I N V E S T M E N T R E S E A R C H S E R I E S The Future of Energy The End Of King Oil s Reign Oil It drives the planet; it is the fuel for transportation, a key source of heat and a critical component of virtually millions of products, from clothing to construction materials. But given that the supply is finite, there are two inescapable facts about oil and other fossil-based fuels: the supply eventually will be depleted and along the way, demand will outstrip production capacity. Increasing demand coupled with dwindling supply has already begun to drive energy prices upward. Recent volatility in oil prices serves as a warning: the price of energy, in particular the price of oil, will increase. Consumers should expect to pay substantially more at the pump in coming years. Investors should recognize that the pain at the pump offers, in our view, an opportunity to profit. How soon the world s supply of oil and oil equivalents will be exhausted is open to debate. There are a number of economic, political and environmental factors at play, including global economic growth, mid-east unrest, terrorism and conservation efforts. Further, as prices rise, new supplies of oil emerge as do efforts to reduce consumption. At current consumption levels, the world s known oil supply will be exhausted within the next 40 years, around 2045. The 40-year estimate may even be optimistic as, despite price increases, the demand from emerging markets, particularly China and India, are driving up worldwide consumption dramatically. Further, the 40-year calculation is based on an estimate of known oil reserves. Estimates of oil reserves are suspect as oil producers (both companies, e.g. Shell Oil, and countries) have a strong incentive to overstate their reserves. On the other hand, the 40-year estimate does not take into account undiscovered or unproven reserves. Exploration and advances in production technology will bring to light additional reserves. OPEC reserve estimates would have to be significantly inflated and new reserve discoveries surprisingly low for the 40-year estimate to be an overstatement. Under the most optimistic scenario, i.e. the doubling of known reserves through additional discovery, consumption growth will mean only an additional decade or two beyond the 40-year estimate until the wells run dry.
Fossil Fuels: Quantifi cation and Defi nitions While oil is the most ubiquitous form of fossil fuel, coal and natural gas can be similarly categorized. All three forms of fossil fuel can be quantified in terms of barrels of oil equivalent (BOE). One BOE equals six million cubic feet of natural gas. For coal, one BOE equals 0.2 (hard coal) to 0.4 (light coal) tons. Current estimates of known reserves for these three forms of hydrocarbons are: Oil: 1.213 trillion barrels Gas: 885 billion BOE Coal: 3.200 trillion BOE June 1967 Six-Day War October 17, 1973 OPEC Embargo January 16, 1979 Iranian Revolution For natural gas, the supply at present rates of consumption will be exhausted in 63 years. For coal, the known supply will last another 183 years. Between these fossil fuels the world consumes 61.7 billion BOE per year, which is 88% of the total energy consumption of 70.4 billion BOE per year. Background: The Economics of Energy Despite political claims to the contrary, energy is an elastic commodity, meaning that consumption and production behaviors change in response to price changes. There is normally a lag in change in consumption as a result of change in price. For example, it takes time for car owners to shift to more energy-efficient vehicles in response to higher fuel prices. A similar lag can occur in other conservation efforts as manufacturing plants require time to change production methods or shift to alternative sources of energy. Price per Barrel of Oil $100 $80 $60 $40 $20 $0 1960 1964 1968 Nominal Price 1972 1976 Inflation-Adjusted Price Monthly Prices Infl ation Adjusted with 2004 as base year 1980 The Price of Oil (1960-2004) 1984 1988 1992 1996 2000 Sources: Bloomberg; Datastream; Guinness Atkinson Asset Management 2004 Despite the recent increase in the price of oil and the claims that it has reached an all-time high, oil, viewed on an historic basis, is not exceptionally expensive. When measured in inflation-adjusted terms using 2004 as the base year, the price of oil is far from its all-time peak of just over $100 reached in November 1979. October 19, 1987 Black Monday From 1970 to present the average inflation-adjusted price for a barrel of oil has averaged $34. And while higher oil prices will depress demand, the January 16, 1991 Iraq-Kuwait Confl ict March 20, 2003 U.S. Invades Iraq
