Driving To Disaster

Jim Brown
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Auto sales for December came in at 13.53 million units on an annualized basis. This was slightly less than the 13.6 million rate in November but still a strong close for the year. This was the strongest pace since 2008. Sales for the year were impacted by the Japanese earthquake and the resulting parts shortage.

Sales are expected to grow in 2012 by +6.7% to 77.7 million vehicles worldwide. That forecast from Polk analysts takes into account the slowing European economy and an estimated +16% increase in sales in China. Looking at the estimates for the next five years you have to be a believer for peak oil or at least much higher prices. With sales increasing at roughly four million units a year to an estimated 100 million annual units by 2017 you have to wonder what will power them.

Polk Vehicle Growth Estimates

In the U.S. we scrap about 75% of the volume of vehicles sold each year. That means out of 13.53 million units sold in 2011 there were about 10.14 million scrapped. In other countries the percentage is significantly less with older cars demanding high sale premiums as they trickle down to the less fortunate in society. Very few cars are scrapped in Asia and Latin America. They have to be really bad off or wrecked to make it to the junk yard.

If we use 50% as a "very round number" and an estimate of the number of cars scrapped globally then we will be adding nearly 39 million new cars to the global fleet in 2012, 42 million in 2013, 44 million 2014, 46 million 2015 and 48 million in 2015. Even if those cars are energy efficient they will still consume a lot of additional fuel. Less than two million cars in 2012 will be hybrids or electric.

Assume for the sake of conversation (and simple math) that each new car in 2012 will average five gallons of fuel per week. Using a round number of 40 million net new vehicles, 5 gal per week, 52 weeks and 42 gallons per barrel you would increase consumption by 652,315 bpd in 2012 for new vehicles alone. That increases by another +684,931 bpd in 2013, +717,574 bpd in 2014, +750,163 bpd in 2015 and +782,778 bpd in 2016. Over the next five years our fuel consumption would increase by 3,587,761 barrels per day from new vehicles alone.

You are probably thinking that is not that bad. However, crude oil does not convert barrel for barrel into gasoline or diesel. A normal barrel of crude oil only produces 19.4 gallons of gasoline. The rest of the barrel is byproducts used for things like jet fuel, asphalt, etc. About 10 gallons per barrel are refined into various fuel oil products like heating oil and diesel.

If we used round numbers again of 25 gallons of gas/diesel per barrel of oil that means we need to discover and produce an extra 6,027,438 barrels of oil per day by 2016 in order to refine 3,487,761 barrels of gasoline from that oil.

Crude Oil Products

Currently the IEA, EIA and OPEC are projecting oil demand growth of roughly 1.5 mbpd every year. For five years that would be +7.5 mbpd so that fits into the scenario described above. Unfortunately those same entities project production declines in existing fields of about 4.5 mbpd every year.

That means we have to find and produce an additional 6.0 mbpd per year just to keep up with current demand growth and depletion. By 2016 that would mean the discovery and production of an additional 30 mbpd of new oil.

Since discoveries of that magnitude require 5-7 years to as much as 7-10 years to bring online after the discovery, all 30 mbpd of that new oil would have to already have been discovered and projects underway to produce it. Unfortunately that is not the case. New supply is faithfully tracked by geologists and analysts all over the globe and updated to the Mega Projects database online. This is the latest graphic from that database. The average of new supply from current and planned projects is roughly 2.2 mbpd through 2015. (Remember a minimum of 5-7 years to develop new discoveries so any project expected to produce before 2016-2018 should be represented here.)

New Supply Additions

I am going to post more on this in a later article but I hope you are getting the picture. Depletion never stops. It is with us every day. New discovery never stops but we are discovering far less than we need to produce in the years ahead.

Oil prices are going up. The short term view of the news reporters is days to weeks. They can't get excited about something months or years ahead because they are geared to today's news today. In news jargon the future does not sell. Tell them a volcano will blow up in 72 hours and every reporter in 5,000 miles will be there to report it. Tell them it will blow up in two years and it won't even make the news.

The peak oil scientists, geologists and analysts have been warning for years but nobody cares. Oil is comfortably over $100 routinely and nobody seems to notice. Back in March 2008 when oil hit $100 for the first time it was all the press talked about. It was either a bubble, the result of evil speculators or blamed on the big oil companies. The press was full of stories every day. Today nobody notices.

We have become immune to triple digit oil prices. There were several articles in the last couple weeks about $5 gasoline in 2012. They were mostly ignored. It will probably happen and of course once it does the press will spend a few minutes reporting it and then move on to something else.

Peak oil is the elephant in the room that everyone ignores because its approach is glacial in speed. This is an immediate gratification world. Everyone is geared to what will happen today or this week. There is no future. Let somebody else worry about that. Unfortunately 99.99% of consumers will not know what hit them when peak oil finally arrives.

