Oil

Random ruminations on acche din and oil price

narendra_modi
One of the more interesting books that I have read this year is Humphrey B Neill’s The Art of Contrary Thinking. The book was first published in the early 1950s and remains in print till today. One of the things that Neill talks about in the book is propaganda. Propaganda is essentially the official communication of a government to the public, which is designed in a way so as to influence public opinion.
As per Neill, propaganda that is “brought down to the level of a school child” works the best. Take the case of George Bush Junior and the American attack on Iraq. The American government propaganda(along with some help from the British) justified the attack on the ground that Iraq had weapons of mass destruction, which the country never did.
As Tim Vanech writes in the introduction to Neill’s book: “governments who wish to go to war prepare their case and go about manipulating the masses into required support.” The American government manipulated its masses by putting out the story of weapons of mass destruction in Iraq to justify the attack. The story worked because it was so simple that even a “school child” would have understood it—the Americans were the good guys going out there to save the world by killing the bad guys in Iraq. And who doesn’t want to listen to and believe in such a heroic tale?
In fact, all communication that works is normally very simple and is dumbed down to a level of a school child. Take the case of Narendra Modi’s election slogan — “Achche din aane waale hain, hum Modi ji ko laane waale hain.” The fact that the slogan was as simple as it was, was a major reason for its success.
In an economic environment which was extremely negative because of high inflation and slow economic growth, the positive slogan caught the imagination of the nation. Neill quotes another writer Gustave Le Bon, who wrote The Crowd: A Study of the Popular Mind, as saying: “Given to exaggeration in its feeling, a crowd is only impressed by excessive sentiments”. And the “excessive sentiments” in acche din aane waale hain influenced voters across large parts of India.
In fact, the slogan was not even original. It was lifted from Franklin Roosevelt’s election slogan in the 1932 US presidential elections “Happy Days Are Here Again.” The 1932 election was fought when the Great Depression was at its worst, and Roosevelt’s slogan offered a lot of hope to people and it worked. Roosevelt won and continued to remain President till 1945 (those were days when the two term limit for a US president did not apply).
What worked for Roosevelt, worked for Modi as well and in the 2014 Lok Sabha elections, the Bhartiya Janata Party won 282 seats. The slogan worked because the people believed in it. They believed that “happy days” were about to come. And Modi like a quintessential politician never explained anything, but promised everything. But all that was nearly one year ago. What the “acche din” slogan also did was that it set the bar very high for Modi. And now one year later, whenever anything negative happens, people are likely to ask (and are asking): “kahan hain acche din? (where are the happy days?)”
A Facebook friend recently wrote about his experience of visiting a petrol pump and the petrol pump attendant asking him: “sahab kahan aaye ache din? (Sir, where are the good days?)” He was referring to the price of petrol and diesel having gone up over the last one month. Petrol prices in Mumbai have gone up by more than 11% since mid April to a little over Rs 74 per litre.
And this is where the acche din slogan is likely to cause problems for the government if oil prices keep going up in the months to come. The price of the Indian basket of crude oil has gone up by 52% since mid January 2015. As on May 15, 2015, the price of the Indian basket was at Rs 4,097.73 per barrel.
When the oil prices were falling between May 2014 and January 2015, people close to the government even credited this fall in price to Narendra Modi. As a February 2015 editorial in the Business Standard had pointed out: “The president of the ruling party, Amit Shah, for example, repeatedly took credit on the campaign trail for lower prices, as did the Union home minister, Rajnath Singh. Even the prime minister has mentioned lower fuel prices, though he has specified that it is because of his “luck”.”
In some conversations that I had (along with some material shared over the social media) I realized that many people seemed to believe, that the Modi government has brought down petrol and diesel prices.
Those who believed that the government was responsible for bringing down the price of petrol and diesel, will now ask—if the government can bring down the price of petrol and diesel, it can also ensure that their prices do not go up. And they will also ask, “kahan hain acche din?” if prices continue to go up.
In fact, things are likely to get difficult for the government as and when the price of petrol and diesel crosses the May 2014 level. In May 2014, the price of diesel in Mumbai was Rs 65.21 per litre and that of petrol was Rs 80 per litre. If oil prices maintain their recent rise these levels will be breached very quickly.
The government can control this price rise by cutting the excise duty on petrol and diesel. Since October 2014, the government increased the excise duty on petrol and diesel four times. This was done to spruce up the revenues of the government and control the burgeoning fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends. What it also meant was that a dramatic fall in the price of oil was not passed on to the end consumer.
Once the petrol and diesel prices cross the May 2014, the pressure on government to control their price will go up. What will not help is the fact some of the top BJP leaders (Modi and Smriti Irani to name two) used the social media extensively in the years running up to May 2014, to criticize the petrol and diesel price hikes carried out by the Congress led UPA government. Also, Bihar elections scheduled for later this year will play a role on this front as well.
My guess right now is that if the oil price continues to rise, the government will have to start cutting the excise duty on petrol and diesel, if they want to ensure that people don’t start asking: “where are the acche din?”. Let’s see how this goes.

