Musings From the Oil Patch – November 27, 2007

• North American Gas Market: So Simple Yet So Complex
• IEA Cuts Oil Demand Forecast Once Again
• How Do You Tell A Bubble from a Peak?
• Future Oil Prices and Economic Activity
• Should Consumers Worry About the Election?

Note: Musings from the Oil Patch reflects an eclectic collection of stories and analyses dealing with issues and developments within the energy industry that I feel have potentially significant implications for executives operating oilfield service companies.  The newsletter currently anticipates a semi-monthly publishing schedule, but periodically the event and news flow may dictate a more frequent schedule. As always, I welcome your comments and observations. Allen Brooks

North American Gas Market: So Simple Yet So Complex

 

In Canada, 70% of conventional oil and gas producer receipts come from natural gas.  In the United States, over 80% of drilling rigs are seeking natural gas resources.  With the importance of natural gas to the health of the North American energy market, it would seem that skyrocketing crude oil prices would be having a more beneficial impact on gas-related exploration and development activity, yet instead, oilfield activity is flagging.  Is the current weakness in natural gas-related oilfield activity totally due to government actions (Canada’s taxation and Alberta’s royalty decisions) and a lack of gas takeaway capacity in the Rocky Mountain region?  We doubt it, which has led us to examine the dynamics of this hemisphere’s gas market.

 

Barely two years ago, natural gas futures prices were climbing toward double digit levels as demand was growing and supplies were limited.  Natural gas prices exploded following the devastation of the Gulf of Mexico gas-producing infrastructure initially caused by Hurricane Katrina and then further damaged by Hurricane Rita.  Natural gas prices spiked to the mid teens per thousand cubic feet, and forecasts called for the $20 price threshold to be breeched in the not too distant future.  Amazingly that didn’t happen.  And less than eighteen months later, in fact, gas prices sank to modern day lows causing producers to reverse course and start shutting down drilling rigs and cutting back capital spending as gas-development profitability came under pressure.  How could the gas market have shifted so rapidly from an extremely bullish natural gas outlook to one dominated by hangdog looks, declining rig activity and producers under financial pressure?  More importantly, are we destined to continue this environment or will we instead experience another period marked by a violent upswing in drilling activity that will further confound forecasters?

 

Exhibit 1. Natural Gas Will Remain an Important Fuel

Source: EIA

 

In order to try to answer that question, we have taken an in-depth look at the factors driving the North American natural gas market.  Our goal and objective is to try to better understand the inner-workings of the natural gas market since it is the prime driver of oilfield service activity today and likely for the foreseeable future.  An upturn in gas-related activity will restore momentum and confidence about the financial health of the oilfield service industry.  On the other hand, continued activity reductions, or maybe even stagnant activity levels, are likely to damage further the financial strength of oilfield service companies. 

 

To examine the North American natural gas market outlook, we need to consider the current and future economics for exploration and development, which are clearly impacted by gas wellhead prices, although rising oilfield costs are also playing a role.  In fact, oilfield costs have been rising rapidly over the past several years as service companies have benefited from unbridled demand, which now has producers facing shrinking profit margins as wellhead prices have remained depressed in recent months.  To assess where gas prices might be heading, it is necessary to examine gas supply and demand trends, including factors such as Canadian and U.S. gas well depletion rates and the pace of new resource developments along with the outlook for gas imports, both from Canada and those in the form of liquefied natural gas (LNG). 

 

Natural gas plays a significant role in America’s energy fuel mix and it is likely to grow as the pressure for new power generating plants with reduced emissions boosts its consumption.  Natural gas is also an important contributor to Canada’s energy supply situation, and should gain a greater role as it fuels the manufacturing process to turn oil sands bitumen into synthetic oil, a growing market.  The challenge for both countries is that U.S. gas supply has been shrinking with the shortfall in demand being met by increased

 

Exhibit 2. Low Gas Prices Drive Demand in Electricity Market

Source: EIA

 

imports from Canada and LNG.  It is the growth in LNG supplies that may prove the most critical variable in understanding the future health of the North American oilfield market.

