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February 09, 2005
Curves, Peaks, Dips & Geophysics
I was going to make an "educational" post today on the subject of the "Big Mac Index" -- everyone knows what that is don't they! -- but the following article just came onto my desk. It's a follow-on from a previous article on oil demand. This article, again from the Rude Awakening newsletter, takes a look at the other side of the equation, oil supply:
By Eric J. Fry
Curves, Peaks and Dips
"Hubbert's Curve" is NOT part of the female anatomy...
But it is, nevertheless, a thing of beauty to long-term
crude oil investors.
Back in the 1950s, Shell Oil geophysicist, M. King Hubbert,
discovered a phenomenon he dubbed, "Hubbert's Curve."
The Shell geophysicist theorized that oil production from a
new field would tend to rise until about half the
recoverable oil had been produced, then peak and fall off
sharply, all along a classic bell-shaped curve.
Furthermore, Hubbert understood that in the real world of
crude oil production, the "second half" of the
theoretically recoverable reserves would be relatively more
difficult - and expensive - to extract, which would prompt
oil companies to abandon fields before extracting all
"recoverable" reserves.
Based on his theories, therefore, Hubbert predicted in 1956
that U.S. oil production would peak in the 1970s. Most of
his contemporaries scoffed at the notion. But his
prediction turned out to be surprisingly accurate. U.S.
production did indeed peak in 1970.
"Using the same model," writes Jeremy Rifkin, author of the
The Hydrogen Economy, "Hubbert estimated in 1971 that the
middle 80 percent of global oil production will be produced
within fifty-eight to sixty-four years, or less than one
lifetime."
In other words, 80% of the world's oil would have been
produced by 2035...at the latest.
"If M. King Hubbert is proven right once again, the world
has either reached or will soon reach peak global
production," observes Steve Belmont in a new report
entitled, "The Death of Cheap Oil." (Belmont is the Senior
Market Strategist for the Rutsen Meier Belmont Group LLC in
Chicago).
"Hubbert's predictions for exploration are also proving to
be true," Belmont continues. "Now that all the cheap
sources of oil have been found, oil companies are cutting
spending for new exploration. The windfall profits
generated by the 3-year run-up in crude prices are not
being spent on finding new oil, but on share-buybacks,
dividends and/or efforts to purchase already-discovered
reserves. Exploration is decreasing because today's
smaller, harder-to-drill fields provide less bang for the
exploration buck."
"Most geologists agree that there is still plenty of oil
left to be discovered," Belmont admits, "but given the cost
of extraction, it is not economically feasible at current
prices. The world may not be running out of oil. It is,
however, running out of cheap oil."
Even the world's largest oil producer may be running low on
"cheap oil"...or any kind of oil, for that matter. Saudi
Arabia pumps 13% of the world's oil and is responsible for
23% of the globe's reserves, making it the most important
player on the supply side, followed by Iran with 11% of the
world's reserves and Iraq with 9%.
"According to official Saudi state calculations," says
Belmont, "Saudi Arabia could produce at current levels of
10 to 11 million barrels per day for 50 years. However, we
view that number with a certain degree of skepticism.
Matthew Simmons, chairman of Simmons and Company
International - an investment bank specializing in the oil
industry says the official Saudi numbers are too high and
that Saudi fields are aging much faster...According to Mr.
Simmons, the Saudis need to strip water out of nearly every
well and this is a sign that Saudi fields are aging much
faster than the industry has planned for.
"Almost every oil field sits on top of water," Belmont
explains. "New oil wells draw up the crude first and have
almost no water content. As a field ages, more and more
water gets mixed with the crude oil. Wells that are almost
dead will reach a 'water cut' of 40%. According to Nasen
Saleri, manager, reservoir management at Saudi Aramco, the
'water cut' for Saudi wells in 2003 was 27%."
In other words, most of the easy-to-get stuff is gone and
only the hard-to-get stuff remains.
