Tuesday, November 1, 2016

Swoon Factor At High Danger Level

In trying to anticipate any dangerous stock market collapses, I keep an eye on leading economic indicators, as I've written about before. But the truth is, no matter how much you study these things, the market has studied it more and will beat you to the punch about every time. I am a great believer in the efficient market theory, so I pay more attention to market behavior than anything else.

One such market behavior is breadth, what all the small stocks are doing that are not seen in the major averages we all look at. Smaller stocks seem to be more efficient in seeing things coming for whatever reasons. Maybe it's because there are more of them and they are less moved by en masse trading, ETFs and so on. So they discount information better as a group. Low breadth, when the smaller stocks are not doing as well as larger index stocks, happens often, but not always, in conjunction with major market declines:

This Business Insider chart from the article "The Stock Market's Breadth Is Unusually Shallow"  shows the red zone breadth levels occurring with the 2000 market top, the choppy, weak 2004 market, the 2007/2008 market top, the 2011 top, and it's showing up now. We are far in excess of the one standard deviation away from the 30 year average. But this condition also showed up several other times with nothing especially bad happening.

All the breadth calculations put moving averages, etc. into a formula and crank out a number. But another way to approach this is with the "eyeball" method. You can survey a set period of a stock's behavior, say 5 months, and classify it as normal or an abnormal swoon. This is somewhat subjective. But I did some surveying of the smaller stocks and used some rules for identifying an unusual swoon:

  • A steady change of slope of the 140 day ema from up to down
  • A persistent negative slope the whole period with widening divergence with the 200 ema
  • A change in trading behavior to high volume, sharp down moves below the 140 ema
  • A sudden large gap move down with no recovery breaking a normal pattern
  • A trading volume average of at least 2000 shares a day - a market participant
All this simply shows a profound weakening in a stock's condition. At any given time in the market, you will have a large population of stocks doing swoons, of course. But this population grows to a certain level just in front of rapid market declines, while the major indexes look fine.

I used this "swoon" consideration to look at small stocks in a steady, good market, mid 2005, and got a normal/swoon ratio of 5.6 showing the weakness level of my rules is a pretty small minority of stocks in a good market. Looking at a bad, but not catastrophic market, mid 2004, I get a normal/swoon ratio of 2.0 suggesting a non-precrash average of something like 4 normal to every swoon case.

To look at how this ratio foreshadows historic crashes, I look at the months just before the crash becomes evident, before there is anything looking scary. For the 2002 sharp crash, I viewed January to mid May when the market indexes looked fine. But the population of these breakdown cases amongst the small stocks was very elevated. You could tell something ugly was brewing by noting how frequently they were showing up. I got a 1.2 ratio there. This was after the recession was over. It was primarily a massive margin debt unwind, not a reaction to a recession.

Looking at 2008, I looked at mid year, while the major indexes looked very normal and get a 1.1 ratio. Looking at our present market, the Dow and Russell look nice. The economic indicators keep dancing between sluggish and pre-recession and have been for years. Since we are in an unprecedented period of weak but not recessionary numbers, I looked at 2014 to see if this was inducing any more swoon phenomena than normal. No, I get a 4.1 ratio there, perfectly normal. But looking at the previous 5 months this year, I am getting a 1.2 ratio - same as it was in front of the 2002 decline and about the same as it was in front of the 2008 decline. We now have the worst of both of these past two worlds - a market margin debt at record high levels and a brewing recession.

Does this mean the market must decline? No, these things can clear up and no one gets hurt. But until it does clear up. I, for one, am being very careful. It could be that we are morphing into a new no growth age for the global economy and this will dictate a vastly diminished population of the small stocks. There is a big difference in how levered small stocks are to economic growth vs the big stocks. If central banks are attempting to do away with economic cycles, and are accidentally shooting economic growth in the head in the process, then the huge population of small stocks will be whittled down over the years from here on. Maybe this is the beginning of that. The state of technical decay in nearly half the small stock world is an unstable condition and can't go on forever.

Sunday, October 9, 2016

What Hubbert Practitioners, Art Berman, and The EIA Agree On With Shale Oil

Oil Is Oil

A big problem with energy thinking today is the notion that "oil is oil" and it doesn't matter where it came from. Wrong! A major criticism you see of Hubbert is when they point to all the "oil" we've found (shale oil, tar sand, kindling wood) and throw it in the URR pot (Ultimate Recoverable Resource) and generate a production curve. This is not Hubbert's method at all, and when you see them doing this, you can ignore the whole analysis. It totally misses the vastly different set of recovery physics between conventional crude and shale, or anything else. Each set of physics demands its own Hubbert tabulation. His method can be done, for example, with the coal production of Australia, or any resource that has and will have fairly consistent recovery geophysics.

The shale oil of the US is ultra critical to oil prices and the world economy. A little considered fact with oil is that world conventional production has been declining since 2005 except for just two players:

Ken Deffeyes, using Hubbert knowledge he learned from him personally, wrote his book Beyond Oil: The View From Hubbert's Peak in 2005 where he said the peak is:
postulated as 24 November 2005 (`Thanksgiving' Day), after this date world oil will go into decline, slowly at first then more rapidly
This was for world conventional oil. Considering that the two players left out of the graph above are climbing almost entirely with shale (US) and bypassed oil (Russia) what you have shown is the world's conventional oil production. Deffeyes missed the peak by maybe a few days.

Isn't it ironic that these two big players, whose oil peaked over 30 years ago at the height of the cold war, are now both displaying a production resurgence that is changing perception of peak oil today. I discuss what's up with Russia here , which may have a lot to do with the cold war. But what about the amazing shale revolution of the US? It is very critical to the global picture, so it would behoove us to use the best projection tool there is to see about the future of shale. This method requires a few years of actual production data to make its projection. Now that we've had a few years of shale oil production, has anyone bothered to tabulate a true Hubbert curve for our shale oil ?