The column appeared on The Daily Reckoning on May 19, 2015

Oil price may touch a new low of $31 per barrel by March 2015

oilVivek Kaul

I wanted to write this column last week but just got a little too involved with the three pieces that I ended up writing on Indian real estate.
As I write this column, the price of brent crude oil is around $48.8 per barrel. This price is expected to fall further over the next two months, for the simple reason that oil inventories all over the world have shot up dramatically.
In a research note titled How Low Will Oil Price Go and dated January 6, 2015, analysts at Bank of America-Merrill Lynch explain this phenomenon. The question is why do inventories build? “Inventories typically build because supply exceeds demand in any given market. But in some markets like oil or gas, storage capacity is a finite number and price declines can accelerate as inventories build.”
In another research note titled Oil price undershoot; Compelling value emerging and dated January 16, the Bank of America-Merrill Lynch analysts note that: “Inventories all over the world are building at a very fast rate. In fact, we have moved up our storage numbers and now expect OECD (Organisation for Economic Co-operation and Development) inventory levels to reach 2,830 million barrels in 2Q15, 180 million barrels above last year.”
Interestingly, oil inventory levels in the United States are at an 80 year high for this time of the ear. Numbers released by the Energy Information Administration(EIA) of the United States on January 16, 2015, shows that oil inventories in the country stood at 397.853 million barrels. Thus the oil inventories “are at the highest level for this time of the year in at least the last 80 years,” the EIA said in the release.
Typically in the past, as supply would increase the Organization of the Petroleum Exporting Countries (OPEC) would cut production and that would prevent a fall in oil price. Nevertheless that hasn’t happened this time around. In fact, Ali al-Naimi, the oil minister of Saudi Arabia, said in a December interview that: “It is not in the interest of Opec producers to cut their production, whatever the price is…Whether it goes down to $20, $40, $50, $60, it is irrelevant.”
The Saudi Arabia led OPEC has essentially been driving down the price of oil to make it unviable for US shale oil firms to keep producing oil. As Niels C. Jensen writes in The Absolute Return Letter for January 2015 titled Pie in the Sky: “In effect, OPEC is trying to destroy the economics of this industry, which admittedly requires quite high oil prices to remain profitable. Only 4% of total U.S. shale production breaks even at $80 or higher. A high percentage of the industry breaks even with an oil price in the $55-65 range.”
Due this OPEC oil production has not been cut and oil inventory levels world over have been shooting up. As land-based inventories start to fill up, the oil inventory will move to ships. “In fact, we see floating storage coming into play over the coming months with roughly 55 million barrels building on ships by the end of 2Q15, as land-based inventories across North America, Europe, and Asia fill up. But even floating storage is limited by its very nature. If crude vessels fill up, shipping rates will spike, and that is unlikely to help any oil producer in the world,” write the Bank of America-Merrill Lynch analysts.
Taking all these factors into account the Bank of America-Merrill Lynch analysts predict that by March 31, 2015, the price of brent crude is oil all set to fall to $31 per barrel. The question though is where will oil prices go from there. That is where things get rather interesting and as I have written in the past, it is very difficult to start predicting oil prices in the short term.
The answer to where oil prices are headed in the short=term probably lies in trying to understand how will oil supply shape up in the months to come. The non-OPEC oil suppliers need to cut oil supply by at least one million barrels per day to restore some sort of equilibrium in the oil market. But how good are the chances of something like that happening?
The Bank of America Merrill Lynch analysts point out that the cash cost of non OPEC producers comes at around $40 per barrel and given that oil prices need to stay below that for a while to get them to start cutting supply. “Many producers are well hedged, face very low cash costs, are partially protected by falling domestic currencies or tax breaks, or are notoriously slow to react,” write the analysts.
Oil companies in Brazil need $23 per barrel to cover their cash cost. Russian producers are well protected because of a huge fall in the value of the rouble against the dollar and have cash costs of around $9-15 per barrel. In case of the major oil companies ,the cash costs range anywhere between $20 to $42 per barrel. Only oil produced in the North Sea has an average cost of around $48 per barrel, which is around the current brent crude oil price.
Hence, non OPEC oil can still continue to produce oil for a while, leading to higher inventories. Given this, Saudi Arabia remains the joker in the pack and depending on which way it goes will decide the way oil prices head in the short term.
From the political posturing that Saudi Arabia has indulged in, it looks highly unlikely that OPEC will cut oil production any time soon, even though the country is losing a lot of revenue by keeping the market oversupplied.
As Brahim Razgallah of JP Morgan writes in a research report titled Saudi 2015 Budget: More than meets the eye and dated January 9, 2015: “All else equal, every $10 per barrel fall in the average oil price widens the fiscal deficit by 4.1%-pts of GDP.” Fiscal deficit is the difference between what a government earns and what it spends.
This deficit is likely to be financed through borrowing. The public debt of Saudi Arabia stands at a rather minuscule 1.9% and hence, it can easily borrow its way out of trouble. Over and above this, the country also has a huge amount of foreign exchange reserves amounting to $734 billion accumulated over the years by selling oil. This money can also be accessed.
Razgallah of JP Morgan believes that: “The 2015 budget deficit will mainly be financed by domestic resources, in our view, with public debt likely to reverse its downtrend from 1.9% of GDP in 2014. We believe the government is unlikely to draw on its external savings (97% of GDP) unless oil price weakness lasts a few years.”
Given this, the way Saudi Arabia behaves in the time to come will decide which way oil-prices head in the short term. And that remains difficult to predict.

