Crude Alternatives

The summer selloff in commodities and the stock market is now underway. As I’ve noted previously in this forum, the catalyst for this downward move is concern over the durability and timing of a global economic recovery.

The proximate cause of the growth scare is the weaker-than-expected consumer confidence and employment reports released last week. Consensus expectations ahead of the consumer confidence release were for a slight uptick; however, the index actually fell from 54.8 to 49.8.  The employment report released on Friday likewise spooked traders, showing about 100,000 more job losses than had been expected.

Neither report alters my view that the US economy will begin a recovery either late this quarter or early in the fourth quarter, an outlook that I explained in the last issue of The Energy Letter, “Buying Opportunity.” However, mixed data on the economic front was enough to spook anxious traders, eager to book gains after a major second-quarter rally. The fear is that a prolonged recession will continue to weigh on global energy demand; a collapse in consumption is the root cause of the big drop in crude prices since last summer.

This selling will likely continue near-term. Oil prices could fall to as low as $55 to $57.50 a barrel over the next few weeks as concerns over demand linger. The same forces are driving stocks; we could see the S&P 500 slip to as low as 800 to 825 over the same period. To play this move, I recently recommended buying an exchange-traded note (ETN) in my subscription-based service The Energy Strategist that’s designed to rise in value when oil prices fall. This ETN makes an excellent hedge against further downside.

However, this correction remains an outstanding buying opportunity over the long term, as I continue to look for a year-end run-up in stocks and commodities. The catalyst for that move will be more concrete signs that an economic recovery is underway and that energy demand is picking up once again. Here’s a rundown of two of the most important and widely watched energy-related markets and some of the developments I’m monitoring.
 
Crude Oil

Last week’s auction for stakes in some of Iraq’s major oilfields was a complete failure. Out of the eight producing fields up for bid, only one resulted in a deal: Integrated oil giant BP (NYSE: BP) inked a 20-year deal on the Rumaila field as part of a joint project with China National Petroleum Corp.

As I noted in the last issue of The Energy Strategist, this looks like a marginally profitable deal for BP at best. It’s a 20-year deal in which BP is paid a per barrel fee for every barrel of crude it pumps above a certain minimum target. BP had asked for $3.99 per barrel and the government offered $2, which BP accepted. Other producers were seeking per-barrel fees of close to $5, but walked away when the government wouldn’t oblige. Rumaila is a huge field and attractive asset, but given Iraq’s ongoing security risks and aging infrastructure, BP is assuming a lot of risk for a marginal potential profit.

This deal illustrates two key points. First, Iraq’s oilfields are huge, but their productive capacity has eroded after years of underinvestment and conflict. The government aims to boost production from the current 2.4 million bbl/day to 4 million bbl/day by 2013 and 6 million bbl/day over the long term. To have any hope of achieving this target, the government needs the expertise and modern technology that international producers and oil services firms can offer. The failure of their first auction suggests that the country has little hope of meeting those objectives.

Some long-term oil bears point to countries like Iraq and note the sheer size of untapped reserves. But the recent failed auction illustrates that there is a big difference between reserves in the ground and actual barrels of production. Projections that Iraq will add millions of barrels of new oil production to global supply over the next few years appear ludicrous.

Second, one of the big problems facing super-major integrated oil companies like BP is a lack of resource access. I suspect the only reason BP agreed to marginal terms for Rumaila was to curry favor in Iraq in the hope of securing better terms on future deals. That strategy might pay off for BP down the line, as the company did spare the Iraqis a total failed auction.

However, this does highlight the problem big western integrated oil companies have in getting access to the world’s largest and most attractive reserves. BP would have never agreed to such poor terms if it had other similar opportunities elsewhere. One of the only areas of exploration available to these firms is deepwater; this is why many of the biggest super-majors have invested so much in deepwater in recent years.

As oil demand rebounds into 2010, look for supply concerns to take center stage as the main upside driver for oil prices.

Alternative Energy

In last week’s issue of The Energy Strategist, I highlighted the climate legislation recently passed by the US House of Representatives. The bill amends the US Clean Air Act, establishing a cap-and-trade system designed to reduce US greenhouse gas (GHG) emissions 17 percent by 2020 and 83 percent by 2050. The baseline year for calculating US GHG emissions reductions under the Act would be 2005, when the nation emitted the equivalent of about 7,250 million metric tons of carbon dioxide. 

This week, I am in Europe for the G8 Summit where climate change and measures to contain global warming will be a major topic of discussion. There are plans for a major climate summit in Copenhagen this December that will lay down a global framework for controlling carbon emissions after the existing Kyoto Protocol sunsets in 2012. Long-time readers know that I don’t enter the global warming debate in this letter. I’m not here to save the world or make judgments about whether global warming is real, caused by humans or extent to which it will affect the global climate. However, that does not mean we can afford to ignore the issue; the energy industry is, by its very nature, the most heavily impacted by legislation aimed at reducing carbon emissions.

Unfailingly, the first energy sector that jumps to mind whenever there is talk of climate change is alternative energy–wind and solar in particular have been heavily promoted as means of controlling greenhouse gas emissions. Here’s a photo I snapped last week of a solar panel in Greece: