With a new year upon us, I believe now would be an excellent time to review several of the biggest themes I see unfolding over the next 12 months. While some of the items/predictions I will cover in this issue have been discussed in previous issues, I will introduce several new themes that I will be exploring more thoroughly in 2011. Let’s get started.
Theme #1: Big Oil Unmasked: I see a battle unfolding in 2011 between the short sellers of the world’s super-majors and those who are under the delusion that large integrated oil companies offer a safe way to invest in the oil industry while collecting a dividend along the way. In the short sellers corner is the world’s most famous short seller, Jim Chanos, who should be taken very seriously. Mr. Chanos first discussed his short position against a “handful” of integrated oil companies that were not involved in the Macondo spill with Bloomberg in July (URL: https://www.youtube.com/watch?v=DNfT14EmNt0 ). The central thesis behind Mr. Chanos’ short position is that several major integrated oil companies have not replaced reserves in years and several companies are in fact liquidating. Mr. Chanos also points out that, based on a review of the financial statements of integrated oil companies, the group is spending 100% of cash flow on capital expenditures and is borrowing to pay a dividend.
One integrated company that is certainly liquidating is Royal Dutch Shell (NYSE:RD). The Hague-based major has seen its daily production fall from 3.51 million barrels of equivalent per day (boe/d) in 2005 to 3.142 million boe/d in 2009 (Source: company financial statements). However the company is likely to see a small uptick in production in 2010 given that production through the first three quarters of 2010 is up slightly due to several new LNG projects coming online. ExxonMobil has also seen its production decline from 4.237 million boe/d in 2006 to 3.932 million boe/d in 2009. The real story at Shell and the other majors is the inability to replace produced reserves with reserves of equal quality.
For example, though Shell’s 2009 annual report states the company added 4.417 billion barrels of reserves during 2009, 2.759 billion barrels were booked due to accounting rule changes. As of the end of 2009, Shell reported 14.132 billion barrels of reserves or about a 12-year reserve life given the company’s current production rate. Big deal you might say. However, if we look a little further into the composition of the company’s reserves, we see a company whose best days are clearly behind it. As a result of a 2009 SEC reserves accounting rule change that was lobbied for very hard by the integrated oil industry, Shell’s 4.417 billion barrel increase in proved reserves in 2009 included a whopping 1.630 billion barrels from the conversion of “proven minable oil sands reserves” to “synthetic crude oil proved reserves”. As of the end of 2009, 11.5% of Shell’s reserves consisted of high cost oil sands reserves in northern Alberta.
An even larger contributor to the reduction in the quality of Shell’s reserves in recent years has been large bookings of natural gas reserves. The below graphic was taken from the company’s Five-year Fact Book 2005-2009 and clearly shows the large contribution natural gas has made to the company’s reserve bookings in the past decade. [It should be noted that the below table does not reflect the conversion of proven minable reserves to proven synthetic oil mentioned above.]:
Source: Royal Dutch Shell Corp.
As you can see from the “Reserves Additions” chart, well more than half of Shell’s reserve additions since 2005 have come from natural gas. Since natural gas reserves generate approximately one-third of the cash flow of oil when produced, there should be no doubt that a barrel of equivalent comprised of natural gas has less economic value than a boe comprised of oil or natural gas liquids. Shell’s acquisition of Marcellus shale player East Resource for .7 billion in cash in May 2010 will only add to its stockpile of natural gas reserves and will further reduce the quality of the company’s reserves.
Since the SEC allows companies to book reserves on a BTU basis and rather than a future cash flow basis, big oil has been masking the deterioration of its business by overpaying for questionable shale gas reserves, low margin oil sands and liquefied natural gas (LNG) projects.
A final thought on Big Oil. Integrated oil companies have virtually nowhere left to explore to replace their rapidly depleting high quality reserves and now have to rely on risky acquisitions to gain access to reserves that will allow them to continue to pay out their high dividends. Once it becomes clear to the investment community that Mr. Chanos’ thesis on the group is correct, we could see significant share price declines amongst the integrated companies. Just to be clear, I do not think that shorting a group with huge leverage to rising oil prices and an ability to hide the deterioration of its business through accounting tricks is a great money making opportunity. I prefer to invest in companies that can identify and exploit new sources of reserves since these companies will provide massive outperformance in a rising oil price environment.
Theme #2: Peak Oil is Recognized: The late Matt Simmons often said that Peak Oil would only be recognized several years after the fact. 2011 will mark somewhere between three and five years after the peaking of world oil production and will likely be the year in which Peak Oil is finally recognized. As I discussed in previous issues, world oil production fell 2.6% in 2009 (Source: 2010 BP Statistical Review) and likely fell in 2010. While there are a few countries such as Brazil, Columbia and Iraq that will be able to grow production over the next few years, several large producing countries that grew liquids production over the past decade have now plateaued. For example, between 1999 and 2009 Russia added nearly four million barrels per day of production while Saudi Arabia, Angola and Kazakhstan all added approximately 1 million barrels per day of production. These four countries, which added a combined seven million barrels per day of production between 1999 and 2009, are unlikely to grow production further due largely to lack of large new discoveries and the maturity of their existing fields. More importantly, the number of countries that are now experiencing declining production continues to grow and the small number of countries that can grow their oil production can no longer offset the far more numerous countries have are well past peak production.