 

When we look at the amount of natural gas reserves versus the history of gas production, it becomes clear that both Canada and the U.S. have been living off the exploration successes of their past.  As shown in Exhibit 3, natural gas reserves in the U.S. have been rising in the most recent years.  In fact, the Energy Information Administration (EIA) headlined its latest estimate of domestic gas reserves with “U.S. Natural Gas Proved Reserves Reach 30-Year High in 2006.”  This reserve growth is mostly attributed to the increase in the exploitation of gas shale resources, although some new deepwater gas discoveries in the Gulf of Mexico have also helped. 

 

Exhibit 3. U.S. Gas Reserves and Production Growing

Source: EIA, PPHB

 

 

 

Exhibit 4. Canada’s Production Growth Flattening

Source: NEB, PPHB

 

The great issue in forecasting gas shale production is the technological challenges of their exploitation that has been hurt by their escalating development costs.  Horizontal drilling and multi-stage well fracturing have been the key technologies that have enabled the producing industry to unlock these unconventional resources.  The future issue is that the most successful unconventional resource basin – the Barnett shale – has physical characteristics that have enabled it to become the second most prolific field in the continental U.S.  Whether any other of the numerous shales or tight gas sands will prove as prolific as the Barnett remains to be demonstrated. 

 

Exhibit 5. There Are Substantial Gas Shale Resources

Source: OGJ

 

 

 

Exhibit 6. There Are Significant Tight Gas Resources, Too

Source: OGJ

 

In a recent presentation, Aubrey McClendon, CEO of Chesapeake Energy Corp. (CHK-NYSE) stated that a Barnett-shale well in Tarrant County, Texas, home to the city of Ft. Worth, is credited with 2.65 Bcf of associated gas reserves.  Since the company has 550,000 acres within the county, based on current well spacing regulations, this suggests the potential for 10,000 wells that would enable Chesapeake to boost its gas production from 3 million cubic feet per day (MMcf/d) to 7 MMcf/d.  If that happens, according to Mr. McClendon, it would force the company to shut in some gas production elsewhere.

 

When we examine the history of drilling and its impact on gas reserves and production, what becomes very telling is the slope of

 

Exhibit 7. U.S. Reserves Growing in Response to Drilling

Source: EIA, Baker Hughes, PPHB

 

the respective trend lines of the curves of net reserves per rig.  That line is upward sloping in the U.S. and downward sloping in Canada.  The former is benefiting from the unconventional gas resources being developed.  The latter is being hurt by the maturing of the Western Canadian Sedimentary Basin and the inability to develop significant new gas resources. 

 

Exhibit 8. Canada’s Drilling for Gas Less Successful

Source: NEB, Baker Hughes, PPHB

 

The recent low natural gas prices, escalating exploration and developing costs and the controversy over the Canadian income trust taxation and Alberta’s new royalty program have combined to guarantee very low drilling activity in 2008.  That will have an impact on Canada’s future gas deliverability as it is relying on a continued surge in drilling to meet its future supply needs as shown by the red area in the chart of Exhibit 9.  In fact, the National Energy Board’s new outlook for Canada’s energy industry suggests that gas exports to the U.S. could fall 30% over the next seven years.

 

Exhibit 9. Canada Depends on More Gas Wells for Supply

Source: NEB

 

Exhibit 10. Gas Consumption Exceeds Domestic Gas Supply

Source: EIA, PPHB

 

Exhibit 11. Canada Has Had Surplus Production to Export

Source: EIA, PPHB

 

Now comes the tricky part of the analysis.  The U.S. has met its gas supply shortfall from consumption growth by relying on increased imports from Canada and foreign gas in the form of LNG.  While LNG has become a more important supply variable in recent years, its importance is forecasted to grow significantly.  Achieving this growth will depend upon the completion of many of the re-gasification facilities currently being permitted or constructed.  At the present time, however, the four oldest LNG importing facilities in the U.S. are still not operating at full capacity, suggesting that the new re-gasification terminals will be fighting for new cargoes of LNG.  The question is where will these LNG cargoes come from and also at what price will they enter the U.S. natural gas supply stream? 

