29 March 2008

A New Era in the Energy Sector

by Joseph Dancy

Last month we delivered a lecture at Southern Methodist University to our Oil & Gas Law class on the 'New Era of Oil: The Age of Scarcity'. This is not a standard law school topic, but relevant when discussing the legal history and development of market demand prorationing, allowables, and conservation regulations.

Our thesis is that we are entering the fourth era of the oil age – one the world economy has never experienced before. This era will cause many disruptions, but will also create investment opportunities that arise only once every few decades.

From the discovery of crude oil in the Drake well in Pennsylvania in 1859 until the East Texas Field discovery and development in the early 1930’s we had a situation where supply was growing exponentially. Increases in demand did not keep pace so the price of crude oil plummeted. Governors shut in oil fields to prevent overproduction and waste. Arising from these problems the Texas Railroad Commission and other regulators obtained the statutory authority to restrict incremental oil production to match global demand.

The second era lasted 1930 to 1972 as state regulators like the Texas Railroad Commission restricted production to stabilize the price. When the production of crude oil peaked in the U.S. in 1972 the role of the Railroad Commission in restricting production passed to the Organization of Petroleum Exporting Countries – the third era of oil. In each of the first three oil eras we had excess productive capacity to meet the rising global demand and any short term shortages that occurred.

Going forward we find ourselves in the position where global demand for crude oil is now approaching the ability of the world’s producers to extract production – and soon demand will exceed productive capacity. For the first time ever we will have no excess global productive capacity to meet growing demand. In such an era – never seen before in the global economy.

We expect the following:

(1) wildly volatile crude oil prices - mostly to the upside,
(2) resource nationalization - the material is too valuable to export,
(3) irrational hoarding behavior by consumers,
(4) a spillover of price volatility into the markets for other energy sources (natural gas especially),
(5) a wild frenzy to acquire domestic oil and gas resources (property deals and deals on Wall Street),
(6) a melt-up of the energy and energy services sector,
(7) a focus on energy conservation,
(8) new opportunities in the solar and wind energy sectors,
(9) more attention on biofuels (emphasized by the 2007 Energy Act) - which incidentally will drive grain prices to record levels, and
(10) as a result of the extreme increases in food and fuel prices we expect to see food shortages, instability, riots, and the like in less developed countries.

One of the most significant developments we expect to see, besides much higher energy prices and volatility, will be the interconnection of the global energy and agricultural markets – tied together by biofuel initiatives. Adequate capital has not been allocated to the energy and agricultural sectors in the face of global physical and political challenges – and that historic misallocation creates great opportunities for business in these sectors. The energy and agriculture markets are quickly converging, which points to much higher prices for both commodities.

Because of these trends we remain heavily over-weighted in the energy and agricultural sectors. The evidence of a new era for both energy and agriculture – reflected in global production and demand data – is compelling.

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