Despite overwhelming evidence that Peak Oil arrived several years ago, wide-scale recognition of this reality will occur in 2011 as the myth of OPEC spare capacity is once and for all relegated to the dustbin of history. According to the International Energy Agency’s (IEA) December 2010 Oil Market Report, OPEC spare capacity currently stands at 5.6 million barrels per day. [The IEA defines spare capacity as volume that can be brought on within 30 days and remain online for 90 days.] I find the IEA’s estimate of spare capacity absurd. In a recent article for the Oil Drum Europe, Rune Likvern produced a very detailed article examining the spare capacity of OPEC among other issues and concluded that the IEA’s is grossly overstating spare capacity. According to Mr. Likvern, total OPEC spare capacity is no more than 2 million barrels of oil production per day and all of it likely lies in Kuwait, Saudi Arabia and United Arab Emirates (Source: https://europe.theoildrum.com/node/6859). While I agree with Mr. Likvern that OPEC is overstating spare capacity, I do not believe the organization currently has any spare capacity whatsoever. Fact of the matter, nobody knows what OPEC’s spare capacity truly is and OPEC will never provide a straight answer. However, we will soon find out the extent of the cartel’s spare capacity as oil prices head back to their all-time high. As oil breaks through 0 per barrel in the first half of 2011, world leaders (mostly from the US) will call on OPEC to be a “team player” and produce more oil and do its part to save the world economy. I suspect we will see a replay of 2008 where output barely grew and numerous excuses were provided for lack of production growth.
While some might think declining world production will mark the end of the world, I disagree. I believe the recognition of Peak Oil will result in a steady, though significant, rise in oil prices that will lead to oil reaching 0 a barrel by 2018 at the latest. This phenomenon will create both winners and losers. Companies and individuals who recognize Peak Oil and adjust their investments and operating methods accordingly will enjoy increased wealth. Those who fail to acknowledge and prepare for rising oil prices will eventually be forced into making painful adjustments to their businesses or lifestyles.
Theme #3: Natural Gas Prices Break Out: In December 2009 I wrote an article reviewing the supply/demand balance of the North American natural gas market in which I predicted a natural gas crisis would arrive by mid-2011. I stand by that prediction with only a small change. While nearly every major natural gas producing area has performed more or less as predicted in the December 2009 issue, there have been a large number of uneconomic wells drilled as part of lease capture programs that might delay the onset of a supply shortage. However, a shortage remains inevitable. Even with the capital destroying drilling of uneconomic gas wells by a handful of operators, natural gas is continuing to tighten and will likely be in a severe deficit by the end of 2011.
Theme #4: Electric Cars Go Mainstream: While 2010 set the groundwork for a large ramp-up in electric vehicle (EV) sales, 2011 will likely be the year that EVs go mainstream. I see several reasons why 2011 should be the year the EV industry achieve what Malcolm Gladwell would call a “Tipping Point” and become a significant part of the auto business.
First, the scarcity of supply is creating its own demand. Early sales figures for the Nissan Leaf, America’s only all electric sedan, appear very strong due to the car’s excellent reviews, strong value proposition for owners who receive a ,500 rebate, roadside assistance if owners ever need a charge for only 0 per year and, most importantly, a big cool factor. Nissan completely sold out its Leaf production for 2010 and sales projections predict large growth in 2011. Due to strong demand, Nissan plans to ramp production up to 500,000 Leafs annually in 2013.
Second, 2011 should also see a large number of product introductions that will greatly broaden the scope of EV offerings and go a long way to making EVs more accepted. GM, Nissan and other car companies have indicated that they plan to grow their EV product lines to meet increased demand.
Third, rising gasoline prices will greatly accelerate EV sales. As new car buyers become increasingly concerned about the rising cost of gasoline, which is likely to hit .00 per gallon in 2011, EV sales will rise dramatically.
Finally, EV recharging stations will proliferate throughout the U.S. and range anxiety will be greatly reduced over the next 12 months. There are now designated parking spots with recharging station popping up all over the country. Some stations have been installed by retailers offering free charges to customers while several companies are rolling out networks of fee-based charging stations. With the rollout of the Nissan Leaf into most areas of the country in 2011 and the numerous EV recharging options now available for the public, I expect to see EVs greatly increase as a percentage of the new car market.
Theme #5: Solar Stocks Hit Tradable Bottom: One of the great mysteries to serious energy investors is the valuation drivers for solar equities. Solar equities seem to trade in sympathy with technology shares and not as part of the energy sector. Now that polysilicon prices have come down to earth after their shortage-induced spike in 2007-2008 and companies are now judged by more normal metrics than by their cost of polysilicon, several operators have separated themselves from the pack. The winners have been able to reduce their costs close to grid parity and have consequently taken market share from the weaker players. I see this trend continuing in 2011.
