Petrocapita UpdateMarch 2011

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OIL PRICES, POSITIVE FEEDBACK LOOPS AND THE BACK OF AN ENVELOPE...

With the recent unrest in some of the world’s most critical petroleum producing regions I thought I might spend some time on the topic of oil prices. However, rather than engaging in what I believe is the largely futile exercise of attempting to predict the price of oil next week, next quarter or even next year, I want to try to address two more fundamental questions. What is the long-term risk to real oil prices from 1) a further economic downturn and at the other extreme 2) accelerating growth in the emerging economies? Research from Cambridge Energy Research Associates provides the answer to the first question. By comparing the cost of production of the various sources of supply that make up current daily production volumes you find that demand would have to drop by approximately 15 million barrels per day (around 20% of daily consumption) to create sustained $60 per barrel prices. The reason for this is straightforward - the seventy million remaining barrels of daily supply would be unprofitable below this price. It is the incremental barrel that sets the market price and as we are in an environment where the production costs of large amounts of incremental oil are very high (think offshore and oil sands) prices must to remain high otherwise supply is shut-in and disappears due to lack of profitability Of course, most analysts have given up forecasting large demand drops for now - certainly not on the order of the 20% it appears is required to create sustained $60 per barrel oil prices again. What is receiving a significant amount of attention is the nature of the energy demand emanating from the emerging economies - it has surprised most analysts in being both large and resilient over the last 3 years. And now for that “back-of-the-envelope”

Petrocapita Update

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Petrocapita Update (continued)

analysis promised in the title. Is it possible to quantify the effect of the emerging economies on oil prices over the next decade? Here is a simple thought experiment using Chinese demand to generate some rough numbers: – China moves from 3 barrels per person per year

to the South Korean level of 17 barrels per person per year

– Transition takes 30 years– Consumption changes are linear– No peak in global production In next 10 years we would have to find 44 million barrels of oil per day (“BOPD”) or around 50% of current production - 26 million BOPD to maintain supply and 18 million BOPD to keep up with demand increases. Now superimpose peak production on top of this demand profile using the following parameters: – Oil demand elasticity of -0.3– Current production 84 million BOPD– Assume pre-crisis starting price of US$ 80 per

barrel– Peak production 100 million BOPD– Post peak decline rate of 3-4% Based on the foregoing, oil prices would increase approximately 250% in real terms over next 10 years - obviously something would have to give in the global economy long before that point and that something would be demand. Just how realistic is it to assume such an enormous affect on the markets from China at the margin? In

its “Energy Outlook 2030” BP predicts that China will be the largest source of oil consumption growth over the next 20 years - increasing consumption by 8 million barrels per day to 17.5 million barrels per day - overtaking the US as the world’s biggest oil consumer. According to the report, developing nations, accounting for 93% of global energy growth over the next 20 years, will drive global energy consumption. In much more detail, according to a report by Joyce Dargay and Dermot Gately: “Two liters a day - that’s what per-capita world oil demand has been for forty years. Yet this constancy conceals dramatic changes. While per-capita demand in the OECD and the FSU have been reduced - primarily due to fuel-switching away from oil in electricity generation and space heating, and by economic collapse in the FSU - per-capita oil demand in the rest of the world has nearly tripled, to more than 1 liter per day. In addition, the rest of the world’s population has grown much faster than in the OECD and FSU (1.85% v. 0.74% annually). As a result, the rest of the world’s total oil consumption has grown seven times faster (4.4% annually, versus 0.6% in the OECD and FSU) - increasing from 14% of the world total in 1971, to 39% today. If annual per-capita oil demand growth rates to 2030 were assumed to be held zero in the OECD, 1% in the FSU, and at its 1971-2008 historical rate (2.54% annually) in the rest of the world, total oil demand will be 138 million barrels per day in 2030 - about 30 million barrels per day greater than what is projected by DOE, IEA, and OPEC. By 2030 the rest of the world’s per-capita demand would be almost 2 liters/day, and its share of total world demand would increase from 39% now to 58%.”

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Petrocapita Update (continued)

Clearly we have some grave challenges building on the supply side. Let’s now delve into another part of the oil price issue that receives far too little attention in the mainstream media - rapidly depreciating fiat currencies and developed nations that for the most part must import large amounts of oil to satisfy domestic consumption and maintain an energy intensive way of life. For example, the US must import around 10 million BOPD (over 10% of global output). How is it possible for western nations to pursue weak currency policies while remaining highly dependent on imports to satisfy domestic oil demand? I often write about the law of unintended consequences as is fitting in a time of unprecedented intervention in the operation of the free markets by non-profit maximizing state actors. Today is no exception. Zero interest rates and their associated money supply expansions may yet serve to bail out the insolvent banking sector but will severely impact the western, middle class way of life via escalating food and energy costs. Channeling the spirit of Rudolf Havenstein, the president of the Reichsbank who oversaw the German hyperinflation of 1921-1923, US Federal Reserve officials have recently been saying that higher oil prices may be the catalyst for further quantitative

easing - to translate for uninitiated, our central bankers are saying that they will need to print more money in order for us to pay our oil bills. The thought that it is the rampant debasement of the world’s fiat currencies that is lurking behind oil’s rise over the last 6 months seems never to enter their minds. Please feel free to contact your local central banker with the definition of a positive feedback loop as I think they may be about to have one demonstrated to them in a very graphic and grizzly fashion. In any event, given the reckless behavior of the developed world’s monetary authorities and the supply/demand fundamentals in the oil markets I believe we will continue to see upward pressure on prices - certainly in nominal terms and most likely in real terms as well. For this reason I remain interested in direct investments in physical production assets over the long-term. Direct ownership of production assets removes the risks and costs bound up in oil equities with their need to engage in exploration to maintain reserve levels. In addition, direct ownership of production assets eliminates a number of critical counter-party and agency risk issues, provides recourse to a physical asset and the returns are of course commodity linked but with ongoing cash flow.

Kind Regards

Stephen Johnston

#400, 2424 4th Street SWCalgary, Alberta T2S 2T4Canada

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