The U.S. Is Not as Vulnerable to High Oil Prices as Previously We believe that oil will breach the $100 per barrel benchmark at some point in the next fifteen years. price of oil had to average an inflation-adjusted $60 per barrel before oil consumption/production actually declined year over year. From 1980 through 1983 oil output declined for four consecutive years as the inflation-adjusted price averaged $69 per barrel. In 1984, as the price declined to an average of $50 per barrel, output once again began to increase and has increased each year since. All of this makes estimating the remaining lifespan of the world s oil (and equivalents) supply tricky business. Should the price of energy, particularly oil, rise dramatically in coming years it may not have the same effect that the oil crisis had in the 1970s. The bad news is this: the U.S. imports about 60% of its oil consumption, roughly 9.6 million barrels per day. This is significantly higher than it was in 1990 when the U.S. imported about 5.8 million barrels per day. Thus, on the surface we are more dependent on imported oil than ever. And, not surprisingly, the U.S. is consuming more oil at present than it ever has, about 20 million barrels per day, or 25% of the daily global production of oil. The good news is that the U.S. economy has grown sharply over the decades since the oil crisis of the 1970s and that despite the absolute increase in oil consumption (and imported oil), the amount of oil per unit of GDP has declined by 44% between 1970 and 2001 according to the Report of the National Energy Policy Development Group to the President in 2001. Part of this decline in percentage of GDP is the result of the low inflation-adjusted price of energy coupled with a growing economy. But a significant portion is a result of the shift from manufacturing to a service economy and impressive gains in conservation (most notably in the form of improving efficiency in factories, office buildings and homes). Clearly if energy prices double (and assuming no change in consumption or overall GDP) then the share of energy as a percentage of GDP will also double. But it is clear that the U.S. is in a better position to withstand higher energy prices than it was in the 1970s. It is our view that energy prices are headed toward significantly higher levels. We believe that oil will breach the $100 per barrel benchmark at some point in the next fifteen years and, further, that average price per barrel will be greater than $40, and possibly greater than $60, over the second half of this estimated span. Simple supply and demand forces will lead to this increase in price.
World Oil Demand Growth 2001-2004 (in millions of barrels per day) World Oil Demand Growth 2001 2002 2003 2004 China 0.1 0.2 0.6 0.75 Asia ex China 0.2 0.1 0.1 0.4 Rest of World Total 0.3 0.6-0.1 0.2 0.9 1.6 0.8 1.95 Source: IEA Oil Market Report Turkmenistan Azerbaijan Mexico Egypt Malaysia Australia Kazakhstan Norway China United States Canada Russia Neutral Zone Indonesia Algeria Libya Nigeria Qatar Venezuela Kuwait Iraq UAE Iran Saudi Arabia 50 50 Non-OPEC Oil and Gas Reserves Oil and Gas in billions of barrels or BOE Oil reserves Gas reserves 100 150 200 250 300 Source: Oil and Gas Journal Databook 2003 350 OPEC Oil and Gas Reserves Oil and Gas in billions of barrels or BOE Oil reserves Gas reserves 100 150 200 250 Source: Oil and Gas Journal Databook 2003 300 Supply and Demand Thirty-eight countries can be classified as major oil producers, 11 of which are OPEC members and 27 of which are non- OPEC members. Collectively these 38 major oil producers plus an assortment of minor oil-producing countries are sitting on the 1.2 trillion barrels of oil and 885 BOE of natural gas reserves mentioned above. Of course there is no real agreement about how large these oil reserves really are. What does seem undeniable, however, is that we are finding reserves now at a much lower rate than we are consuming them. According to one oil industry chief executive we are finding reserves at a rate of seven billion barrels per annum against our consumption rate of 30 billion barrels per annum. More relevant to today s price is the current daily supply and demand for oil. At the moment the world is experiencing an oil demand growth shock. In 2003 demand from the developed world, especially the U.S., grew strongly as did demand from China. In 2004 growth from these countries continues to be strong; further, the balance of Asia is increasing its demand for oil. On the supply front there are three components to consider. First, the rate of non-opec production capacity is growing. In recent years, the former
Oil Consumption and Production by Region Asia North America Europe West Africa Latin America and Mexico Former Soviet Union Middle East and North Africa -15 Production -10-5 Consumption Export or Import Source: IEA Monthly Oil Market Report April 2004 0 Amount of Oil in millions of barrels per day "Export or Import" = Production - Consumption 5 10 15 Soviet Union supply has been growing annually at a rate of about 0.5 million barrels per day. This growth, however, has been principally from repairing tired infrastructure and such a growth rate is likely to be hard to sustain. Additionally, West Africa, Canada and Brazil have seen another 0.5 million barrels per day annual growth in production capacity. But like the former Soviet Union, this growth is not looking easy to maintain. Meanwhile, output from the U.S. and North Sea is shrinking. Second, the potential for growth in OPEC production capacity is becoming increasingly smaller. At present, most of OPEC, with the exception of Saudi Arabia, is operating at near capacity. It should be noted, however, that it is difficult to ascertain what is really happening to OPEC production. Third and final is the question: how effective has OPEC been in managing supply? Since 1998, OPEC has been surprisingly effective in keeping supply well matched to demand, effectively keeping the world oil supply a little tight. It is this combination of strong demand, slow non-opec production growth and effective OPEC supply management which has been the major driver of recent increases in world oil prices. 