Once the deliberate downward pressure on these assets eases, there will be a resurgence in prices

Recent days have seen an intense debate within the analyst community on the hot topic of the year — commodity prices. Many have started writing obituaries for the commodity bull and pronounced an end to the ascent in commodity prices. The impact on the corporate sector was advocated to be salutary and it was widely expected to signal an end to the woes of the equity investors.
My humble views on the subject are as follows:

- The demand supply forecasts of analysts project future production vis-à-vis consumption patterns of mining companies versus state trading corporations of importing countries. In the absence of first person contact with these parties, most reports are mere guesstimates.

- Oil prices are the hub around which the currency, bullion and base metal prices revolve. Many analysts have started calling a top on Crude prices. Have we forgotten the fact that it’s election year in the USA and the administration will want to curb prices of black gold? Or have we ignored the recent lesson in history between June 2006 and December 2006 when oil prices collapsed from $80+ levels to sub-$50 barrel, coincidently, the year of the mid-term polls in the USA. Ironically, oil prices zoomed by over 100% in about a year thereafter.

- How many analysts factor in the peak oil figures declared by Lukoil (Russia), Mexican government, Indonesia and the supply-side disruptions in Nigeria? Iran is reportedly facing peak oil in some of its major fields.

- How many reports on oil prices factor in the high “water cuts” in the giant Saudi oil wells of Ain Dar, Shedgum, North Uthmaniya, Abqaiq, Berri and Safaniya? Water cut is a geological engineers’ term for the number of barrels of water produced from a productive well, vis-à-vis the number of barrels of oil harnessed from the same well?
How many million barrels of sea water are being pumped in the Ghawar super giant oil wells a day to maintain the oil pressure from these ageing Saudi reservoirs of seemingly unlimited oil?

- When there is jubilation in the oil energy analysts’ fraternity on enhanced oil recovery (EOR) techniques, how much attention has been focused on the fact that the “new age” oil drill bits cost upwards of $1,50,000 per piece? And that these drill bits (some of them made of diamonds) wear out rapidly?

Have the escalating prices of oil drilling equipment (especially offshore rigs), EOR chemicals been accounted for? What about the rising costs of setting up the gas oil separation plants that are needed as we drill deeper and deeper for oil? How many wells are now drilled beyond the oil-gas “window” and how much deeper do we drill?
The oil-gas window is around 7,500-15,000 feet below ground level.

- It is an established fact that the low-lying fruit has been plucked in the oil drilling space. Now, the oil that will be recovered will contain high sulphur and salt. Using that oil will mean de-salining it, are these additional costs factored in by analysts? If these overall costs (which will keep rising over the years) are added, there will be a level below which oil cannot go.

Has this level been accurately computed? Refining high sulphur oil consumes more energy to refine it to acceptable grades, adding to the cost matrix. Has a long-term equation been figured out yet?

- Hopefuls and optimists talk of alternate fuel sources and a possible shift to non-oil source for our energy needs. How many analysts have thought about the capital costs required to shift to non-oil sources? How rapidly can will the relatively poorer third-world countries switch over without incurring expensive international debt?

- Analysts who forecast a collapse in copper prices (copper is the tin roof of economic activity) seem to base their hypothesis on current declines in the red metal’s prices. Has the fact that the global commodity research bureaus’ reports seem to indicate that our global reserves of copper are now revised to 28-30 years from the earlier 60 years been taken into account? Or is it just the “China factor” that is the trigger for such optimism on (lower) price projections?

- Why is BHP Billiton intent on a hostile takeover of Rio Tinto? Why is L N Mittal (an astute businessman) trucking up with BHP Billiton, and calling copper his next big opportunity?

Now for some hard answers:

Before reading further, remember that in the commodity trend determination business, 6-12 months maybe a blink as compared to long term in the case of equities. Commodity trends last decades.

Now here goes - the Society of Petroleum Engineers has advocated a reduced rate of recovery over the next few decades as oil production hits “Hubbert’s peak”. Their reports are cutting, accurate and first hand. More importantly, they are views of men and women who go in the field and dig into the ground rather than type reports from air-conditioned offices. The CEO of Lukoil (Russia’s oil corporation) has announced a steady decline of up to 10-15% every decade, starting now. Mexico has already announced a sharp drop in oil recovery from USA’s backyard. Unless modern technology is brought in right away, no respite is likely in the future.

These are signs of peaking. The Saudis have constantly resisted pressure from the International Energy Agency for an energy audit. Saudi Aramco (the state oil giant) has stopped issuing figures which indicate a break-up of the production figures per oil well per year. OPEC itself allocates quotas to its member nations based on claimed reserves rather than proven reserves. Who is to establish these reserves as authentic if the IAE is not allowed to conduct verification audits? Sure, nuclear power and fuel cell technology maybe brought in, but I cannot think of my car running on uranium anytime soon.

I expect the post-US election year to be particularly tough on the global energy front as the supply-side constraints choke the optimists. Once the deliberate downward pressure on these hard assets is eased, there will be a resurgence in prices.

I am afraid the following rally may just surpass the recent one. In my humble opinion, the commodity bull is just taking a breather, forget his obituary for now. The future shock will lie not in rising commodity prices, but in not preparing for it.

Vijay@BSPLindia.com