All its mined raw materials are actually depleting resources.

Even though there may be an abundance of, say, iron ore, at the end of the day, it is still a finite resource, just as oil resources are finite, and so is gold and all other minerals.

While hard commodities may come off the boil in the medium term, the number of new liquid natural gas, iron ore, gas, coal and infrastructure projects under way and on the drawing boards in Australia should enable the likes of Boom Logistics, RCR Tomlinson, GRD, and Monadelphous Group to continue to produce strong results as cost pressures abate in the downturn.

Worryingly, food prices remain extremely high, with the major factor here being the influence of increasing world population pressure, exacerbated by the ‘normal’ impacts of droughts, floods, ice storms and wars.

Prices for wheat, rice, corn and other staples have moved up to levels which, combined with falling global inventories of grain, are likely to lead to widespread famine in many parts of the world as 2008 moves into 2009.

Readers should expect to see substantial and inflationary price rises at the grocer for stable foods as 2008 rolls on.

Observant readers will have already noticed large price rises for bread and some movement on meat.

•••

Briefcase likes this theme of watching where directors and management of companies are putting their own hard-earned cash.

The so-called ‘insider buying’ by directors is a very useful, though not foolproof gauge of corporate health.

By this Briefcase means buying by people from within companies, not those with information not commonly available in the market.

Buying by directors has been increasing and Briefcase loves to see management ‘eating their own cooking’, to quote Warren Buffet.

This week we have noticed continued buying by the managing directors of Havilah Resources, Horizon Oil, and GRD Ltd.

Perhaps GRD’s MD read my recent StockAnalysis report, which valued the company at between $1.56 and $2.20 per share, or more likely he already knows that the stock is a standout buy at below $1 per share.

Meanwhile, directors of Bass Strait oil Company have been taking up their rights issue, which is also a good sign of their confidence in upcoming Gippsland Basin drilling, but no guarantee of success.

••• 

Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au

STANDING BY BUSINESS. TRUSTED BY BUSINESS.

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