20 25 30 Oil Cartels from Rockefeller to OPEC The daily price of energy is determined by short-term levels of supply and demand. At present, the most important determinate of supply is OPEC and the short-term oil price is almost entirely determined by OPEC s effectiveness, or lack thereof, in managing the oil market. Oil is a commodity for which short-term demand is affected little by price. As a result, relatively smaller amounts of over- or under-supply can have a remarkably large effect on the price. Hence the price of oil tends to be extremely volatile if it is not managed by someone. Because these booms and busts are difficult for individual companies to cope with, the industry has gone along with cartel-type arrangements for the last 120 years. Cartelization started with John D. Rockefeller in the 1880s. His role as cartel manager was inherited by the Texas Railroad Commission (which curiously had the job of regulating Texas oil output for 60 years) when Standard Oil was broken up. In the 1970s OPEC seized the baton. From time to time, such as in 1986 and 1997, the cartel has broken down, but it usually has worked. We believe that OPEC is now firmly in control; their activities are tacitly supported by most of the other players in the oil market, most notably the oil majors and the Russians. Even if none of these will admit it, they all benefit from a properly managed and relatively high average oil price. Despite the strength of the OPEC cartel at present, it is arguable that their role as price setters is waning. Each of the OPEC members is currently producing at near capacity with the exception of Saudi Arabia. Saudi Arabia is working to increase its production to counter recent increases in oil prices. At some point Saudi Arabia will also be producing at maximum capacity. Once all of OPEC is producing at maximum capacity it will have lost much of its ability to set a cap on the world price of oil, although it will of course retain the ability to ensure there is a floor.
It is our view that any meaningful increase in production will only come about as a result of meaningfully higher prices. Further, the Hubbert curve (see sidebar) would suggest that at some point in the next few years the peak in production will occur whatever the price of oil meaning that year-over-year declines of production are on the horizon. Long Term Supply and Demand Over the last 33 years daily oil consumption has risen by approximately 30 million barrels, just under one million barrels per day each year. In recent years over one-half of the growth in demand has come from Asia. In the last 17 years, Asian demand has grown by 10 million barrels daily. Looking forward, Asia is going to continue to be the engine of global oil demand growth. It is hard to see how it will not grow by at least this amount over the next 17 years. In fact, growth is more likely to accelerate as Asia goes through the energy intensive stage of economic lift off. If Asian oil demand were to grow by the same percentage over the next 17 years as it did over the last 17, it will have grown by 27 million barrels per day by 2021. To illustrate this growth in Asian oil demand one simply needs to examine the potential for growth in the Chinese automobile industry. At present, domestic Chinese automobile demand is rising dramatically towards two million vehicles per year. There exists a remarkable parallel between U.S. automobile demand in 1910 to Chinese automobile demand today. The simple statistics are these: China is producing one car for every 600 people. That equates to the U.S. automobile penetration in 1910. In the next 10 years U.S. car production and consumption jumped ten-fold to one car per 60 Americans. If China s car production were to follow that same trajectory it would equate to 21 million additional cars per year in a decade s time. This would mean that China would be approaching the same 150 million automobiles owned by Americans. Given that U.S. gasoline consumption is nine million barrels per day it is easy to see how China s consumption can rise dramatically. Based on 2003 data, the world is consuming approximately 78.4 million barrels of oil per day. For 2004 this figure is likely to increase by 1.9 million barrels per day to 80.3 million barrels per day. We estimate that oil consumption worldwide, at current price levels, will reach at least 100 million barrels per day in 20 years. In fact, if our estimate of an increase in demand from Asia alone in the next 17 years will add an additional demand of 27 million barrels per day, then the daily demand will equate to 107 million barrels per day without any increase in demand from the balance of the world. The question is whether production will be able to keep up with demand. Not surprisingly, capacity can increase as prices rise to support additional production. But that increase in production is really a function of cost. It is our view that any meaningful increase in production will only come about as a result of meaningfully higher prices. Further, the Hubbert curve (see sidebar) would suggest that at some point in the next few years the peak in production will occur whatever the price of oil, meaning that year-over-year declines of production are on the horizon.