"Consequently," Belmont's report concludes, "we may have
entered an era of perpetual shock where supply and demand
are balanced so precariously that the slightest disruption
could send prices soaring. The world is currently using 98
percent of its producing capacity; OPEC was pumping flat
out in 2004 yet prices remained stubbornly high. This was
unprecedented in the short history of crude oil."
So there you have it, folks; demand is climbing and
supplies are dwindling...At least CHEAP supplies are
dwindling. So what's the far-sighted investor to do?
Belmont recommends call options on crude oil futures.
That's his business, of course. Steve is not a stockbroker;
he's an options broker on commodity futures. So naturally,
he prefers this medium as a way of capitalizing on the
crude oil rally he anticipates.
"Most investors think of energy stocks first," says
Belmont. "However, if you own the more well-known stocks
you also know that they haven't kept pace with crude oil
itself. History has proven that an investment in energy
stocks is not necessarily an investment in crude oil. In
fact, in the recent bull market, traditional energy stocks
have not returned anywhere near an investment in crude oil
itself - not by a long shot."
To illustrate his point, Belmont presents the nearby chart
showing "the relative performance of crude oil [versus]
Chevron Texaco since early 2002, a period that encompasses
most of the bull market. As of late December 2004, crude
oil had gained 157%. Chevron Texaco had gained only 16%.
There are numerous other examples of the same phenomenon."
Why not play crude oil directly, Belmont asks?
"NYMEX crude oil futures and options allow investors to
make bets on the movements of crude oil directly," he says,
"offering the cleanest possible play on this most essential
of all commodities. Crude oil futures are extremely
volatile, so we would not recommend trading them directly
for most investors. Crude oil call options are another
story. Crude oil call options trade on the New York
Mercantile Exchange or NYMEX...
"Each NYMEX crude oil call option," Belmont explains,
"gives the buyer of the call the right but not the
obligation to be long a futures contract covering 1,000
barrels of light, sweet West Texas Intermediate grade crude
oil at a specific price known in option jargon as the
'strike price.'...For example, as we write this report, the
spot (front) contract West Texas Intermediate crude oil
futures are trading at roughly $45 per barrel. Long-dated,
December 2006 $50 crude oil call options are going for
roughly $2.30. Multiply times the 1,000-barrel contract
size to get a total cost of $2,300 per option.
"At $60 per barrel, a $50 call would be worth at least
$10,000. Why? Because the holder of a $50 call could simply
exercise the right to be long at $50 per barrel and then
turn right around and sell his 1,000 barrels into the
market for the going rate of $60 per barrel. Multiplying
the $10 per barrel difference times the contract size of
1,000 barrels yields a gross profit of $10,000 per option.
Since our hypothetical option holder paid a premium of
$2,300 for the right to be long, the net profit on this
position would be the $10,000 gain minus $2,300 or $7,700."
Of course, options buyers should not forget that a DROP in
the oil price would render a $50 call option worthless.
Your editors at the Rude Awakening are prohibited from
revealing the exact option Belmont recommends currently.
But we can share his rules for buying options on crude oil:
1) Buy NYMEX calls with at least 15 months until
expiration.
2) Buy calls with strike prices no higher than 10% above
the spot crude price.
3) Pay no more than $2,500 for each option.
Lastly, Belmont advises, "Consider buying NYMEX crude calls
in multiples of two, holding one for the long term and
using the other as a trading position."
Your New York editor contacted Steve yesterday to find out
how Rude Awakening readers could reach him, in the event
that they wished to do so. "Well, I'll be skiing this
week," Steve said sheepishly. "So they should contact my
colleague in Chicago, Sue Rutsen, at 800-345-7026."
"Thanks, Steve."
Now that's what I call an "educational" post - not only educational but immediately "useful"!
The Rude Awakening is published daily alongside it's parent publication The Daily Reckoning
Posted by Tony at February 9, 2005 04:24 PM
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