 

 

 

 

 

 

 

Exhibit 12. U.S. Depends Upon These Import Sources

Source: EIA, PPHB

 

The amount of LNG scheduled to be developed in the future is expected to be significant.  Almost every gas producing country in the world that does not have a domestic gas need or is not adjacent to a growing gas market is opting to build gas liquefaction facilities.  As a result, the cost of these plants has escalated dramatically, to the point that ExxonMobil (XOM-NYSE), one of the leaders in developing new huge LNG projects in the Middle East, has cancelled a project in Qatar due to poor economics and questions about the volume of gas in the supplying field. 

 

Exhibit 13. Rising Facilities Costs and Delays Impact Supplies

Source: BG Group

 

 

 

 

Exhibit 14. LNG Market Patterns of the Past

Source: BG Group

 

As the LNG market becomes more global, the biggest issue will become the amount of gas storage facilities available geographically.  The past LNG market structure did not require as much storage capacity as now, and as it will in the future.  Unless and until other regions of the world expand their storage capacity, the U.S. will continue to be the swing factor in the LNG global trade.

 

Exhibit 15. U.S. The Global LNG Market Balancing Factor

Source: BG Group

 

 

The largest market for LNG is the Asia/Pacific region followed by Europe and then North America, although that is not the case for total gas demand.  However, as pointed out by the International Energy Agency (IEA), the amount of natural gas storage capacity relative to annual gas demand is in the reverse order of LNG demand.  As the IEA calculates, the ratio of total working gas volume to annual gas demand is the smallest in North America and highest in Asia/Pacific.  The ratio of working gas to gas demand shows how the U.S. has become the LNG storage swing factor. 

 

Exhibit 16. Gas Storage Is Greatest in North America

Source: IEA, PPHB

 

This gas storage factor will put significant pressure on all regions to add to their storage capacity.  The U.S. is adding more storage, but as we have seen from industry research, the amount of new storage capacity announced proves often to be well in excess of the amount eventually constructed.  (See Exhibit 18.)  It appears that Europe is planning to add some gas storage capacity, but there is little new storage being built in the Asia/Pacific region.

 

Exhibit 17. U.S. Gas Storage Relative to Demand is Large

Source: EIA, PPHB

 

Exhibit 18. New Gas Storage Plans Look Expansive: But…

Source: Article in OGJ

 

When we look at the growth of LNG supplies to the U.S. market monthly, one can clearly see the huge growth in supply in recent years.  However, when we look at the arrival of LNG on an average daily basis and by year, not only is the jump in recent years’ supply clearly evident, but the timing of the arrival is also clearly evident.  It comes in the first part of the year, peaking in the early summer before declining.  What appears to be happening is that because Asia/Pacific and Europe do not have sufficient storage capacity to hold large inventories of LNG, they are passive buyers in the first half of the year and more aggressive buyers in the second half as winter nears. 

 

Exhibit 19. LNG Imports Are Growing

Source: EIA, PPHB

 

Exhibit 20. Growing LNG Imports Peaking in the Spring

Source: EIA, PPHB

 

The U.S., because of its large storage capacity, is able to acquire LNG cargoes earlier in the year and store the volumes for the winter.  But with that strategy comes the problem of an earlier fill of domestic gas storage facilities that then acts to depress natural gas prices that undercuts the economics of drilling and development of North American gas resources.  As this cycle continues to operate, the underlying depletion of gas resources, both in the U.S. and Canada, will eventually force natural gas prices higher on a sustained basis to re-stimulate gas exploration and development activity.   

 

Exhibit 21. Note Storage Reaches 5-Year Capacity Early

Source: EIA

 

As storage capacity is filled up during the first half of the year as LNG shipments into the U.S. increase, natural gas prices have a tendency to weaken.  This pattern has existed for several years now, and is likely to continue as U.S. gas storage facilities play a growing role in the balancing of the global LNG market. 

 

 

 

 

 

 

 

Exhibit 22. Notice Gas Prices Slump in First Half of Year

Source: EIA, PPHB

 

The lack of meaningful improvement in natural gas prices since 2005 has resulted in a flattening, and small decline in recent weeks, in the U.S. drilling rig count.  The Canadian rig count, while demonstrating its historical seasonality, has shown a generally negative trend over the 2005 to 2007 year-to-date period.  Until natural gas prices begin to show a sustained upward trend, or oilfield costs decline by a meaningful amount, it is hard to expect to see much improvement, or maybe any improvement, in the North American drilling rig count.

