Agcapita Update

March 2011
Agcapita Update

OIL PRICES, POSITIVE FEEDBACK LOOPS AND THE BACK

OF AN ENVELOPE...

With the recent unrest in some of the world’s most critical

petroleum producing regions I thought I might spend some time
on the topic of oil prices.  However, rather than engaging in what
I believe is the largely futile exercise of attempting to predict the
price of oil next week, next quarter or even next year, I want
to try to address two more fundamental questions.  What is
the long-term risk to real oil prices from 1) a further economic
downturn and at the other extreme 2) accelerating growth in the
emerging economies?
 
Research from Cambridge Energy Research Associates provides
the answer to the first question.   By comparing the cost of
production of the various sources of supply that make up current
daily production volumes you find that demand would have to
drop by approximately 15 million barrels per day (around 20% of
daily consumption) to create sustained $60 per barrel prices. 
 
The reason for this is straightforward - the seventy million
remaining barrels of daily supply would be unprofitable below
this price.  It is the incremental barrel that sets the market price
and as we are in an environment where the production costs of
large amounts of incremental oil are very high (think offshore and
oil sands) prices must to remain high otherwise supply is shut-in
and disappears due to lack of profitability
 
Of course, most analysts have given up forecasting large
demand drops for now - certainly not on the order of the 20% it
appears is required to create sustained $60 per barrel oil prices
again.    
 
What is receiving a significant amount of attention is the nature
of the energy demand emanating from the emerging economies
- it has surprised most analysts in being both large and resilient
over the last 3 years.  And now for that “back-of-the-envelope”

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Agcapita Update (continued)
analysis promised in the title.  Is it possible to quantify
the effect of the emerging economies on oil prices
over the next decade?  Here is a simple thought
experiment using Chinese demand to generate some
rough numbers:
 
–   China moves from 3 barrels per person per year
to the South Korean level of 17 barrels per person
per year
–   Transition takes 30 years
–   Consumption changes are linear
–   No peak in global production
 
In next 10 years we would have to find 44 million
barrels of oil per day (“BOPD”) or around 50% of
current production - 26 million BOPD to maintain
supply and 18 million BOPD to keep up with demand
increases.   Now superimpose peak production
on top of this demand profile using the following
parameters:
 
–   Oil demand elasticity of -0.3
–   Current production 84 million BOPD
–   Assume pre-crisis starting price of US$ 80 per
barrel
–   Peak production 100 million BOPD
–   Post peak decline rate of 3-4%
 
Based on the foregoing, oil prices would increase
approximately 250% in real terms over next 10
years - obviously something would have to give in
the global economy long before that point and that
something would be demand.  projected by DOE, IEA, and OPEC. By 2030 the rest
 
Just how realistic is it to assume such an enormous
affect on the markets from China at the margin?  In
its “Energy Outlook 2030” BP predicts that China
will be the largest source of oil consumption growth
over the next 20 years - increasing consumption
by 8 million barrels per day to 17.5 million barrels
per day - overtaking the US as the world’s biggest
oil consumer.   According to the report, developing
nations, accounting for 93% of global energy growth
over the next 20 years, will drive global energy
consumption.
 
In much more detail, according to a report by Joyce
Dargay and Dermot Gately:  “Two liters a day - that’s
what per-capita world oil demand has been for
forty years. Yet this constancy conceals dramatic
changes. While per-capita demand in the OECD
and the FSU have been reduced - primarily due to
fuel-switching away from oil in electricity generation
and space heating, and by economic collapse in the
FSU - per-capita oil demand in the rest of the world
has nearly tripled, to more than 1 liter per day. In
addition, the rest of the world’s population has grown
much faster than in the OECD and FSU (1.85% v.
0.74% annually). As a result, the rest of the world’s
total oil consumption has grown seven times faster
(4.4% annually, versus 0.6% in the OECD and FSU)
- increasing from 14% of the world total in 1971, to
39% today.    If annual per-capita oil demand growth
rates to 2030 were assumed to be held zero in the
OECD, 1% in the FSU, and at its 1971-2008 historical
rate (2.54% annually) in the rest of the world, total oil
demand will be 138 million barrels per day in 2030 -
about 30 million barrels per day greater than what is
of the world’s per-capita demand would be almost 2
liters/day, and its share of total world demand would
increase from 39% now to 58%.”  
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Agcapita Update (continued)

Clearly we have some grave challenges building on easing - to translate for uninitiated, our central
the supply side.   Let’s now delve into another part of bankers are saying that they will need to print more
the oil price issue that receives far too little attention money in order for us to pay our oil bills. The thought
in the mainstream media - rapidly depreciating fiat that it is the rampant debasement of the world’s fiat
currencies and developed nations that for the most currencies that is lurking behind oil’s rise over the last
part must import large amounts of oil to satisfy 6 months seems never to enter their minds. Please
domestic consumption and maintain an energy feel free to contact your local central banker with the
intensive way of life.  For example, the US must definition of a positive feedback loop as I think they
import around 10 million BOPD (over 10% of global may be about to have one demonstrated to them in a
output).   very graphic and grizzly fashion.
   
How is it possible for western nations to pursue weak In any event, given the reckless behavior of the
currency policies while remaining highly dependent developed world’s monetary authorities and the
on imports to satisfy domestic oil demand?   I often supply/demand fundamentals in the oil markets I
write about the law of unintended consequences believe we will continue to see upward pressure on
as is fitting in a time of unprecedented intervention prices - certainly in nominal terms and most likely in
in the operation of the free markets by non-profit real terms as well.  For this reason I remain interested
maximizing state actors.  Today is no exception.  in direct investments in physical production assets
  over the long-term.    Direct ownership of production
Zero interest rates and their associated money supply assets removes the risks and costs bound up in oil
expansions may yet serve to bail out the insolvent equities with their need to engage in exploration to
banking sector but will severely impact the western, maintain reserve levels.   In addition, direct ownership
middle class way of life via escalating food and of production assets eliminates a number of critical
energy costs.  counter-party and agency risk issues, provides
  recourse to a physical asset and the returns are of
Channeling the spirit of Rudolf Havenstein, the course commodity linked but with ongoing cash flow.
president of the Reichsbank who oversaw the
German hyperinflation of 1921-1923, US Federal Kind Regards
Reserve officials have recently been saying that higher
oil prices may be the catalyst for further quantitative Stephen Johnston

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