(The article originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 27, 2015) 

Oil and dollar: Why Obama’s love for Taj lost out to Saudi King’s death

Obama

Barack and Michelle Obama were supposed to be in Agra on January 27, 2015, visiting the Taj Mahal. Instead they will now be going to Saudi Arabia to pay respects to  King Salman bin Abdulaziz, the recently crowned King of Saudi Arabia and the family of the late King Abdullah bin Abdulaziz, who died on January 23. Bloomberg reports that keeping with religious tradition, Abdullah was was quickly and quietly buried on the day he died.
A newsreport in The Indian Express points out that the “Supreme Court had earlier directed all visitors to the Taj Mahal to disembark at the Shilpgram complex, 500 metres away, and board an electric vehicle to the entry gate.” This was deemed to be a security risk by the Secret Service that guards President Obama and hence, the visit was cancelled.
This reason has since been denied by the White House. A more plausible reason lies in the shared history of Saudi Arabia and the United States. As Adam Smith (George Goodman writing under a pseudonym) writes in Paper Money: “In 1928, the Standard Oil Company of California, Socal, had failed to find oil in Mexico, Ecuador, the Philippines, and Alaska. As a last resort, it bought concession from Gulf on the island of Bahrain, twenty miles off the coast of Saudi Arabia, and found some oil. Socal sought out Harry St. John Philby, a local Ford dealer…who was a friend of the Saudi finance minister, Sheikh Abdullah Sulaiman…For 35,000 gold sovereigns, Socal got the concession for Saudi Arabia. Sheikh Abdullah Sulaiman counted the coins himself. Socal’s Damman Number 7 struck oil at 4,727 feet in 1937.”
This is how Saudi Arabia’s journey as an oil producer started. The United States was the world’s largest producer of oil at that point of time, but its obsession with the automobile had led to a swift decline in its domestic reserves.
President Franklin D. Roosevelt realized that a regular supply of oil was very important for America’s well-being. Immediately after attending the Yalta conference in February 1945, Roosevelt travelled quietly to the USS Quincy, a ship anchored in the Red Sea. Here he met King Ibn Sa’ud of Saudi Arabia, the country which was by then home to the largest oil reserves in the world. Ian Carson and V.V. Vaitheeswaran point this out in their 2007 book, Zoom—The Global Race to Fuel the Car of the Future.
Car production had come to a standstill in the United States during the course of the Second World War. Automobile factories became busy producing planes, tanks, and trucks for the War. Renewed demand was expected to come in after the end of the War. Hence, the country needed to secure another source for an assured supply of oil.
So, in return for access to the Saudi Arabian oil reserves, King Ibn Sa’ud was promised full American military support to the ruling clan of Sa’ud. It is important to remember that the American security guarantee made by President Roosevelt was extended not to the people of Saudi Arabia nor to the government of Saudi Arabia but to the ruling clan of Al Sa’uds.
Over the years, Saudi Arabia further returned the favour by ensuring that Organization of the Petroleum Exporting Countries (OPEC) continued to price oil in terms of dollars despite the fact that it was losing value against other currencies, especially in the 1970s.
Attempts were made by other members of the OPEC to price oil in a basket of currencies, but Saudi Arabia did not agree to it. This ensured that oil continued to be the international reserve and trading currency. Most countries in the world did not produce oil and hence, needed dollars to buy oil. This meant that they had to sell their exports in dollars in order to earn the dollars to buy oil.
If Saudi Arabia and OPEC had decided to abandon the dollar, it would have meant that the demand for the dollar would have come crashing down, as countries would no longer need dollars to pay for oil. Hence, oil will continue to be priced in dollars as long as Al Sa’uds continue to rule Saudi Arabia because they have the security guarantee from the United States.
Further, Saudi Arabia remains a close ally of the United States despite the fact that the late Osama bin Laden was a Saudi by birth. Osama was the son of Mohammed bin Awad bin Laden and his tenth wife, Hamida al-Attas. The senior bin Laden was a construction magnate who was believed to have had close ties with the Saudi Royal family.
Since 2008, a lot of shale oil has been discovered in the United States and the production of oil in the United States has gone up by four million barrels per day to nine millions barrels per day, with almost all of the increase coming from increased production of shale oil. This is only a million barrels per day lower than the daily oil production of Saudi Arabia.
Given this, why does the United States still need to continue humouring Saudi Arabia? It is now producing enough oil on its own. James K. Galbraith has an answer for it in The End of Normal: “There is no doubt that shale is having a strong effect on the American economic picture at present…But the outlook for sustained shale…production over a long time horizon remains uncertain, for a simple reason: the wells have not existed long enough for us to know with confidence how long they will last. We don’t know that they won’t; but also we don’t know that they will. Time will tell, but there is the unpleasant possibility that when it does, the shale gas miracle will end.”
Jeremy Grantham of GMO goes into further detail in a newsletter titled The Beginning of the End of the Fossil Fuel Revolution (From Golden Goose to Cooked Goose: “The first two years of flow are basically all we get in racking…Because fracking reserves basically run off in two years and can be exploited very quickly indeed by the enterprising U.S. industry, such reserves could be viewed as much closer to oil storage reserves than a good, traditional field that flows for 30 to 60 years.” The process used to drill out shale oil is referred to as fracking.
Hence, shale-oil might turn out to be a short-term phenomenon. As of now shale oil is not going to replace cheap traditional oil, which is becoming more and more difficult to find. As Grantham points out: “Last year for example, despite spending nearly $700 billion globally – up from $250 billion in 2005 – the oil industry found just 4½ months’ worth of current oil production levels, a 50-year low!”
It is worth remembering that the United States consumes 25 percent of the world’s daily production of oil and half of its daily production of petrol, or what Americans call gasoline. The fact that it is using way too much oil becomes even more obvious given that it has only five percent of the world’s population. Given this, it still needs Saudi Arabia.
Hence, the Obamas need to go to Saudi Arabia and offer their condolences on King Abdullah’s death as soon as possible. The Taj Mahal will have to wait.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The article originally appeared on www.Firstpost.com as on Jan 26, 2015 

