Current Events

Join us as we watch the crisis unfolding

July 12, 2007

Sunset

There have been no radical changes since my end-of-2006 update. The US Department of Energy, Energy Information Agency, spreadsheet shows world production down about 1.2 percent from the 2005 peak www.eia.doe.gov/ipm/t11d.xls. (Microsoft Office Excel Workbook) Production from Saudi Arabia is reported to be 10 percent down from mid-2005 www.eia.doe.gov/ipm/t11c.xls, (Excel Workbook) although Saudi Aramco insists that they have additional oil for sale. Although I am still a bit nervous about using the EIA data, it is issued monthly. The Oil & Gas Journal data comes out only at the end of each year. Newspaper stories hint that the International Energy Agency is close to admitting that peak oil is near.

The impending doom and gloom from the world oil peak is ominous. There has been so little preparation and yet, if I am correct, the peak is upon us. We're feeling it now. The US government tried to cushion the bad news by introducing a "core inflation rate" which excludes energy and food. Word is getting around. The July 2, 2007 cover of the New Yorker shows the Statue of Liberty holding up a torch consisting of a fluorescent light bulb. It looks as if we will go through another US presidential election with no candidate calling attention to the world oil problem, or to the North American natural gas problem. My only hope is that a candidate, who learns from private polls that he or she is behind, will drop the oil bomb into the debate.

It looks as if we will go through another US presidential election with no candidate calling attention to the world oil problem, or to the North American natural gas problem.

Let's talk about money. What can individuals do even when their government tries to ignore the problem? Knowing that the oil peak is happening is almost like insider information. This was confirmed at the end of a financial discussion in Tokyo. The head of a firm told me that he had read Hubbert's Peak when it came out in 2001. He said that he believed my message, acted on it, and he "made a hell of a lot of money." I was later told that his firm was the biggest hedge fund in Asia. I didn't get to ask how many zeros there were in "a hell of a lot of money."

Part of the problem revolves around energy price volatility. On a time scale of several years, the world oil shortage is almost guaranteed to raise oil prices. On short time scales, momentary price excursions generate substantial paper gains and losses. Many days, I have to grit my teeth as prices drop on all my oil investments. A variety of investment opportunities exist: common stocks, bonds, futures contracts, and options for future sales and purchases. After one of my talks, two financial managers suggested that options on oil futures contracts would allow me to make large profits from a small amount of money. I bought a book on futures trading, and read about strategies like the short bull straddle and the iron butterfly. Besides their complexity, commodity options typically extend only about two years into the future; short enough times to be dominated by the price volatility. Further, I never got over distrusting the futures markets because of the way the Hunt brothers were treated during their silver excursion in 1980.

My first love in the oil investment market was a resource trust. In the simplest form, resources trusts purchase the "farmer's royalties," which is the 1/8 or 3/16 of the oil and gas income paid by the operating company to the mineral-rights owner. At one convention, I was told that the purest example of a royalty trust was Sabine Royalty Trust (trading symbol SBR). My first investment was in Sabine. I was delighted that it paid dividends monthly and in addition to the regular dividends, the share price staggered irregularly upward.

Sabine was a fixed entity. It couldn't waste money drilling dry holes. Also, Sabine's charter precluded investment in additional royalty streams. In addition, there was a sunset clause: if the income were to become less than $2 million per year, the properties would be sold off and the proceeds distributed to the shareholders. The sunset clause was kind of scary; my original investment principal would go down to zero. In the short run, the price for oil and natural gas was increasing faster than the Sabine production declined. But some day, production had to drop to zero. It seemed prudent to sell out well before the sunset. I now think that this might have been the right answer to the wrong question.

My response was to write a computer program to evaluate the present-day value of the future cash flow expected from Sabine. The actual production decline was recorded in successive Sabine annual reports. In addition, the annual reports contained reserve evaluations from the respected firm of DeGolyer and McNaughton. Future production was relatively easy to estimate. In addition, if the sunset clause kicked in and the assets were sold, a standard around the oil industry says that properties sell for roughly three years worth of production.

There were two big uncertainties: How fast does the price of oil and natural gas rise? What discount rate should I use to measure the present-day value of the future cash flow? Discount rates are emotional issues. Investors in risky businesses, like oil, often discount the value of future cash at 15 or 20 percent. The Federal Reserve interest rate is currently 5 percent. The Sierra Club insists that the future value of wilderness areas should not be discounted at all. I used both the oil price increase and the discount rate as axes of a graph, and computed the present-day value of the future cash flow for every point on the graph.

The result was a surprise. If Sabine were under priced, if the current price were less than the present-day value of the future cash flow, I would do better to ride off into the sunset while continuing to hold Sabine. If the resources trust is over priced, I should sell it off right away. For a wide range of price increase rates and discount rates, Sabine seemed overpriced. In a conference with yet another financial firm, I learned that the firm had also done a Sabine evaluation, which also showed it to be over priced. It was a bit of an emotional issue; Sabine was my first love. But, I had to put my money where my mouth is and I sold out my Sabine position.

The same firm had run evaluations of other US and Canadian resources trusts, as well as a different type of evaluation for publicly-traded US oil and natural gas companies. In addition to doing it right, they did a huge amount of work. I have protected the confidentiality of their work, and I ought not to use this university web site to advertise their wares. Further, they are selling an unregistered security and the Securities and Exchange Commission ruling of 1997 restricts their market to individual investors with more than $5 million in total investments. If anyone with more than $5 million in investments wants to send an e-mail to me, I will be happy to forward it to the investment firm. But no cheating, if you have only $4 million invested I'll forward your e-mail address to a Nigerian scam artist.

I've become the least glamorous kind of investor: buy-and-hold. No exotic straddles, no leveraged investments. A year ago, I eagerly read William Poundstone's book Fortune's Formula, in part because Claude Shannon (a founder of information theory) had a prominent role in the book. To my disappointment, Shannon was a stodgy buy-and-hold investor. I was hoping to read about something worthy of a hedge fund.

While I go along happily making a reasonable return on my oil and gas stocks, I have a second worry. If the price of energy goes up, the price of food goes up, and the price of gold goes up, am I simply watching the US dollar shrink? Is the almighty dollar riding off into the sunset? In one sense, my investments are a bank account denominated in barrels of oil instead of in dollars. It makes me nervous. Is the dollar sinking in the western sky?


 
 
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