 

Exhibit 23. North American Drilling Suffers From Gas Weakness

Source: Baker Hughes, PPHB

 

Eventually the physics of natural gas reservoirs will result in a decline in productive capacity that will pressure gas prices and force the producing industry to return to exploration and development.

 

 

 

Exhibit 24. U.S. Gas Well Depletion Will Drive Prices Higher

Source: IHS

 

Exhibit 25. Canada Has a Similar Depletion Problem

Source: CAPP, NEB

 

However, how long it takes for this LNG/storage-fill and weak natural gas price cycle to be broken is impossible to determine.  Its existence will depress current and future oilfield activity until the physical demands from reservoir depletion undercuts productive capacity and permanently boosts gas prices to levels that re-ignite exploration and development activity.  Is that a 2008 event?  More likely it won’t happen until 2009, baring a severe winter that wipes out gas storage supplies.

 

 

IEA Cuts Oil Demand Forecast Once Again

 

The IEA reduced its fourth quarter 2007 and full year 2008 oil demand forecasts due to slowing economic growth and the emergence of signs that high oil prices are dampening consumption.  Fourth quarter oil demand was reduced by 500,000 barrels per day (b/d) while 2008’s demand was lowered by 300,000 b/d.  The current IEA forecast calls for 2007 oil demand to average 85.7 million b/d (+1.2%) and 88.7 million b/d (+2.3%) in 2008.  In both cases, the IEA says that the demand totals will be highly dependent upon winter weather.  The IEA said that part of the reason for its reduced fourth quarter estimate is due to European citizens delaying filling their heating oil storage tanks likely with the hope for lowered prices, or in the belief that this winter will prove mild.

 

This delaying action by consumers suggests that they got the memo on the outlook for this winter’s weather that calls for a near normal winter, but which means that it will be warmer than last winter meaning less fuel will be consumed.  If that turns out to be the case, then consumers will be victorious by not having bought expensive heating oil to put into storage.  On the other hand, they could be caught short and the consumer response could lead to a spike in oil prices.  We wonder, however, whether the IEA has been getting Al Gore’s and the UN’s memos about global warming and its impact on energy demand due to moderating European and North American winters.  We know the IEA has been talking about the need to reduce emissions to counter global warming, but maybe they too are waiting to see how consumers really react to the global warming fear before seriously adjusting their forecasting models.

 

Regardless of the winter, all the economic signs point to sharply lower economic activity in 2008 than previously thought (and maybe than current forecasts).  Signals of reduced economic activity suggest that the IEA’s 2 million b/d growth in oil demand in 2008 may turn out to be too high, as have most of its forecasts so far this decade with the exception of 2004 when it totally missed China’s explosive demand growth.  Even China is aggressively taking economic action to slow its economy and lower its demand growth.  As Michael C. Lynch, president of Strategic Energy & Economic Research, Inc. stated, “Demand growth at present is one-half to two-thirds the long-term trend, and while Chinese oil demand is growing rapidly this year, it is growing much more slowly than in the past – about 6% versus 8-10% previously.”  With this trend underway, it is likely that the IEA will be further reducing its 2008 oil demand forecast, which could take some of the wind from the sails propelling oil prices toward the $100 per barrel marker.

 

 

How Do You Tell A Bubble from a Peak?

 

There has been substantial discussion in the financial press and general media about investment bubbles and how people need to do a better job of identifying them and avoiding investing in them.  From the dot.com boom of the late 1990s to the real estate and subprime mortgage bubbles of today, the public has been bombarded with advice about how it could have avoided each of these many bubbles.  The list of bubbles – or possible bubbles – continues to grow, but knowing when a solid investment trend is about to become a speculative bubble is extremely difficult to discern, if not impossible.  The challenge is that investment bubbles do not necessarily fit Justice Potter Stewart’s comment about pornography: “I know it when I see it.”  Instead, it’s more like ‘I’ll know it when I look back from the rubble of the burst bubble.’  By then, of course, it’s too late.

 

During the 1970s, when oil prices exploded due to the emergence of energy nationalism – the use of oil as a political weapon – coupled with the dynamic of accelerating global energy consumption meeting constrained energy supplies, the oilfield service stocks were the best performing stock market sector.  Over the decade of the 1970s, oilfield service stocks rose six-fold compared to about a 20% gain for the S&P 500 index. 

 

With oil prices skyrocketing in recent months in response to similar supply/demand trends as experienced in the ‘70s, this decade is beginning to look a lot like that earlier period.  So far this decade, except for the recent pullback in energy stock prices, the oilfield service stocks that comprise the Philadelphia Oil Service Stock Index (OSX) have increased in value by roughly 250% compared to a single-digit advance for the S&P 500.  The oilfield service stock price rise has mirrored the robust growth in the industry’s earnings due to stepped up drilling and development activity in response to escalating oil prices.

 

With crude oil prices flirting with the $100 per barrel threshold, the pullback in oilfield service stock prices has many investors wondering whether the stocks are starting to run out of steam as more and more antidotal evidence suggests that changes in oil demand patterns are underway.  Some of the demand shifts are related to weakening economies, both in the U.S. and Europe, as financial problems and inflation pressures force their citizens to moderate their spending, the principle driver of global economic activity.  Should oil prices fail to continue rising, investors will be faced with the prospect that the very strong oilfield service company earnings growth pattern will soon falter.  As the stocks have been priced for perfection, any weakness – real or perceived – in their earnings growth outlook will result in the valuations being reduced. 

 

On October 15, the OSX hit 310, the highest point in its ten-year existence.  Barely one month later, the OSX index had fallen by 12.5% to 271.  Over the same period, the Dow Jones Index fell 7.3% from a near record-high of 13,985 (the high was 14,165).  While the OSX performance this year placed it among the stock market sector leaders, when the fall correction came it was sharp and brutal.  Is this a bubble bursting or merely a correction in a bull market? 

 

In the context of trying to answer the question of whether we were experiencing a bursting bubble, we found the following information quite interesting.  According to the fund counter statistic maintained on the Energy Hedge Fund Center (EHFC) web site, today there are 595 energy related hedge funds in operation.  This means the funds have been registered with appropriate securities regulators.  These energy hedge funds are focused on a variety of aspects of the energy industry.  The definitional categories used by the EHFC to qualify as an energy-focused hedge fund include that the fund invest in: energy equities; energy debt; distressed assets (such as power stations); oil and gas commodity futures trading; and/or over-the-counter (OTC) energy derivatives trading in crude oil, petroleum products, natural gas, electric power and coal.

 

Exhibit 26. Energy Hedge Funds Are Popular

		Pct.
Commodity	197	33%
Equity	202	34%
Hybrid	45	8%
Alternative energy	39	7%
Fund of Funds	47	8%
Infrastructure	17	3%
Unclassified	41	7%
Water	2	0%
Shipping	5	1%
	595

Source: Energy Hedge Fund Center, PPHB

 

Seventy-five percent of the energy hedge funds monitored by the EHFC are equity, commodity or funds of funds oriented.  The balance is comprised of alternative energy, infrastructure and other specialty sub-sector energy funds.  The almost 600 fund total is up from 250 energy hedge funds in 2005, less than two years ago.  Is that growth rate a sign of a bubble developing or just astute fund managers identifying a long-term investment opportunity?

 

Another test for uncovering an emerging investment bubble is to examine the relative importance of the sector within the broad stock market.  One may reflect back on the dot.com investment boom that saw technology stocks soar to lofty valuations based on ephemeral measurements rather than solid investment fundamentals.  Does anyone remember that some tech stocks were valued on multiples of revenues?  Or how about valuations tied to estimates of the number of eyeballs that looked at a web site?  Then there were the click-through metrics that were supposedly signaling revenue generating events – only the sales never materialized.  The idea of assets, net income or even cash flow as being important in the valuation of these stocks was considered so ‘old school.’  However, when the party ended and the air came out of this bubble, the stock prices collapsed faster than one could say ‘click-through’ or ‘eyeballs.’  

