Oil and Equities Jude Wanniski August 17, 2004

Hugo Chavez, the socialist president of Venezuela, can’t be such a bad guy if Wall Street can celebrate his triumph at the polls Sunday, when he decisively turned back the recall attempt by his political adversaries. There are of course other reasons why the Dow Jones Industrials rallied so smartly Monday, but the Chavez victory brought instant relief from fears that the petroleum workers would strike again, shutting down production and perhaps sending oil over $50 bbl. It is bad enough to be living with $46 bbl, a price that threatens much of the world economy and is a definite drag on the U.S. economy. When can we expect a decline to a more liveable $35 bbl, let alone the $28-$30 bbl the Saudi oil minister says the OPEC countries would like to see? As we are discovering, it may take longer than we believed, even with lessening geopolitical risks.

On May 4, our client letter, $38 Oil, In Perspective," addressed the traditional relationship of gold and oil: “With gold at $392/oz., that works out to 14 bbl. to the ounce (not far from the 15 bbl./oz. average that has prevailed since 1948), as opposed to 10.3 bbl./oz. at $38. We would be hard pressed to find a sustained oil/gold ratio at that level in recent history, which tells us that the price is almost entirely geopolitical.” I’m afraid that with gold at $406 and oil at $46, the ratio has dropped to 8.8 bbl./oz, which makes 10.3 look heavenly, at least putting oil below $40 bbl. What’s going on? We asked George Yates of the Heyco Energy Group, former president of the Independent Petroleum Association of America, who tells us the core problem is that total excess capacity is now thought to range between 0 and 1.5 million bbl. per day (MB/D): “This is a tiny amount, if it exists at all, considering the world market consumes some 80 MB/D and is growing some 2-to-3.5% per year. It is this thin capacity that drives the ‘security premium’ rather than the threat to security itself.”

By that he means is that if the markets knew there was excess capacity of 5-to-10 MBOD, the threats from Venezuela or Yukos or Iraqi pipeline disruptions would be shrugged off by the market. A supply disruption for whatever geopolitical reason would be offset by tapping the excess. Aside from security issues, thin capacity also invites other forms of disruption such as refinery fires, pipeline malfunctions and simple inability to properly match grades and gravities of crude production to refining. One of the most positive functions of OPEC over the years was its ability to maintain excess capacity in order to keep prices within its target range, managing supply to meet the world’s demand needs. In the 1997-98 period, the market assumed 8 MB/D of excess capacity, which was about 12% of the market. These were the crunch years of the U.S. monetary deflation that sent gold down to $300 oz. from $385 oz., with oil following the same percentage path and then some, from $25 bbl. to $10 bbl. In normal times, Yates assumes 5% excess capacity enables OPEC to maintain an optimum range, which would mean at least 4 MB/D against current consumption he believes is now at 81 MB/D.

We know there is plenty of proven oil reserves in the world, roughly 1.2 trillion bbl., almost exactly double the reserves of 1971. Of that, about 2% is in the U.S. The question we should pose, says Yates, is how long it will take to find enough deliverable oil to replace depletion, meet additional growth in the market, plus bring excess capacity back to normal levels: “If we assume that we need 5% excess capacity, and a 2% depletion rate with growth at 2% (retarded by high prices), we would need to find another 7 - 7.5 MB/D of deliverable oil to address this problem in twelve months (if 5% overcapacity solves the problem). This is very unlikely and if we did, we would still need additional capacity the next year for production growth and depletion. More likely we’re on a treadmill -- an effort over several years to catch up with demand similar to our situation with domestic natural gas.”

Yates is not especially encouraged by the high rig count, pointing out that the average rig drilling for natural gas in 1993 found 28 BCF per year and last year the same rig found only 14 BCF. While not to the same extreme, he says the same trend exists in oil worldwide. We have burned through supplies from giant oil fields that were relatively cheap to find, but these will now have to be replaced by more expensive supplies. There is no doubt in his mind that $40 oil would be enough to solve the problem, but that the prodigious amounts of capital and effort needed to develop the necessary capacity will not appear as long as the world energy industry is not sure the price would be maintained.

This of course brings us back to the gold/oil ratio, which is so out of whack chiefly because President Nixon took the U.S. off the gold standard in 1971. In his Saturday column, Floyd Norris of The New York Times lays out some good arguments on why high oil prices may not be temporary, focusing on infrastructure rather than production. I wrote him a note saying: “I`m glad to see you made the point that oil companies are reluctant to invest in new infrastructure when they are not sure prices will stay at a point where they can get adequate ROI. But you might have mentioned the fact that it is the floating dollar that causes these problems. If the dollar was fixed to gold, there could not be the kind of inflationary and deflationary monetary swings that undermine the dollar`s utility as a unit of account, where price moves do reflect real supply/demand conditions and are able to efficiently allocate capital to where it is needed most.”

Even if we fixed the dollar to gold, thereby removing the risks of monetary error to the energy markets, Yates doubts there will be a return to the 15-to-1 ratio of oil to gold in the next two or three decades. The energy is there in one form or another to satisfy the demands of world economic growth, but it takes more and more time to discover and deliver it in the escalating quantities demanded by the developing world. The United States is especially vulnerable because the environmentalists have stacked the deck against further exploration (not to mention new refineries) in our own backyards, which means more imports.  He agrees with Fed Chairman Alan Greenspan that Liquified Natural Gas [LNG] is the shortest term answer, but even if the effort were begun now to liquefy the abundant natural gas now available outside the U.S. and transport it to terminals here where it can be used, he thinks price relief would be seen by 2008. In other words, Wall Street will need help from other sources to make headway between now and then.