While strength in the important European solar markets has helped the sector make it through the economic downturn of the last two years, I expect the huge and largely untapped North American and Chinese markets to play an increasing role during the next several years. For example, the Province of Ontario is very serious about reducing its carbon footprint and is going forward with the de-commissioning of the western hemisphere’s largest coal fired electricity generating complex. The Province is replacing its coal generating capacity with a combination of natural gas fired plants and renewable power sources. Numerous large-scale solar projects are currently underway in Ontario.
Though I do not have any solar stocks in the Model Portfolio at the present time, a period of NASDAQ weakness will create a great buying opportunity for solar stocks. I expect to add several of the world’s strongest solar companies to the Model Portfolio over the next 12 months.
Theme #6: Dollar Weakness Returns with a Vengeance: While the severely flawed US dollar has enjoyed a respite from heavy selling in recent weeks as the problems in Europe have taken center stage, it is only a matter of time before the investment world comes to its senses and realizes the US dollar offers no shelter from the world’s financial storm. In recent days author, philosopher and self-described flâneur, Nassim Taleb has been on several media outlets presenting the thesis that Europe’s recognition of its difficult financial position has put it in a much better position than the US, which has barely recognized the depths of its worsening financial crisis. I fully agree with Mr. Taleb’s view and I have discussed this subject numerous times over the past year.
More importantly, budgetary pressure at both the federal and local levels is nearly certain to derail the nascent recovery and put substantial downward pressure on the dollar throughout the course of 2011. One analyst who has been prescient about exploding debt levels and the enormous role government stimulus has played in the recovery is the Prudent Bear’s Doug Noland. While I have long known that the economic recovery was largely dependent on federal and state stimulus, I had no idea things are as bad Mr. Noland’s research indicates. Consider the following from Mr. Noland’s recent Credit Bubble Bulletin:
“In just 9 quarters, total federal liabilities have ballooned .013 TN [trillion], or 60%. After doubling mortgage Credit in less than 7 years, our system is now on track to double federal debt in about four years. Federal expenditures jumped to a record SAAR [seasonally adjusted annual rate] .760 TN during the third quarter, up 6.4% from Q3 2009; up 19% from Q3 2008; and 29% higher than Q3 2007. Federal expenditures increased to 25.5% of GDP during the quarter, up from 20.8% in Q3 2007. During the quarter, combined federal and state & local expenditures reached almost 40% of GDP (vs. 34.4% during Q3 2007).” [Emphasis added.]- Doug Noland December 17, 2010
With 40% of Q3 GDP comprised of government spending and control over federal government coffers now in the hands of Republicans in the US House of Representatives, many who rode to victory on the platform of reducing the size of government, there is nearly certain to be a contraction in GDP next year. Under no foreseeable set of circumstances will private sector spending be able to make up for a potentially huge decline in government spending. Additionally, I do not see how any serious analyst, whether on Wall Street or elsewhere, can defend 3% or higher GDP growth in 2011 given the condition of federal, state and municipal balance sheets and the US economy’s huge dependence on government spending. Contracting GDP will lead to further weakness in the USD since a weak economy will keep real interest rates negative.
While some might think fiscal discipline will help the US dollar, I disagree. I think the time to head off a collapse of the US dollar has already come and gone. No amount of budget trimming at this point is going to prevent a run on the US dollar. There is simply no politically feasible way to cut enough spending to get anywhere close to balancing the budgets of the federal government and some of the big, deficit-laden states. Look at the case of New Jersey. Governor Chris Christie is making many, many tough choices but is still faced with a huge budget gap of approximately $10.5 billion in fiscal 2012. This comes after closing a budget gap of over $10.7 billion in 2011 through delaying pension payments and other one-time tricks. There are no more tricks up Governor Christie’s sleeve left to play. Without further bailout money from the federal government in 2011, which may or may not arrive, New Jersey will be forced to restructure its debt. Other states, including my home state of Illinois, have yet to even start addressing their structural budget deficit issue and are on the fast track for financial meltdown. The topic of state and local insolvency has been covered extensively by uber analyst Meredith Whitney, whose firm recently wrote a nearly 700-page research report detailing the scope of the problem.
While 2010 was the year of several full-blown European sovereign debt nervous breakdowns; the EU has at least addressed its spending problem. However solutions as to how several Eurozone members will avoid default once the short-term bailout expires have yet to emerge. I believe 2011 will be the year in which the currency market wakes up to the problem of the US dollar and the USD falls sharply against the euro, yen and my favorite currency, gold.
Additionally, a weakening dollar is very bullish for oil and natural gas prices since energy commodities are increasingly seen as stores of value in a world awash in ever-depreciating dollars.
In conclusion, 2011 should be an outstanding year for energy investors who are willing to look beyond conventional wisdom and position themselves into investments that will benefit from the themes I discussed above.