Investing in the energy sector is the slam dunk play of the decade. This is a long term buy and hold strategy based on the peak oil story. We KNOW oil prices are going up long term. In our calendar that is not 12 months. It is 3-5 years or even longer.

Over that period prices will go up and down but the long term trend will always be up. If you are not prepared to ignore the volatility or even take advantage of it by adding to positions on the dips then you may lose money. That is true of any investment not just energy positions.

As energy investors we have an ace in the hole. We know the end of the story and that puts us ahead of 99.99% of the rest of the world and we will reap the long term rewards.

Analysts that only look at the charts and ignore the macro data and the long term supply and demand implications will always be wrong. People expecting oil prices to go back to $60 or less are missing the big picture.

Prices can always decline as we saw after the 2008 spike. As the subprime recession hit the price of crude collapsed but it was not due to any material change in the commodity. Unemployment spiked. Oil demand declined dramatically on a temporary basis and prices fell. It was a great buying opportunity. Oil prices now are back over $100 and headed higher. Before that spike the $65-$75 range was considered reasonable. Post spike it was $75-$85. Today a $100 barrel is reasonable.

Saudi Arabia, producing over 10 mbpd, needs oil prices above $91 per barrel to balance the budget. They made some big promises to head off a revolt in Saudi Arabia when the Arab spring unrest began. They are planning on spending $185 billion to finance new apartments, hire 50,000 idle males as security guards and implement dozens of other social programs to keep the population under control. At the same time they are spending tens of billions to explore and produce new oil. The ex vice president of Saudi Aramco said the money being spent on new production was to replace declining production in older fields. They are accelerating production on the Manifa heavy crude field by ten years because they see the future and it includes a shortage of oil. Otherwise why spend $20 billion racing to develop a heavy crude field?

The sanctions on Iran are going to raise oil prices. This problem with Iran is not going away soon and it could have military implications. There is no way Iran will avoid seeing oil sales decline unless they suddenly claimed they had halted uranium enrichment and welcomed verification by the IAEA. That is not going to happen. Oil sanctions are going to have a severe impact on Iran and they might be just dumb enough to start attacking Persian Gulf neighbors just to cause havoc in retaliation for the sanctions. If the shooting starts the price of oil will rocket significantly higher.

The problem energy investors face is the eventual fuel price recession. We know it is coming and we know it will be ugly. It could be short lived but repetitive in nature where it comes back again every 24 months. Or, it could be long lasting where oil prices continue to climb or at least level off at a higher level. When fuel prices become unbearable the demand will decline. Prices will ease. Consumers will eventually become accustomed to paying the somewhat higher prices again and the cycle will repeat with prices going even higher before easing. In peak oil parlance this is called the "undulating plateau" and the most common forecast for peak oil. It will be rationing by price. Those that can afford to pay will drive. Those that can't afford it will not.

The upwardly mobile Chinese middle class will be the winners. They have the most disposable income and the +16% increase in annual auto sales will not slow materially. They have no memory of what gasoline prices should be based on a historical perspective of driving from age 16 in America. We think gasoline should be cheap because it always was. They simply think gasoline should be available and price is not material. They don't have the decades of historical precedents. For many this is their first car ever.

I paid $2.72 per gallon in Albuquerque NM this week. Compared to the $3 average in Denver that was cheap to me. There is a good possibility we will see $5 gasoline in the U.S. this summer. That will likely kill any weak economic growth and there is a 25% chance of pushing us back into a recession.

Quite a few analysts believe the 2008 recession was actually caused by high gasoline prices and not the subprime crisis. The high fuel prices put a serious crimp in blue collar budgets and caused a wave of delinquent mortgage payments, which led to the subprime crisis. I think there may have been some impact from the high fuel prices but the liar loans and fix and flip in the home sector was already in deep trouble. The high gasoline prices probably accelerated the decline.

My wish for 2012 would be to escape the year without a fuel price recession. I would like to see oil prices continue to rise but do it slowly. Oil at $115 to $125 by year end would not be a disaster in a growing economy and it would be very beneficial to the energy sector. Equity prices would rise and activity in the sector would accelerate.

Eventually the pain will arrive. The economic slump in Europe kept production and demand more or less in balance in 2011 and that should continue in 2012. Once the U.S. economy accelerates that balance will fade and we will tip into higher oil prices and lower inventory levels. The longer we can escape the ultimate peak the better off we are. Once the peak in production has occurred it will lead to decades of declining supplies and constant adjustments by consumers to cope with the shortages.

Plan for this peak today and profit from it when it occurs.

Jim Brown

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