Oil Crunch!

By: David Chapman | Fri, Sep 2, 2005
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Words cannot be found to describe the devastation of Hurricane Katrina. One is both awed by the power of Mother Nature and the destruction it can wreak and the folly of man that created the towns and cities from the wetlands and bayous that used to absorb hurricanes of this force. Also we are marvelled by the budget cuts to New Orleans flood control (cut by 44% in the past two years) even as FEMA had identified New Orleans as one of the three most likely to be struck by a disaster. Eight months ago we were awed by the power of the Asian tsunami that killed tens of thousands and caused destruction in several countries. And while that turned into a massive relief effort it did not impact major population centres and the economic impact was largely localized.

This time it is different. Our hearts and sympathy certainly go out to the dead and the estimated million homeless. Most of us can only imagine what they are they are going through and how we would cope with something like this ourselves. The scenes are like a something from an apocalyptic movie complete with anarchy and lawlessness, some and of it driven by pure survival to obtain food. While the death toll will not even come close to the destruction of the Asian tsunami the relief and rebuilding effort will be immense compared to that disaster. The economic impact on the communities impacted pales the tsunami disaster. And even worse the wave generated by the disaster sends out an economic shiver across North America and the world.

Oil is the lifeblood of the economy. As much as we need to wean ourselves off of it, without it our economies would grind to a halt and we would in some respects be returned to the 19 th century. We are now going to face a crunch. While most of us can watch the misery of those caught up in the disaster no different then we would in passing a traffic accident, albeit a rather big one, we will feel the pinch ourselves at the pump and to heat our home this winter as the price of gas and energy climbs higher. Much higher.

So what has caused it? Quite simply Katrina slashed through what is estimated to be 35% of America's oil production and 20% of its natural gas. The US coast guard has said that at least 20 oilrigs and platforms were missing in the Gulf, either sunk or adrift. While apparently damage to the main offshore port known as the LOOP is minimal it has nonetheless been shut down. The LOOP is America's largest import terminal and handles 11% of US imports. Numerous pipelines have been damaged so the ability to transport anything assuming that the others were operatable has been severely constrained. Finally the refineries in the area have been severely impacted and according to articles out of 14 refineries in the area only one is operatable and one other reduced the remainder are either shut down (4), suffered loss of supply (3), water damage (3) and the remainder are barely functioning. Refineries in the area represent at least 10% of the US's refinery capacity.

Many of the refineries are operating with only skeleton staff. Many of the employees are amongst the homeless and will be unable to come back possibly for weeks or months. Assessment on the damage to the refineries will take over a week alone assuring that they will be out of commission for some time. Indeed they don't have electricity so assessment almost seems moot. Flooding may have caused debilitating damage. The ability to get the rigs back up and operating will be measured in months possibly longer. The LOOP can be restarted but the oil would have no where to go because the refineries are offline, the pipelines are shut down and the passage up the Mississippi is out of commission for an unknown period. 95% of the daily oil output in the Gulf is offline and upwards of 90% of the natural gas and across the nation it has knocked out 20% of all of America's production.

In order to try and combat this the White House announced that they were releasing oil from the Strategic Petroleum Reserve and apparently at the same time try and replace it. But the SPR only has 700 million barrels. This is a mere band-aid and will have little impact. And where are they going to get the oil to add to the reserves and at what cost as oil prices soar? It is about 50 days demand in the US (although a year and half of US production) and given that refinery capacity is already flat out and at least 10% capacity is off line possibly for months it really has no where to go. Gas prices are already reflecting the growing potential for shortages complete with huge price increases all at once and line-ups and shortages forming to get gas. Gas prices have already in some instances jumped 20% or more and are assured to go even higher. Airline companies are already cancelling flights, as they cannot get jet fuel. The entire airline industry already reeling may be put into its final death spiral. We may complain but there is essentially nothing that can be done.