Falling oil prices: Modi and Jaitley should be thanking Saudi Arabia

narendra_modiVivek Kaul

Urjit Patel, one of the deputy governors of the Reserve Bank of India (RBI), recently explained the benefits of the dramatic fall in crude oil price for India. As he put it: “The dramatic fall in oil prices is a boon for us. It saves, on an annualised basis, around US$ 50 billion, roughly, one-third of our annual gross POL (petroleum, oil and lubricants) imports of about US$ 160 billion. This is on a back-of-the-envelope, top-line basis. Of course, there will be leakages and other set-offs. But our external situation undoubtedly improves. The welcome development enhances our disposable income (which will increase consumer demand for other goods and services), reduce input cost of our businesses (which will increase margins and help to enthuse investment demand), and aid government finances by reducing the energy subsidy burden in the budget.”
This paragraph needs a detailed discussion. On May 26, 2014, the day Narendra Modi took oath as the prime minister of India, the price of the Indian basket of crude oil stood at $108.56 per barrel. Since then the price of the Indian basket has fallen dramatically and on January 13, 2015, it stood at $ 43.48 per barrel.
Hence, the oil price has fallen by nearly 60% since the Modi government came to power. This, as Patel puts it, has led to a dramatic fall in our oil import bill. He goes on to say that it also increases our disposable income, which in turn will increase consumer demand.
The logic here is very straightforward—people will spend a lesser amount of money to buy oil products, and the money thus saved would be spent on other goods and services. Nevertheless, things aren’t exactly like that. The government hasn’t passed on the entire fall in the price of oil to the end consumer.
As mentioned above the price of the Indian basket of crude oil has fallen by 60% since May end. Nevertheless, petrol prices haven’t fallen by 60%. In Mumbai, the petrol price has fallen by around 14% since April 2014. The same logic stands true for diesel as well.
This has happened because the government has increased the excise duty on petrol and diesel thrice since October 2014, in order to shore up its revenues. The tax growth had been assumed to grow at 16.9% at the time the budget was presented, whereas the actual growth in tax collections between April to November 2014 has been around one-fourth of that at 4.3%.
Analysts Chetan Ahya and Upasana Chachra of Morgan Stanley estimate that the Modi government will collect nearly Rs 14,600 crore between December 2014 and March 2015 through the higher excise duty on petrol and diesel.
What this tells us is that the major benefit of the fall in oil price has gone to the government and has not led to the disposable income of the citizens going up majorly as suggested by Patel. I don’t see this increase in disposable income being big good enough to lead to an increase in the consumption of goods and services.
As author Satyajit Das points out in a recent research note titled Reverse Oil Shock: “While positive for public finances and economic efficiency, the diversion of the benefits from consumers to the government is contractionary, reducing the effect on growth.”
The index of industrial production (IIP) data suggests the same. IIP is a measure of the industrial activity in the country. When looked at from the use based point of view, for the period April to November 2014, the consumer goods number was down by 5.7% and the consumer durables number was down by 15.7%, in comparison to the same period last year.
Patel then talks about falling oil prices reducing the input cost of our businesses. This, he goes on to say, will increase margins and help to enthuse investment demand. Again this sounds very logical, but it does not take into account the biggest problem facing Indian businesses today, which is excessive leverage (i.e. very high debt).
In the Mid Year Economic Analysis, the Chief Economic Adviser to the finance ministry Arvind Subramanian pointed out: “Over-indebtedness in the corporate sector with median debt-equity ratios at 70 percent is amongst the highest in the world. The ripples from the corporate sector have extended to the banking sector where restructured assets are estimated at about 11-12 percent of total assets. Displaying risk aversion, the banking sector is increasingly unable and unwilling to lend to the real sector.” This has led to a situation where banks aren’t interested in lending and corporates aren’t interesting in investing.
Hence, while a fall in oil price will help corporates, it can’t be a major driver in corporate investment picking up.