 

If we use the relative importance of an investment sector within the broad stock market measure as represented by the S&P 500 index, we can begin to get a feel for whether a bubble might be developing.  Over the decade of the 1970s energy stocks, as a percentage of the S&P 500 grew in importance from 14% at the end of 1968 to 27% in 1980. 

 

Exhibit 27. Energy Is Still Not As Important as in 1990

Source: SeekingAlpha.com

 

A chart of the movement of industry sectors weighting within the S&P 500 was recently prepared by SeekingAlpha.com.  It clearly shows that energy stocks have increased in importance in 2006 and 2007 from their low point (5.6%) in 1999, or right about the time global crude oil prices fell to $11 per barrel.  Even with the performance of energy stocks in the first half of 2007, the sector’s weighting of 11.7% at the end of September is still below the 13.4% recorded in 1990.  In contrast, technology stocks that accounted for 6.3% of the S&P 500 in 1990 soared to 29.2% in 1999, before collapsing to 14.3% in 2002.  At September 30, technology accounted for 16.2% of the index’s value. 

 

The major domo impacting the S&P 500 in recent times has been the financial sector that has climbed from 7.5% in 1990 to 22.3% in 2006 and recently sat at 19.8%.  Of course that weighting was prior to the recent implosion of financial stocks due to the travails of the sub-prime mortgage market and its derivatives.  The message is that what goes up usually comes down.  The question is how fast does it fall?

 

Generally we have found that out-of-favor sectors as measured by their low weighting in the S&P 500 index are often attractive areas to seek undervalued stocks.  On the other hand, those sectors with the greatest weighting in the index often contain over-valued stocks.  The problem is that under-valued and over-valued stocks can often retain that designation for extended time periods.  As a result, disciplined investors who resist buying over-valued stocks are often enticed to, coerced to, or out of sheer frustration buy the stocks at what often turns out to be the wrong time.  On the other hand, those who have bought under-valued stocks are often destined to under-perform the overall stock market because they don’t hold any of the stocks that are driving the market higher. 

 

So what is it for energy stocks?  Is it a bubble bursting or merely a pause in a bull market?  While there is substantial long-term growth potential in the energy sector, the most recent period of explosive industry activity is proving unsustainable.  That means that incremental profit margins have likely peaked and the rate of year-over-year earnings growth is slowing.  Neither condition is positive for increased stock valuations.  This probably means that energy stocks, and oilfield service stocks in particular, are destined to trade in a range that will be bounded on the upper end by their recent 52-week highs.  To go higher will require another upswing in frenetic drilling and development activity to induce investors to aggressively buy these stocks and boost their valuations.  This doesn’t mean that new investors will be hurt by buying the stocks, but the heady performances of the past 18 months will be distant memories before we see that type of euphoria again.

 

 

Future Oil Prices and Economic Activity

 

If there is a joker in the equation of what happens to the global economy in 2008 it is tied directly or indirectly to where crude oil prices go.  With oil prices flirting with the magical $100 per barrel level, all eyes are focused on whether it jumps that barrier and unleashes a wave of inflationary forces into the global economy, or if it falls short and begins to tumble toward a substantially lower level.  We found two contrasting perspectives on the question.

 

The first was from a report on a week-long investment conference on global wealth that took place at the Dubai International Financial Center in the United Arab Emirates the week before Thanksgiving.  The last day of the conference was devoted to a bevy of investment bankers, consultants, traders and economists discussing the outlook for energy markets and the direction for oil prices.  At the end of the session, the moderator asked the audience about future oil prices.  They responded to suggested price ranges by voting on handheld devices.  The results were not surprising as they reflect the momentum underlying the strength in crude oil prices over the past sixty days.  The survey price responses were as follows:

 

            $50 – $100           3%

            $100 – $150       51%

            $150 – $200       33%

            >$200               13%

 

Given that the respondents are forecasting higher oil prices, the past relationship between oil prices and energy stocks suggests a continuation of strong energy stock price performance.

