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Economics: An Oil Storm?
New York: October 10, 2005
By John R. Stephenson

China should clock in some impressive economic gains this year with many forecasters calling for growth to continue to spurt at a 9 percent annual rate or greater. That's good news for commodity prices around the globe as the surging Chinese economy has been one of the chief architects in the resurgent commodity boom. That's good news also for the ruling party who need economic growth to continue at a torrid clip in order to create meaningful employment for some 25 million new job seekers each and every year. But much of this growth is reliant on strong export markets. With the U.S. consumer clocking in a negative savings rate over the last few months it begs the question - when will the Chinese consumer do more?

While car dealerships are reporting a drop in SUV sales and hurricanes Katrina and Rita have put a crimp in gasoline sales, overall demand for this non-renewable commodity remains strong. The reason? Demand is continuing to surge throughout the rest of the world and is likely to remain buoyant for years to come. Beijing is adding some thirty thousand new cars a month to the city and demand in India, South America and Russia is strong and getting stronger all the time. How important is oil to the economies of the world? Very important, China's foreign policy is dominated by two main themes: preventing Taiwan from becoming independent and securing sufficient supplies of oil.

During the 1970s, we saw the rise of OPEC as the producing fields in the United States started to decline and Japan and Western Europe started to evolve as economic powers. These factors contributed to the oil shock of the 1970s, but today, the situation is potentially much worse as the sheer numbers of people who are becoming part of the new world order from an emerging China, India and Russia are truly staggering. If the current trend line continues, China will go from importing 7 million barrels per day of oil to 14 million barrels of oil a day in 2012. Growth of this magnitude would necessitate the finding of another resource base as large as Saudi Arabia in order to satiate this growing demand.

But where is this supply going to come from? Hard to say, but in 2004 China began competing with the United States for exploration concessions in Canada and Venezuela. Many people such as Philip K. Verleger Jr., a leading oil economist, thinks that the solution lies in conservation, but concedes that because of North America's own consumption patterns to say nothing of the war in Iraq: "We have lost the ability to lecture anyone." But if nothing is done, gasoline prices are likely to spiral out of control, as well, higher crude prices have the unintended consequence of strengthening the very worst political systems in the world — places like Sudan, Iran and Saudi Arabia which, in spite of their oil riches, have surprisingly low per capita incomes. Not to mention the environmental problems which are likely to ensue as we become ever more desperate to find and secure access to this commodity. Already, the newspapers in China are filled with headlines about blackouts, brownouts and the energy shortage. U.S. officials estimate that twenty-four out of the China's thirty-one provinces are experiencing power shortages.

With China butting up against energy constraints on an almost daily basis, not to mention surging demand growth from India, Russia and South America, can competition over this resource be avoided? For the sake of the world, one would hope so, however, the record on this matter is less than encouraging which increases the odds that we will see a global oil crisis sometime in the next ten years.

The supply story is truly dismal as half of the world's oil supply is provided by just 120 fields, 95% of which have been producing for 25 years or more. While the largest oil exporter in the world, Saudi Arabia, claims to have nearly inexhaustible oil reserves, Saudi production has remained flat over the last two years as world demand has been surging. Less encouraging still is the fact that over the last twenty-five years, the Saudis have chosen not to invest in developing any new oilfields within the kingdom meaning that any significant export growth is years away.

Oman, Yemen, Syria, Kuwait and Iran have all reached peak oil. Iran reached peak oil in 1976 (at that time it was producing 6.5 million barrels a day) and today produces about 3 million barrels of oil a day. Peak oil is a much talked about condition which refers to the fact that all reservoirs, fields and countries eventually reach a point at which production stops increasing and starts a gradual process of decline until all the oil in the ground has been exhausted. With all of its neighbors reaching peak oil, is it possible that Saudi Arabia may have reached its peak and is starting to slide down the back half of the oil supply curve? Quite possibly, yes.

What about all the oil we were supposed to secure as a result of the Iraq war? That too, appears problematic. Before the war, Saddam Hussein produced, supplied and smuggled some 3.5 million barrels of oil a day to a thirsty world. Today, with insurgents running around blowing up pipelines and other oil infrastructure assets, the productive capacity of Iraq is bumping along at just 1.5 million barrels a day. Our troops stand by as the oilfields, refineries and pipelines burn a vital source of energy to an increasingly desperate world. The lessons learned by insurgents? Target the oil infrastructure of a country that is reliant on oil for its economic well-being and you can destabilize the regime.

With many of the insurgents fighting in Iraq being of Saudi nationality, the possibility of a future destabilizing resistance in the world's largest oil-exporting nation becomes increasingly more likely. Saudi boasts an incredibly young population with some 43 percent under age 18 with many of its young trained in religious studies rather than having an economics or business education. As with many nations who have the blessing and the curse of abundant oil, the Saudi rulers can get rich and stay rich by drilling for oil rather than by utilizing the talents of their people. Oil money in Saudi Arabia as in Nigeria, Venezuela and Iran is used by the ruling elite to monopolize the instruments of state power — the army, police and intelligence forces without ever introducing power sharing or government transparency to the people. The result? Massive discontent among the general population.

Investors worried about the coming oil storm should consider building a portfolio around the Canadian oil sands producers. The Canadian oil sands have something that many other countries don't have. Rich oil deposits. With a reserve base of 175 billion barrels of proven reserves, the Canadian oil sands rank second in the world behind Saudi Arabia. And the exploration boom has just begun. In the words of Richard Kinder, the CEO of Kinder Morgan, a large U.S. master limited partnership which recently acquired pipeline assets in the oil sands producing region says: "The oil sands represents the next energy tsunami. and quite simply a place we wanted to be."

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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