The Hubbert Curve As a framework for thinking about the world s oil production and supply it is useful to understand the work of M. King Hubbert, the Shell geologist who in 1956 correctly predicted that U.S. oil production would peak in 1970. Oil analysts have applied Hubbert s methodology to world oil production and are predicting that world oil production will peak within the next 15 years. Essentially Hubbert s technique was based on the prediction that the production level for oil as it was utilized, would follow a normal distribution. Thus, if the U.S. had 200 billion barrels of reserves, when 100 had been extracted, U.S. production would begin to decline. Assume the world originally had three trillion barrels of oil reserves. If two trillion had been discovered thus far and one trillion had been consumed, then one trillion barrels would remain to be discovered. A peaking of oil production would occur after another one-half trillions barrels had been consumed, and this would probably occur in about 15 years. It is worth noting that Hubbert s methodology is based on a purely statistical analysis of exploration and production data. It does not take into account new development like tar sands which could potentially prolong oil supplies for a few decades. Nonetheless, the reason this analysis is important is that if demand is set to rise to 100 billion barrels per day and there isn t the production capacity to match, oil prices can only move in one direction: up. Hubbert Curve Projection of Global Oil and Natural Gas Liquids Production 1930 19401950 1960 1970 1980 Coal US-48 Europe Russia Other M.East Heavy etc. Deepwater Polar U.S. Natural Gas Liquids Russia Other Europe 1990 2000 2010 Guinness Atkinson Peak Year Estimate Middle East 2020 2030 Nuclear 2040 2050 Source: The Association for the Study of Peak Oil and Gas, C.J. Campbell, June 2004 In the fashion of Hubbert, Dr. Colin J. Campbell of the Uppsala Hydrocarbon Depletion Study Group in Sweden has produced the above graph showing his estimate of the peak production year at 2008. Guinness Atkinson is estimating the peak production year will occur between 2015 and 2020. Hydroelectric 0 35 30 25 20 15 10 5 Billions of Barrels per year Gas Oil Source: BP Statistical Review of World Energy June 2003
The Future of Energy As the world faces dwindling supply and higher prices for oil, there is a tremendous appeal to the idea of inexpensive, nonpolluting, renewable energy. As the cost of conventional energy continues to rise there will be more attention paid to alternative forms of energy. At present all alternative forms of energy suffer from some combination of economic, technical or scalable issues. Alternative Energy Cost Comparisons Type of Energy Efficient Coal Power Station Solar Wind Biomass Energy Cost per kwh 2-3 8-23 5 7 Sources: Dan Lewis, Economic Research Council UK; Peter Hoffman, Tomorrows Energy; Solar Integrated Technologies Fossil fuels account for approximately 88% of world energy consumption; nuclear and hydroelectric account for about 6% each; wind, solar and biomass account for less than 1% of world energy consumption. None of these alternative energy sources represents a threat to the dominance of fossil fuels at present. Over the coming decade, as hydrocarbon fuel costs rise, alternative energy solutions will gradually become economically viable, presenting investment opportunities as they develop. Until we reach a point that alternative energy makes meaningful inroads oil will continue to drive the planet. Before then tightening supply and demand for oil and other fossil fuels will inexorably nudge oil prices ever higher creating perhaps the greatest opportunity of the first quarter century of the new millennium the ownership and exploitation of the world s dwindling hydrocarbon reserves. This research paper is authorized for use when preceded or accompanied by a current prospectus for the Guinness Atkinson Global Energy Fund. The prospectus contains more complete information, including investment objectives, risks, charges and expenses related to an ongoing investment in the Fund. Please read the prospectus carefully before investing. Mutual fund investing involves risk and loss of principal is possible. The Guinness Atkinson Global Energy Fund invests in foreign securities which will involve greater volatility, political, economic and currency risks and differences in accounting methods. The Fund is non-diversified meaning that it concentrates its assets in fewer holdings that diversified funds. Therefore, the Fund is more exposed to individual stock volatility than diversified funds. Distributed by Quasar Distributors, LLC (07/04) 135N0704P Guinness Atkinson Guinness Atkinson Asset Management, LLC, sponsor of this Investment Research Series, is a specialist mutual fund manager. With offices in Los Angeles and London, Guinness Atkinson manages the Guinness Atkinson Global Energy Fund. Guinness Atkinson Funds 21550 Oxnard St., Suite 750 Woodland Hills, California 91367 800 915-6565 www.gafunds.com