 

Exhibit 28. Rising Oil Prices are Good for Energy Stocks

Source: Financial Postcards

 

The question raised by the survey’s results is how will the global economy survive the impact of such a significant rise in energy prices?  That question was addressed in an economic column in the recent issue of The Economist magazine.  As the article pointed out, the two worst global recessions of recent decades were preceded by huge and sudden rises in the price of oil – 1973 and 1979 – when OPEC limited its oil shipments.  These two events fit the textbook definition of an economic “shock” – a sudden change in business conditions.  These abrupt increases in oil prices have been associated with the view of stunted economic growth ever since.

 

Higher oil prices act like a tax on consumers and hurt the economy because they reduce purchasing power and shift the income to others to spend.  While there are a number of impacts from the jump in oil prices – higher consumer prices, squeezed consumer budgets; unprofitable production and possible job losses – the biggest is the destabilizing effect of the shift even if all the transferred income is eventually spent by the recipients.

 

Given this history of oil prices and economic activity, it is clearly a wonder that the soaring oil prices of the past few years have not disrupted the five-year period of strong global economic growth.  Now come two papers authored by three respected economists that analyze this phenomenon.  They come to similar conclusions that oil price shocks do not hurt as much because oil is used less intensively than before, largely since the economy is more flexible and because central bankers are better at controlling inflation.  (We have not yet obtained copies of the papers so we are relying on The Economist’s analysis.) 

 

The first point about oil’s intensity in today’s economy has been well known and documented.  The flexibility of the economy is somewhat more suspect, in our view.  We think part of the explanation is that the U.S. economy is less manufacturing and basic industry-based and more geared to technology and intelligence industries.  As a subset of that trend is that those countries that are replacing U.S. manufacturing are able to leap to state-of-the-art technology in their manufacturing practices that generally are much more efficient than older manufacturing processes.  Whether central bankers are more astute in managing inflation, we believe, is a conclusion open for debate.  Regardless, the view of these three economists is becoming the accepted explanation for the lack of damage to economic growth and the currently restrained amount of inflation despite sharply rising oil prices.

 

Exhibit 29. Energy Prices Have Not Hurt The Economy

Source: The Economist

 

As The Economist points out about the two papers, their analysis does not include the impact of the sharp run-up in crude oil prices over the last year, which, since summer, has mirrored the oil price jumps of the 1970s.  The recent jump in oil prices comes at a particularly bad time for American consumers who are also being hit by falling house prices, tighter borrowing standards, rising joblessness that makes the economic outlook for consumer spending cloudy, at best.  Could we see in a few years from now papers offering an economic analysis that counters these two papers?  Maybe the cartoon in The Economist regarding oil prices and the global economy foreshadows that analysis. 

 

Exhibit 30. Energy Crushes the Economy

Source: The Economist

 

 

Should Consumers Worry About the Election?

 

Based on a recent poll of American voters by The Economist and YouGov about their attitude toward climate change, we think there may be social and economic changes on the way.  The U.S. Congress currently is struggling to craft an energy bill that can pass both legislative houses, and survive a likely presidential veto.  The legislative struggle will intensify over the next several weeks as Congressional leaders are determined to enact a law before the legislators’ Christmas break in mid December.  While this battle is intense, the more telling issue is what happens after the 2008 election.  And on that question, the recent poll sheds significant light, which could be foreshadowing the future direction of U.S. energy policy and the resulting societal and financial fallouts for the country.

 

 

Exhibit 31. Recent Poll Suggests Democrats Will Tax Energy

Source: The Economist

 

The poll was taken of likely Democratic and Republican voters and addressed a number of climate change issues and possible solutions.  On the question of what they considered to be the most serious environmental problem facing the world today, 53% of Democrats said global warming while only 9% of Republicans thought so.  When asked about their view of using gasoline taxes to help reduce carbon dioxide emissions, an overwhelming number of Democrat and Independent voters were either strongly or somewhat in favor of the proposition in contrast to Republicans.  With the growing prospect of a Democratically-controlled White House and both Houses of Congress, the potential for enactment of this agenda is growing.  While it will still be some time before it happens, the uncertainty about how to plan corporate strategy in the face of such an uncertain (and possibly radically different than today’s) energy policy is likely to cause companies to limit capital spending initiatives.  That uncertainty will further hurt the near-term health of the U.S. economy.

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