Now that brings us to Patel’s final point which is that a fall in oil prices will “ aid government finances by reducing the energy subsidy burden in the budget”. In this case the answer is slightly complicated.
In the budget presented by Arun Jaitley in July 2014, it was assumed that the total oil subsidies for this financial year would work out to Rs 63,426.95 crore. Jaitley was assuming a low number to start with, given that Rs 35,000 crore of oil subsidies hadn’t been paid for in the last financial year.
Hence, Jaitley only had around Rs 28,400 crore to play around with in the oil subsidy account.
With a massive fall in the price of crude oil, the oil marketing companies are no longer suffering any under-recoveries on the sale of petrol and diesel. Nevertheless, they do suffer under-recoveries on the sale of domestic cooking gas and kerosene.
Data released by the Petroleum Planning and Analysis Cell (PPAC) shows that in case of PDS(public distribution system) kerosene and cooking gas, the under-recoveries for the month of January 2015 will be Rs 19.46 per litre and Rs 235.91 per cylinder respectively.
The oil marketing companies need to be compensated for these under-recoveries. In fact, the under-recoveries for the first six months of this financial year were Rs 51,110 crore. This number is already higher than the Rs 28,400 crore that was left in the oil subsidy account. Given this, there can’t be any cut in oil subsidies that were budgeted for.
Nevertheless, as explained earlier, the government has raised excise duty on petrol and diesel thrice since October 2014, in order to shore up its revenues. And that would not have been possible if the oil price had not fallen.
Also, Modi and Jaitley should consider themselves lucky that the crude oil price has crashed by 60% since they came to power. If that had not been the case, then the amount allocated by Jaitely towards oil subsidies would have been wholly inadequate. This would have pushed up the fiscal deficit of the government. Fiscal deficit is the difference between what a government earns and what it spends. In fact, the fiscal deficit of the government is already at 99% of its annual target for the period between April to November 2014. This number has also been achieved only after a massive fall in oil prices.
Given this, Modi and Jaitley need to thank the Saudi Arabia led Organization for the Petroleum Exporting Countries(OPEC) which hasn’t cut production despite falling oil prices. This has driven down the crude oil price even further.
Saudi Arabia is doing this in order to ensure that it does not lose its market share in the global oil market. At the same time, it is trying to make things difficult for shale oil firms in the United States, which have suddenly started producing a lot of oil over the last few years.
As Niels C. Jensen writes in The Absolute Return Letter for January 2015 titled Pie in the Sky: “In effect, OPEC is trying to destroy the economics of this industry, which admittedly requires quite high oil prices to remain profitable. Only 4% of total U.S. shale production breaks even at $80 or higher. A high percentage of the industry breaks even with an oil price in the $55-65 range.”
In the past, the Saudi Arabia led OPEC had cut production in times of falling oil prices. But that has not happened this time around. In January 2014, the nations in the Persian Gulf were pumping out 23.41 million barrels of oil per day. By September 2014, this number had remained more or less constant at 23.49 millions barrels of oil per day, despite falling crude oil prices.
n fact, an AP newsreport points out that the energy minister of the United Arab Emirates, a member of OPEC, said yesterday that “there are no plans for OPEC to curb production to shore up falling crude prices, and instead put the onus on shale oil drillers for oversupplying the market.”
Nevertheless, it needs to be pointed out that the difference between supply and demand for oil is not huge. As Das writes: “The structure of the oil market entails fine margins between demand and supply. The current oversupply is around 2 million barrels a day.”
Data from the Energy Information Administration of the United States points out that the average daily production of crude oil between January and September 2014 stood at 77.17 barrels per day. In comparison to this, the difference between the oil supply and demand works out to 2.6% (2 million barrels expressed as a percentage of 77.17 barrels) of total global production.
Despite this small gap, oil prices have fallen by close to 60% since May. As Jensen points out: “even modest changes in the balance between supply and demand can have a dramatic impact on price, provided demand for, and supply of, the commodity in question is inelastic, and that is precisely the case as far as oil is concerned.”

The column appeared originally on www.firstpost.com on Jan 15, 2015

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek) 

Despite recent fall, oil prices will touch $100 per barrel again

light-diesel-oil-250x250Vivek Kaul

This column should complete the trilogy of columns on the price of crude oil. In yesterday’s column I had argued that it is difficult to predict which way the price of oil would go in the short-term, even though it seems that it will continue to remain low.
The more important question is which way the price of crude oil will go in the long term. While exact forecasting is risky business, the direction of the price rise can be predicted especially when structural factors are at work.
Nevertheless, before we get around to doing that, we first need to understand why is oil so important for the progress of human civilization. As Jeremy Grantham of GMO puts it in a newsletter titled The Beginning of the End of the Fossil Fuel Revolution (From Golden Goose to Cooked Goose: “The quality of modern life owes almost everything to the existence of fossil fuels, a massive store of dense energy that for 200 years had become steadily cheaper as a fraction of income. Under that stimulus, the global economy grew ever larger.”
By fossil fuels Grantham means coal and oil. But what is it that makes oil so important? Grantham explains it through an example of one of his sons who is a forester. Grantham talks about a situation where wood is needed for heating purposes and hence, trees need to be cut. This can be done by hiring local labour who will use their axes to cut trees, and paying them a respectable minimum wage of $15 an hour. The other option is to fill a chainsaw with a gallon of gas and use that to cut trees.
As Grantham writes: “One of my sons, a forester, tells me he could cut all day, 8 to 12 hours, with a single gallon of gasoline and be at least 20 times faster than strong men with axes and saws, or a total of 160 to 240 man hours of labor. For one gallon!”
If people had to be hired to do the same job around $2,400 (160 x $15) to $3600 (240 x $15) would have to be paid. That’s the value created by one gallon(or 3.79 litres) of gasoline(or what we call petrol in India) which costs around $3 in the United States.
This “surplus value” created by gasoline and other petroleum products were a major reason which helped usher in the industrial revolution in the Western world. Before the world discovered fossil fuels it was totally dependent on wood from trees for its energy requirements.
As Grantham writes in another newsletter titled Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever: “[Wood]…was necessary for producing the charcoal used in making steel, which in turn was critical to improving machinery – a key to progress. (It is now estimated that all of China’s wood production could not even produce 5% of its current steel output!) The wealth of Holland and Britain in particular depended on wooden sailing ships with tall, straight masts to the extent that access to suitable wood was a major item in foreign policy and foreign wars. Even more important, wood was also pretty much the sole producer of energy in Western Europe.”
Other than being used for making charcoal, wood was also used to power steam engines and for heating purposes. What this meant was that forests were rapidly cut down for wood which was required to produce energy. “Not surprisingly, a growing population and growing wealth put intolerable strains on the natural forests, which were quickly disappearing in Western Europe, especially in England, and had already been decimated in North Africa and the Near East. Wood availability was probably the most limiting factor on economic growth,” writes Grantham.
If the world had not discovered first coal and then oil, it would have run out of trees by around 1850, estimates Graham. And there would have been other impacts as well. “By 1900 wars would have been fought over forests, and the population – without oil-intensive agriculture, both for growing and transportation – would have peaked out probably well under two billion and our species would indeed have had its nose pushed up against the limits of food,” writes Grantham.
That is the importance that fossil fuels, in particular oil, have had on the human civilization over the last two hundred years. So, it is important that the world continues to have access to “cheap” oil. But will that be case?
As Niels C. Jensen writes in The Absolute Return Letter for January 2015 titled Pie in the Sky: “The world will still run out of cheap oil (cheap as in approx. $25 per barrel of production cost, as is currently the average production cost in the Middle East) over the next decade or so. It is hard to predict exactly when, because OPEC members are not the most informative people in the world.”
This, despite the fact that over the last six to seven years the world has managed to increase the production of shale oil. In the United States oil production has gone up by 4 million barrels per day to 9 million barrels per day and almost all of it has come through shale oil production.
Even with this, the future does not look very encouraging. And there is a reason for the same. As James K. Galbraith writes in The End of Normal: “There is no doubt that shale is having a strong effect on the American economic picture at present…But the outlook for sustained shale…production over a long time horizon remains uncertain, for a simple reason: the wells have not existed long enough for us to know with confidence how long they will last. We don’t know that they won’t; but also we don’t know that they will. Time will tell, but there is the unpleasant possibility that when it does, the shale gas miracle will end.”
Grantham goes into detail about the point that Galbraith makes. The process used to drill out shale oil is referred to as fracking. As Grantham points out: “The first two years of flow are basically all we get in fracking…Because fracking reserves basically run off in two years and can be exploited very quickly indeed by the enterprising U.S. industry, such reserves could be viewed as much closer to oil storage reserves than a good, traditional field that flows for 30 to 60 years.”
Hence, shale oil will be what Jensen calls a “relatively short-lived phenomenon”. It is not replacing cheap traditional oil which is becoming more and more difficult to find. “Last year for example, despite spending nearly $700 billion globally – up from $250 billion in 2005 – the oil industry found just 4½ months’ worth of current oil production levels, a 50-year low!,” writes Grantham.
Hence the oil industry in the “last 12 months” has replaced “only 4½ months’ worth of current production!” This, despite the boom in shale oil production.
What this clearly tells us is that the recent fall in the price of oil is at best a temporary phenomenon. Over the long term, oil prices can only go up. As Jensen puts it: “we will see the oil price at $100 again, and it won’t take many years, but it could be an extraordinarily bumpy ride.”
Meanwhile,watch this space.

The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 14, 2015