The only oil producer that has any ability to expand production capacity is Saudi Arabia and from what we understand they are admitting they will be unable to meet oil demand even if they are able to increase it slightly. Compounding the problem is that other countries such as China and India and others will also be trying to add to their reserves at the same time. China is reported to have built huge holding tanks waiting to be filled that they will purchase at any price. Something will have to give. If the ability to expand capacity and add to world supply is virtually nil then how will demand be fulfilled given the fact that a significant chunk will taken off the world market possibly for months? The world uses a billion barrels of oil every 12 days and finds maybe if everything goes well 30 million barrels during that period. The reality is considerably lower.

With upwards of 3% of global supply possibly off the market for months the focus may shift to the world's oil producers. Oil we remind everyone is a political commodity. That is an unavoidable fact. Both the US and China have declared that oil is a strategic commodity. Both countries have strategic interests in far-flung regions of the world and troops are there as well to protect their interests. But many countries are unstable with rebels and civil strife and if even just one of these countries were impacted in a world already being squeezed between the growing demands and dwindling supply it would only add to the crunch.

Some of the countries that are potentially strife with rebel and civil problems that could disrupt oil supply are Cameroon, Congo, Ecuador, Colombia, Egypt, Kazakhstan, Turkmenistan, Uzbekistan, Indonesia, Iraq (where 3 years after the invasion to topple Saddam the country is producing only half what it produced under Saddam and an insurgency rages), Nigeria and Yemen. Two of the world's major oil producers are Iran and Venezuela. In Iran the US continues to sabre rattle over possible nuclear ambitions while both Russia and China have invested billions to ensure their own supplies and interests. Venezuela is in the process of cutting deals with China as they continue their spitting match with the US. Any attempt to overthrow President Chavez could trigger huge oil disruptions in this major producer. Saudi Arabia, the world's largest producer and holder of the world's largest reserves have suffered rebel strife. An attack on oil facilities would be devastating.

While Canada is a major producer and supplier to the US the political fallout from shortages in the US could have significant ramifications if the US under NAFTA exercised the energy provisions that say that Canada must supply the US even if it causes shortages in Canada. We emphasize. Oil is extremely political.

The fallout from Katrina may be just starting to surface. Already the growing shortages and line-ups in the US are reminiscent of the Arab Oil embargo. Gasoline futures are surging even faster than oil prices. In 1974 the Arab Oil embargo triggered the steepest recession since the Great Depression. Will this time be different? Indeed it could be worse as in the 1970's while production was peaking in the US it was still expanding in the rest of the world. No more. Production peaks according to the EIA and Dieoff, production peaks are hitting every oil producing country over the next five years.

Quite simply we are running out of the fuel for the global economy. Oh there is lots of oil, enough to last a couple of centuries, but much of the remaining reserves are hard to obtain (deep sea) in environmentally unstable places or in the Canadian tar sands and the Venezuelan shale fields. The costs to really tap into those reserves are far higher than current prices. And what remains today is coming under increasing guardianship as the global powers, primarily the US and China rush to protect or seize outright strategic interests. A conflict between these two oil superpowers could lie in the future as they try to protect their interests.

Katrina may turn out to be the economic trigger for a global economic reckoning that many of us have been predicting. Scoop has for years advised that we had minimum targets for oil prices of $70/$75. We are now there. It may only be a pause in the coming oil crunch. North America in particular and to a lesser extent the world is going to discover that oiloholicism has a cost. The major beneficiaries of this disaster outside of the human tragedy and rebuilding effort that will be required are the energy sector and ultimately the gold sector as the US$ falls as a result of the coming economic slowdown. Other sectors especially real estate and financials will come under increasing pressure as the costs grow and blowback occurs.


David Chapman

Author: David Chapman

Technical Scoop

Charts and technical commentary by:
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David Chapman is a director of Bullion Management Services the manager of the Millennium BullionFund www.bmsinc.ca

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