Yes. Tad Patzek has done a Hubbert curve on the two big shale oil plays of the US and published them earlier this year - "Is US Shale Oil Production Peaking?"

Who Is Tad Patzek?

Tad Patzek is Professor of Petroleum and Chemical Engineering at the Earth Sciences Division and Director of the Upstream Petroleum Engineering Center in KAUST, Saudi Arabia.  You can read his blog here.

He and Art Berman, a "good friend", collaborate to make Hubbert curves for both gas and oil in the shale fields. Berman supplies the data and Patzek does the rest. According to Wikipedia,
"The focus of his research is mathematical modeling of earth systems with an emphasis on multiphase fluid flow physics and rock mechanics [spending] years as a researcher at Shell Development under M. King Hubbert"
A fellow grasshopper of Hubbert, like Deffeyes, he generates curves per the methods used in his highly cited study  "A Global Coal Production Forecast With Multi-cycle Hubbert Analysis". If anyone on earth is qualified to make a Hubbert curve for Shale, it would be Patzek. Here is the Bakken:

And here is the Eagle Ford:

This is all very unsettling when you consider that the only thing propping us up from a return to Hubbert's curve for conventional, where we were driven to over $100 a barrel in 2012, is the current US shale oil boom we are enjoying. That's over 4 mb/d, and the two plays pictured above account for over 3 mb/d of that. Are we soon to lose our only prop saving us from peak net energy? This would have severe consequences on the price of oil out 5 years and beyond..

Patzek isn't the only one using Hubbert's method on US shale. David Archibald has done some curves that closely agree with the above in "The Imminent Peak In US Oil Production" posted over two years ago at Peak Oil Barrel, where the site's subtitle reads "The Reported Death Of Peak Oil Has Been Greatly Exaggerated".

The over-production problem I've discussed in other articles for the large conventional fields of Russia and Saudi Arabia may apply also to our shale oil when you consider that the shale drilling boom was fueled by free money and a massive debt frenzy. Instead of price wars or cold wars running the oil fields, we've had the bankers running our fields. The mechanics of shale over-production are different, but whatever they are, there has probably been a lot of it. A Bloomberg article "Refracing Is The New Fracking" points to one possible over-production mechanism, new fracking blasts before a well's first fracking production is over:
It’s easy for things to go wrong. If poorly executed, the maneuver could take oil from the producing zones of other wells, or worse yet, ruin a reservoir. Then there’s the concern that some industry analysts have that a refrack only accelerates the flow without increasing the actual total output over the life of the well. EOG is among the drillers that remain reluctant to start using the procedure.
Patzek views refracking as a poor substitute for making a good well to begin with:
As to the refracking the jury is out. Very poor wells may see some increase of production. Very long wells cannot be reentered towards the toe. Other wells may see the new fractures linking back to the old ones with no incremental benefit. I think that the technology of controlled refracking will improve, but I doubt if it will change the picture dramatically. The key is to make a good well first time around and improve how this well is hydrofractured. There is a lot of work done everywhere on this subject, including yours truly.
Arthur Berman is a consultant to several oil companies and provides guidance to capital formation and investment conferences. He is an energy contributor at Forbes and is interviewed often on CNN, CNBC, and other major media outlets. Does Berman buy this popular notion that we have many decades worth of shale oil to rely on? Well, he recently wrote an article titled, "Why Today's Shale Era Is The Retirement Party For Oil Production" wherein he states:
... looking at the Eagle Ford shale ... even the EIA shows Eagle Ford oil production peaking in 2016... Where do we get this decades of production? ... Eagle Ford isn’t going to stop in 2016; it will go on for many, many years, but at greatly reduced rates of production every year ... They look at the US tight oil plays and they see a couple of years, maybe five years before things start to fall off.
Rex Weyler, a director of Greenpeace said of shale:
In spite of huge shale and tar reserve discoveries, peak discoveries remain well behind us, in the 1960s. My father, a petroleum geologist his entire life (and still, in Houston, Kazakstan…), knew about shale and tar deposits when I was a teenager in the 1960s. He called them “the dregs.” These deposits are not really news within the oil industry. And they are the dregs because of high cost, low EROI and rapid depletion.
It is only prices around $100 that brings dreg oil out. Fracking was invented in 1947. It is less a technology revolution than a price revolution. Berman doesn't think the popular $60 figure for their profit point is right - more like $85-$95. He looks at free cash flow as a big measure of this. If you look at cash flow from operations on these companies, it's typically good if oil stays above $60. With free cash flow including a lot of future building cap-ex, Berman seems to be stretching present costs to cover typical future ambitions. He claims in the above article that, "these plays cannot survive on anything other than sustained $100, $90, $95 oil prices and that is the bottom line."

The profit points may be debatable, but the awestruck view of shale as new vistas of added oil supply seems like a pipe dream of either bad analysis or head-in-the-shale ignorance. Berman agrees:
... once your conventional production peaks, then you are going to be increasingly driven to more expensive, lower quality kinds of sources and that is exactly what we are seeing ...  Sure, we will find something more than what we have. Will we find the equal of what we found so far? Highly unlikely ...  I mean, these shale basins are not news ... The big companies have had teams of geologists and geophysicists and engineers studying them for decades ... so when the prices got high enough and the technology arrived ... companies knew exactly where to go.
If you look at the EIA total shale oil projection, you can see this "sweet spot first" effect evident in their production profile:

Here we see pretty much the same peak time frame for shale (yellow) as the Hubbert curves for the Eagle Ford and Bakken plays, the two sweetest of the sweet spots, with the super-fast ramp-ups in production. The giant, high quality Permian Basin is also contributing to this profile, but with a slower climb and a slower projected decline. The sharp climb pictured closely reflects what Eagle Ford/Bakken has done while the EIA sees the Permian and the sum of all the lesser plays coming on line hereafter plateauing a top and making for a much slower decline than just the two big play Hubbert curves. But they still see about the same overall top that the two big, explosive plays may produce by Hubbert linearization.

You have all these independent means of analysis in Tad Patzek,  Art Berman, and the EIA in close agreement. Patzek is using Hubbert's math method (with Berman's data) while Berman does meticulous well-by-well reserve data accounting. And they both agree on a shale oil production peak in 3 years or less. The EIA also is projecting this with a 2020 peak. If that's all true, in just 3 years, conventional will be declining along with shale oil. With these declines, the only meaningful prop keeping us above Hubbert's curve for conventional oil will then be buckling, and we will once more be in a losing battle with rising demand, as we were briefly before the shale sweet spots ignited in 2012. You will probably want to be long oil once this condition sets in, barring a really bad global economy.

Shale Oil outside the US

The EIA  says the US has 78 of world's 419 billion barrels of unproved technically recoverable reserves of shale oil. There is shale outside the US, but as explained in this study, "The Shale Oil Boom: A US Phenomenon" it is unlikely that the US shale explosion will be replicated elsewhere. The reason - logistics:

  •  The shale boom has depended on an exponential growth of wells drilled. Unlike conventional, shale oil requires punching holes in rock like crazy like a machine gun. No other country has anything like the drilling rigs of the US, where 60% of all the rigs in the world are. They simply don't have the tools or crews to make it happen. The study concluded that this is unlikely to change in this decade because of the time needed to build and man the right rigs and equipment.
  •  Also a problem is that the thousands of new wells a year will be impossible in the more populated areas like Europe due to environmental and other concerns.
  •  And nowhere but the US do you have the small independent oil companies that are needed to take on the fast moving, high risk business profile of shale. And in most other countries with shale, the property is state owned with issues unlike the private and freely sold property rights of the US.
  •  Also in other countries, they don't have the pipeline infrastructure or water supply needed by the water intensive shale business.
The study concluded:
For all these reasons. it is difficult to believe that a US style shale revolution may occur in any other part of the world in the foreseeable future.
The other shale plays in the world will be played - eventually. As oil stays high enough, these countries will deal with all the above logistic roadblocks, and this oil will find its way onto the market. If the "dreg" US shale card soon goes into a decline, there are other cards to play in global net energy supply. But how quickly can those cards be played?  It will likely be in small, erratic doses.

This is why it is so critical to build the natural gas bridge away from oil, as I and others have been writing about for 10 years now. Fracked natural gas has much different dynamics and will peak much later than oil, (around 2040 by Hubbert and other means) and is a much superior transportation fuel than refined oil. The Pickens Plan is needed more urgently now than ever.

Monday, September 26, 2016

Past Over-Production And A $100 Oil Norm For The Future

A Hubbert curve has proven to be about the most accurate way of estimating a production peak time frame for any resource extracted by a consistent method over the life of the resource. But there is one thing that rarely gets considered in Hubbert projections. In 1956, geologists ran the oil fields of the world. A conventional reservoir has an oil/water interface where pressurized water forces the oil up through the wells. Once the water migrates past this interface, as happens with faster rates of production, the drive mechanism for the reservoir is reduced. Oil gets stranded and can only be recovered by secondary methods at much lower net energy levels. Some water encroachment happens no matter what the recovery method over the life of the field, but geologists know just the right production rates to keep the drive at the optimal level through the field's life. Hubbert based his neat, symmetrical logistic curves on this in the peaceful 1950s.

But then we had geopolitical mayhem take over the oil fields. Saudi Arabia was the big swing producer (the Fed of oil) and, most of all, we had a cold war with oil financed expansion of the Soviet bloc, and an oil price war in the '80s and '90s between these two mega-players. It was a political soap opera, but suffice it to say that Russian centric geopoliticians began running the elephant oil fields of the earth. And they were not good geologists. This aspect of our present day energy markets is very rarely discussed or even considered. But its ramifications could be enormous. It is likely there was much over-production of the major fields with permanent reservoir damage.

No one can say just how much over-production and damage was done, and the secretive governments involved have never volunteered this information. The Wikipedia account for "Oil Reserves in Saudi Arabia" mentions Matt Simmons and his criticism of field management and noted:
"Simmons also argued that the Saudis may have irretrievably damaged their large oil fields by over-pumping salt water into the fields in an effort to maintain the fields' pressure and boost short-term oil extraction"
As I mentioned in this article, the decisive weapon deployed against Russia in the cold war was the Saudis' big production ramp and price war starting in the mid 1980s. There are those that claim this was in blatant partnership with Reagan, as this piece in the Telegraph details, with the main witness being none other than Michael Reagan, the president's son.

As for the massive Russian fields, well some say that, in the Soviet era, they were run as a military funding unit. They had no vibrant economy, so their massive oil fields were their prime treasury supply to build their empire, so they badly over-produced with poor technology. Russia is one of the most complicated oil cases on the planet, and opinions and future projections are all over the map.

But I want to present one scenario that would greatly alter oil price projections and energy investing out five years plus. I also should point out that over-production was not just a Russian thing, but they may be the biggest case of it. I should also point out how critical the Russian elephant fields are to the global production picture. The simple fact is that global crude has peaked and come off the plateau except for two players:

In the U.S. it is only the frantic shale boom diverging away from this peaking process. That's another story. As for Russia, it could be said that they are the most critical country in the world now for future oil pricing. This is because their production is over twice that of the U.S. shale and its future perhaps even shakier.

The following graph depicts the general effect of over-production:

The blue line is the kind of geologically sound curve Hubbert generated for the recovery of a large body of oil with just a little, maybe accidental over-production. The red line shows the effect of severe over-production, and has the effect of steepening the climb on the upside, but also steepening the decline rate an even greater amount after the peak with a greatly damaged field. 

As you can see from the graph, the price paid for all the added oil extracted pre-peak is a lot of oil that gets left in the damaged field. The peak time frame is about the same, thus Hubbert's peak time accuracy, and the total oil extracted is roughly the same. So how does our actual oil production history look so far?

This is a logistic fit of crude consumption done by Graham Zabel in 2007 and shows a couple interesting things. First, it's logistic, so it should be in accordance with Hubbert methods for peak projection. It is not Hubbert's method, but does show how well our production history so far is falling into line with typical, sound geology. It includes about 10 mb/d of the usual add-ons to conventional crude, but it does show the 2005 arrival at a bumpy plateau we've been on with conventional oil ever since.

Second, it shows us just where the over and under production areas are on the natural curve. From the late 1930s to the mid 1960s we had mild under-production, due in part to an economy emerging from the Depression. Then we had a booming economy and a historic surge in the principle use of oil, U.S. driving, amounting to over a doubling of miles driven from 1962 to 1977. This sent oil into mild over-production. Then a dramatic improvement in average gas mileage (and other oil uses) induced by the Arab oil shocks sent mileage up from 13 mpg in 1975 to 22 mpg in 1985. We also had a big slowing in the climb of miles driven. All this dipped the oil production curve back to mild under-production. Overall, as can be seen in the above chart, what was soundly produced and consumed followed market forces pretty closely.

So how did the dynamic duo of field mismanagement, Russia and Saudi Arabia, respond to all this?

Per this study by Political Economist, these two mega producers, making about 1/4th the world's supply, severely over-produced in response to the driving demand ups and downs, but the Soviet cold war financing over-production went on long after the driving demand dropped in the mid '70s. This went on until the Saudi ramp-up drove the Soviet oil industry to ruin in the '90s. Things have since settled back to typical Hubbert dynamics (red curves) as calculated here by Political Economist. But was there field damage?

I again refer you to the opinion of Matthew Simmons. He was an oil investment banker in the industry since 1973, was an oil advisor to the president and a member of the Council On Foreign Relations. He went through a mountain of SPE papers (Society of Petroleum Engineers) to write Twilight In The Desert in 2005. There was massive damage according to Simmons. He claims significant damage in Saudi Arabia, but also had this to say on Russia:
"The oligarchs who own and operate most of Russia's oilfields are aggressively tapping into the myriad pockets of bypassed oil ... This performance demonstrates the steps that can be taken to boost production after a field has been reduced to pockets of bypassed oil that water sweeps leave behind. These practices have accounted for most of Russia's surprising production rebound. But they are temporary, one-time remedies ... all oil fields have their rate sensitivities . Ignoring this concept and over-producing jeopardizes future production for any field, even in such prolific oil provinces as Western Siberia and Saudi Arabia." Twilight In The Desert, Matthew Simmons, p.307
One could look at the Hubbert curves above and say that Russia and Saudi Arabia aren't due to peak until clear out to beyond 2030. But there is serious doubt among Hubbert mathematicians whether the classic single curve is appropriate for these two cases. You could consider the curves shown above as "what should have been". Generating a Hubbert curve is based on the production physics staying about the same. When there are two vastly different ways of producing a large body of oil, like a country, sometimes a double curve is generated to better project the future. The very prolonged and severe over-production of the Soviet era could be considered a whole separate set of physics, and would justify a double math treatment for Russia, and by extension, to Saudi Arabia as well:

Sam Foucher, an oil analyst, presented the above in 2007 as his best Hubbert fit of what's to happen with Russian oil. I have added the data points through 2015. It has proven to be pretty accurate so far almost 10 years later. Russian production continued the rapid rise to just below the former peak and has been struggling to climb much higher in a similar plateau top as the '80s. If this projection plays out, it means Russian oil will soon turn into the same king of fast decline as the fast upside of the '60s and '70s and the fast decline of the '90s.

This view of Russia's oil future is from mathematicians viewing public data available on a secretive government from the outside. What do the Russian's themselves foresee? Russia projects their own oil future with a couple of Russian think tanks in "Global And Russian Energy Outlook to 2040". In that work, they conclude :
"Conventional oil (excluding NGL) production will drop to 3.1 billion tonnes by 2040 from the current 3.4 billion tonnes, and the long-discussed 'conventional oil peak' will occur in the period from 2015 to 2020. The drop in its extraction will be due to the gradual working-out of reserves of the largest existing fields." (p35) "Exports of petroleum products will peak in 2015 and will then gradually decrease ..."(p111)

Note they say here exports will peak in 2015 - that's the end of their contribution to the staving off of global decline for anyone living outside of Russia. This would leave just the U.S. shale prop in the global picture. Here is how the Russians see their crude in the years ahead:

"From old" means the oil they see coming from their existing aging elephant fields, so named because they can't be missed in exploration, and 99% of this oil globally has been found for over 30 years. This chart is based on two very optimistic items. First, it displays a 4.5% annual decline rate from the old fields, the "standard" rate applied to global post-peak fields. If these fields were greatly damaged as Simmons says, the decline rate will be much greater than that. Second, the blue parts of the bars are presenting the finding and exploitation of many more elephant equivalents. Good luck with that.

To give you an idea of how differing the explanations are on Russia, consider this fly in the ointment with the Simmons view above. A poster at The Oil Drum claims to have this simple explanation of the '90s rebound in Russian production:
About a month ago, I had the pleasure of spending 5 hours with the Chairman Emeritus of the most prestigious petroleum engineering consulting firm in the world as part of the SPE Distinguished Lecturer program. His firm has done reserve/ engineering studies in every major producing area of the world. He spent a lot of time in Russia over the past 12 years. He told me I wouldn't believe the principal reason for the Russian production increase from 1995 to 2005. They didn't have well tubing that had the tensile strength to run below 1,000'!!! As a result, the bottomhole pumps were set to 1,000' or shallower in all their wells. When they started tubing them deeper and pumping them down, here came the oil.
So this expert is saying the poor Soviet materials they had limited the wells to 1000' or less when clear back in the 1950s, average well depths were four times that. They were just scratching the surface in Russia!

But this explanation flies in the face of most expert opinion on Russia. It could be that they were just exploiting the top layer of oil fields and bungling that with over-production, putting a damaged cap on a lot of stranded oil to be recovered later with secondary recovery at lower production rates and low net energy levels. In my comments on the above cited article, I said this back in 2007:
Russia's very big part in the global peak can not be considered apart from the very large impact of the very large Soviet Union. The Russian production chart isn't a case of a single peak per Hubbert's theory, but what is going to be a twin peak ... One interesting article is this one written by an Air Force major in Air University Review in 1980. Way back then, he sounded just like Simmons today only talking about Soviet fields and predicting a production collapse by the mid '80s (which, in fact, did happen) ... He points out that Russia ambitiously directed over half of their oil exports to Eastern Europe and other parts of the expanding empire, and other geopolitical factors that led to serious overproduction where "...rewards for exceeding goals are given without regard to productivity over the long term ...The consequences are...overproduction of existing fields using low productivity techniques that reduce the total amount of recoverable oil." The major was thus accurately predicting the first Russian peak (a Twilight on the Tundra).
The Russian over-production was apparently bad enough to be a military cause for concern in 1980, just before the production collapse of the mid '80s, which was about it for the primary recovery of conventional crude according to Simmons. But as I said earlier, we mustn't just blame Russia for a possible field damaging production spree in years past. Any country with the elephants and an urgent need for oil revenue was about equally to blame:

Venezuela's chart looks even worse. In fact, the study by Political Economist cited in these charts looks at the top 11 mega producers, and all but Canada, US, China, and UAE have been severe over-producers. I'll give Iraq a pass on this since its erratic chart from political instability can't tell us much. Did everybody in the oil business over-produce. The study gives a chart for global production without these top 11:

Note that it is dropping off sharply from the 2005 peak.Clearly, not everybody over-produced. It was the large field owners that stepped in to the driving demand excess 45 years ago that were also playing all the political fun and games.  The geologists weren't in charge as they were elsewhere. The vast majority of the earth's fields were run sensibly. But here's the thing - The big 11 producers account for over 70% of the projected global peak production. They have done their deeds to the earth's elephant fields, the irreplaceable ones that have been mostly exploited. This soon may come back to haunt us.

Governments running oilfields is still a problem, as this article "Oil's Dark Secret" details. About 90% of the post-peak half is owned by state-run companies. Because they are not good at exploiting what they've got, "oil production will be even more concentrated in the hands of the national firms of Russia and the Persian Gulf."

All this is not good news for those of us stuck on the post-peak side of conventional oil's foreign affairs fun and games. Energy planners and forecasters tend toward an existing field post peak average decline rate of about 4%. But consider this. The Cantarell elephant field of Mexico, as recently as 2004, was the biggest producer in the world except for the Saudis' Ghawar field. It was over-produced in its later stages and has declined now to just 12% of its peak production, a 14% annual decline rate as opposed to the widely assumed 4% for existing production.

All fields behave differently, but if we are underestimating over-production damage to our elephants, we could all be in for a surprising oil production decline rate from damaged fields. Without the policies and infrastructure built needed to get us off the high net energy of conventional oil, with such things as The Pickens Plan, we may be left with a net energy crisis a few short years down the road.

This all sounds very gloomy. But there is a lot of high cost oil out there yet to be drawn into the market by high prices. We found that out when oil was at $105 and climbing in 2012, which drew a flash of American shale oil out of the rock. I'm writing an article on what's really out there in shale, and it shows that the U.S. shale experience is not easily replicated globally. But it will be replicated! Due to several factors, global shale oil will be slower to ponce on high oil, and may be more expensive. And I think oil will be cheap for a while before global shale supply is activated. But we are going toward a global secondary recovery cost norm (think bypassed oil, shale and other "dreg" oil). It's expensive but there is a lot of it. We think of the break-even cost for shale as about $60. But Art Berman believes that counting the typical total balance sheet tendencies of these aggressive companies, it's more like $100 for the "going concern" oil price. Oil at $200 will mean serious demand destruction and belated switch-over to natural gas. So I see oil modulated at $100 or a little more for a long time, if we can keep net energy from falling over the math cliff, as I discussed in this article- a big if.

We (Marketocracy) are publishing an article at Forbes online this week about an investing strategy for all this and a discussion of one stock in particular. The tentative article title is "Russia, Saudi Oilfield Mismanagement" in interview format with Ken Kam as the contributor. You can google to read it, probably later this week.

Friday, September 16, 2016

We Still Despatately Need a Natural Gas Bridge

[This is a republication of part of an article I wrote back in 2011, when oil was marching up to its highest average price ever in 2012. Now a shale oil blitz has taken everyone's mind off the need for anything but oil. But as I will show in a future article, this may not last very long. In the meantime, when we should be using the shale reprieve to help in a scramble to get our transportation switched over to natural gas, we are instead leaving the Natural Gas Act of 2011 dead in the Congress. This will come back to haunt us in the years ahead]

I have said in many past writings over the years that the US is the global village idiot when it comes to energy policy. I'd like to reiterate that here. But there seems to be a change happening in our Washington D.C. that is warming the heart of me, T. Boone Pickens, Jim Cramer, Harry Reid and a whole new army of nat gas fans.

I have described the danger of trying to safely get to a post carbon world without a carbon bridge. The problem with solar, hydrogen, ethanol, and wind is that they take about as much fossil fuel to make these forms of energy as the energy it gives us. They do not displace much fossil fuel if any. There are exceptions, like sugar ethanol; but until we have a good scientific handle on what is really worth a big infrastructure build, in net energy terms, we desperately need a good old fashioned high net energy bridge fuel - like natural gas.

Even before the fracing revolution of the last 5 years, there was a span of about 25 years between the Hubbert calculated peak production of conventional crude oil and the corresponding peak for conventional natural gas. As we pass the oil peak, and I'm referring to oil from conventional pressurized reservoirs which takes relatively little energy to retrieve, the still climbing nat gas curve starts to form a criss-cross where we embark on the "bridge" to a stable energy supply for the next couple decades. If you put all the forms of energy on a time-line, you see this bridge and its relation to the developing fuels of the future: (click to enlarge)

You basically have the huge separation by scale between the fossil fuels and the renewables. The fossil fuels are here and now while the renewables are a tiny fraction of our supply and aren't going to replace fossil fuels any time soon. This is why Washington's veto of anything with carbon in it is so dangerous. It prevents maybe a fraction of the CO2 that gets emitted by volcanoes and other natural sources, but surely cripples a massive share of our energy supply and keeps a post peak-oil bridge from being built for the civilized world.

As the chart shows, a twenty year bridge can be built on either coal or nat gas. Coal has two major problems. It is dirty, and it is of questionable net energy. You can burn it as has been done for hundreds of years with decent net energy, but poison our globe. Or you can go the CTL route (Coal-To-Liquids) and put coal derived fuel into your gas tank without having to burn it. The problem with this is that the EROEI (Energy Return On Energy Invested) calculations I've seen for this process are all over the map with most of them around 3.5 or so. This doesn't do much good in displacing crude - you need around 6 or higher, nat gas and oil are estimated at 8-11 currently. CTL certainly needs to be developed, as Sasol SSL and others are doing. But we know that nat gas is 30% cleaner than the oil we're using and we know that the shale gas net energy, at least for now, is good. The recent tech breakthrough in fracing, by the way, pushes the nat gas peaking curve much further out into the future.

The combination of peak oil and gas fracing has radically altered the oil and gas markets. Traditionally, one could judge valuations of the oil or gas price by just multiplying gas by 6. But the last 5 years has seen the end of this age:

We are now entering an era of troublesome oil prices and cheap nat gas. I still see arguments that gas must rise because it's so out of sync with oil. But that won't happen until a massive switchover of usage happens from oil to gas.

Which brings us to The Nat Gas Act of 2011. This bill was introduced into the House mid year and now has been sent to the Senate as of late November. It used to be mostly a Republican idea, but it is gathering strong bi-partisan support with Senate Majority Leader Harry Reid a key ring leader. This bill would give tax breaks to the purchase and usage of trucks designed to run on nat gas, and other gas infrastructure incentives. It's strengthening support is chronicled in DC Tripwire: NAT GAS Act: Is The Time Finally Right ?

Wednesday, August 17, 2016

Marion Hubbert and Boone Pickens On Oil's Mess

The price of oil is as difficult to predict as it is important to investors' economic outlook.  Books have been written on a correlation between climbs in oil and subsequent recessions so that all you had to do is look for a swift enough climb in oil to know that a recession was soon to follow.  But for every such analyst, there is one who points to weak oil as a sure sign of recession at hand.  Whatever your views, we all know oil is the 800 pound gorilla in the economic china shop.  So when accomplished oil price experts like Daniel Yergin and Boone Pickens speak, investors lean, hand cupped to ear, to listen.

Hubbert's Curve

In the early days of oil in 1956, a Shell geophysicist named Marion Hubbert, a much more obscure expert, developed a math model of oil production.  He was reviled as crazy, almost unpatriotic in the robust American oil business of the 1950s.  But his projection method called for a peak in US production in 1970, after which would be a permanent decline.  And that actually happened:

The red line is Hubbert's math projection made in 1956, and the green line is how it actually turned out.  The above Wikipedia chart is for the lower 48 and doesn't show the large contribution of Alaska in the '80s. But Alaska wasn't even a state in Hubbert's 1956 model.  His math was for conventional oil from naturally pressurized reservoirs (the only kind of oil they knew back then) and it has essentially proven to be correct.

But then, along came shale. This unconventional bonanza has blown the needle far away from Hubbert's curve of physics for conventional reservoirs.  Drilling horizontally in oil laden rock and propping open fissures with sand fracking is a totally different recovery with a whole new set of physics and planet of reserves. This departure from Hubbert's world can be seen very graphically in the US production history above. Two things happened to take us far away from the conventional curve, deepwater oil in the Gulf, which started in earnest in the mid '90s as the above chart shows, and the recent shale revolution, the radical explosion starting in 2009.

So, as Hubbert's projection for a global peak approached in the early 2000s, slightly fewer considered him a lunatic because his US prediction had been so accurate.  His global peak prediction was refined mathematically by Ken Deffeyes, a Shell associate of Hubbert's, as being 2005.  So how did Hubbert's global prediction turn out?  Well, that crazy man was right again:

The peak was 2005 right on the nose, just as Deffeyes pegged it in his 2005 book Beyond Oil
and in his 2001 book Hubbert's Peak: The Impending World Oil Shortage where, according to Amazon's review :
Deffeyes used a slightly more sophisticated version of the Hubbert method to make the global calculations. The numbers pointed to 2003 as the year of peak production, but because estimates of global reserves are inexact, Deffeyes settled on a range from 2004 to 2008
You see varying levels of this "conventional" oil from about 74 mb/d (EIA numbers) to around 84 mb/d depending on how many NGLs (natural gas liquids) and other things are included in "oil".  NGL is from gas production, so purists don't like lumping them in with crude production dynamics.

Here we see a rough breakdown of just what is propping us up from the disasters of peak oil. The two big props are the pale green one and the pink one - that is fracked gas liquids and shale oil (unconventional crude).  If it weren't for the gas shale fracking revolution that came along, natural gas production, along with the associated liquids, which get put into the "oil" totals, would have plummeted long ago.

This difference in conventional crude and total liquids is behind all the arguing over whether peak oil was right or wrong. "Peak total liquids" has not happened yet, and with shale, may not happen for a long time.  Peak conventional crude did happen, and it happened exactly as Hubbert and Deffeyes said. It is also what Boone Pickens has said.  Without the pink prop shown above, we would be put back on Hubbert's curve, and Pickens estimates something like $175 oil would result.  And without the natural gas shale fracking giving us the green prop, oil would probably be even higher, if the economy could stand it.

Boone Pickens On Peak Oil And The Saudis

The two vastly different types of oil source never gets explained very well, and few understand the difference or its immense implications.  This is very evident, for example, in the tempestuous Dec. 23, 2014 CNBC Squawk Box interview with Pickens, right after the sharp collapse in oil, where Joe Kernen calls anyone who still believes in peak oil a nut saying "that was a horrible call".  Pickens responded, "You need to go back and look at what happened to oil production without the United States."  Kernen then goes on about the Malthusian bet on world catastrophe.  Pickens responded, "Yeah, well that's all good bullshit and all  [this cracks Kernen up] ...in 2005, you peaked.  Go back and look at it ... I'm the expert, not you ...what saved you was the shale."  The conversation meanders from there with Kernen complaining that "oil is oil", not understanding much about the oil business. Shale is as if we traveled to a whole new planet and began farming it and adding it to our earth oil that we've been poking a holes in underground balloons for.

Anyway, all this has abruptly propelled us far away from Hubbert's curve into a world now drowning in oil.

As if all this natural over supply against a weakening global economy wasn't enough of a price killer, we have the price war aspect of oil production as a nasty reality in our world today.  Saudi Arabia, thought of as the swing producer, operates mainly conventional fields with high EROI (net energy and ease of extraction) and they frown on significant competition.  They not only frown on it, they annihilate it.

Some say this is really what happened with the fall of the Soviet Union in the late 1980s.  Reagan's arms race was a real pain for the Soviet economy.  But as the forbes.com article "It's Time To Drive Russia Bankrupt - Again" pointed out:
It wasn't Reagan's massive defense build-up, or his Star Wars program, that drove the Soviet Union to the wall; it was the decline in real oil prices caused by the Reagan/Volker/Greenspan strengthening of the US dollar.

The Saudis rubbed salt into those monetary wounds, because Russia was co-leader in the world's oil production at the time with poor quality fields nowhere near the Saudis' EROI and profit price.  The Saudis gunned production with their better fields to levels beyond prudent oil field physics and flooded the market with oil just below Russia's break-even price - and Russia suffered an economic collapse.  Thus we had the dramatic decline in prices going into the late '90s while Russia's inferior fields were being put out of business.

The Saudis have been aiming that same gunnery at their new enemy, the US shale producers now, as Boones Pickens has often pointed out. In a 4/28/16 article in The Tulsa World titled "T. Boone Pickens calls U.S. oil industry 'dead in the water'."  they said of Pickens:
Since 1980, he recalled in an interview, he has watched oil prices plunge five times worldwide. Four of those times, he said, Saudi Arabia stepped in to cut its oil production, balance the market and bring prices up again. The fifth time — this time — the Saudis kept pumping away, prices stayed low and U.S. companies let their drilling grind to a near-stop. Pickens doesn’t expect them to resume anytime soon ...
The Saudis could be waiting for the destruction of the shale industry before they bring prices back up again. Are they really that cut-throat?  Pickens certainly thinks so.  On the pending public offering of Saudi Aramco stock :
 “It’s a joke,” he said, because stockholders would own stakes in a company still very much subject to Saudi politics. “Who the hell would want to own Saudi Aramco?”
You could, however, make the case that it's mainly the shale explosion that is acting as the swing producer nowadays, not the Saudis. Take a look at this chart:

Here we see that total shale has added 5 mb/d to the world's production whereas the Saudis have been flat since mid 2011, and their market moving excess capacity is thought by Pickens to be only about 1-2 mb/d.  In a price war, are they fighting with a pea-shooter compared to the shale guns?

Well, fighting they are.  And they're putting up a pretty good scrap.

Pea-shooter or not, OPEC is the only one shooting any ammo in this war.  Their lifting costs are only about $15 a barrel, lower than anywhere.  The higher cost US and Russian producers are not trying to keep any lid on prices and aren't trying to drive anyone out of business.  But Aramco is a state run company, meaning that they run the government with their oil profit.  And they need about $80 oil or they must cut services, impose taxes, or dip into their cash reserves of $750 billion built from $100 oil.  In the current price melt, they are burning that reserve at $6 billion a month, a rate that will leave their peashooters empty soon.  So it's a rope-a-dope strategy by everyone against them, hoping they exhaust their arsenal soon and have to live with oil climbing over $60, limited only by real supply and demand in the US/Russia production onslaught.

The Saudis may soon become a more a victim of low oil than a victor.  As was pointed out in an article "Saudis Will Not Destroy The US Shale Industry" at The Telegraph, their temporary ploy can only force the shale properties and technology to change hands, not ever be destroyed.  For all the damage they inflicted on Russian oil in the '90s, Russia is now the world leader in production, outdoing the Saudis.

I have said all that to say this: the price of oil is not controlled by supply and demand equations you can tote up and say price must do this.  It is controlled by aberrant malinvestment cycles gone crazy, geopolitical price war machinations, surprise innovations, and about everything under the sun that any sane investor avoids.  For about 5 brief years from 2003 to 2007, oil pricing was between price wars, economic collapses, and surprise innovations; and Hubbert's curve took firm control as the peaking of conventional ran us way short of oil.  I was fascinated with Hubbert's theory and went long energy in those years.  But ever since it was de-Hubbertized in 2008, I have avoided the whole sector.

Oil simply has way too many layers of unpredictability in it now, many I haven't even mentioned - like Iraq's future flood of the only significant light, sweet fields left unexploited , and the very dangerous net energy problem with shale.  Boone Pickens has a history of making some very good calls on oil, but over the last couple years, he has been way wrong, calling for $80 in early 2015 by the end of that year, and missing big on the high side since then.  I'm not knocking Pickens.  I am a great fan of  US natural gas as a bridge fuel in trucking and the whole Pickens Energy Plan for America.  I was writing on this bridge fuel thing years before he went to Congress with his proposal.  He is on my short list of people I'd like to see as Secretary of Energy, president, or whatever position could enact The Plan.

But I think oil has gotten to be almost uninvestable, and even the best predictors are stumped.  We are in a transition zone.  On the other side will be a stable shale industry, in different hands, and it will be a good investing area again. We aren't there yet.

Adding to all the mess oil has gotten into is the whole banking aspect of it.  As we all know, the shale drillers have borrowed heavily in the NIRP free money years with oil above $55, putting their fortunes in the same boat with a great many banks.  Now with the oil oversupply keeping the price in the range where conventional oil profits but shale doesn't, the Saudis are again showing little mercy on their competition, and are thus at great odds with banking as well this time.  But this isn't 1988, and in this derivative crazed banking world we live in today, if they do to shale what they did to the USSR, we all could be in a heap of trouble.  The Saudis are probably aware that the shale debt craze has put $2 into the ground for every $1 of revenue, and they just have to keep oil below $60 until the shale companies fold up.

We are going to have banking troubles while bankruptcy courts redistribute the valuable shale properties, until the US shale is "restarted" after oil stays high for awhile.  In the above mentioned The Tulsa World article, Pickens was speaking at a gathering of supply-siders, including Art Laffer, Steve Forbes, Larry Kudlow, and some fund managers:
It’ll be hard to start the United States back up,” he said ... They pressed Pickens on how high prices would need to rise to bring U.S. oil rigs back online en masse; he said higher than $40 or $50 a barrel — probably closer to $60.
If we stay in a stable price war, with excess conventional capacity from the likes of the Saudis keeping the shale industry throttled, we will eventually be put back on Hubbert's curve where no excess capacity exists anymore from shale or anybody; and, as Pickens is predicting, prices will then ascend and slowly bring shale back.  This would likely be a gentle process of perhaps many years. We should be so lucky.  If the Saudis' price war and the banking problem induce shock into the financial system, a badly hurt global economy could have a not so gentle effect on oil.

All the aforementioned changing-of-hands of the valuable shale assets may provide some adventurous plays for the brave with some of the assumed prime beneficiaries of such a shuffle of the cards.  That would be the cash rich big oil companies looking to rebalance between conventional and shale assets.  The abrupt shale explosion has them way behind the curve on this.  Some companies to consider there are Exxon Mobil (XOM) Royal Dutch Shell (RDS/A) and ConocoPhillips (COP).  Conoco in particular is making a "massive wager" on US shale according to a Bloomberg release from a little over a year ago "ConocoPhillips Bets On Shale In Major US Spending Shift".  They are "pledging" to spend 50% more over the next three years, and much of that may be pennies on the dollar if the shale bust continues.

But I think such investment plays would have to be considered as much higher risk than what we normally think of with such names.  We have an unprecedented confluence of unstable, opposing mega forces acting on oil right now.  So my best investment advice with oil is - don't even go there.

Sunday, July 31, 2016

Gold And The Banks

A lot of things are said to drive the gold market, but a good argument can be made that banking health is a major driver, if not the major driver.  I made this point about our current markets in my article "Gold, The New Anti-Commodity, And Derivatives".  After comparing the resurgence of GLD to a few of the usual suspects that gold is supposed to respond to, and finding little or no correlation, I compared gold to the inverse of the financials, and here we do, in fact, find a pretty solid correlation going on right now :


In horseshoes, we call this a "leaner," the next best thing to a dead ringer. Here we see that gold has been strongly correlating to the inverse of the financials. It's the banks that gold seems to be mainly concerned with ...
Over the years, there has been a very strong correlation between the big gold moves and bank health. This isn't talked or written about very much as gold is supposed to move opposite the dollar, opposite the stock market, or as a result of interest rate changes.  But if you examine history, you find that the most massive gains in the gold miners tend to happen when very serious trouble is engulfing the banking world.

It certainly was so in the 1930s. As I pointed out in my article "A Study In Crashology", there were a lot of moving parts in the puzzle back then.  Most people think the stock market crash in 1929 was the immediate cause of the Depression.  But this market event was just a big valuation correction of speculation in the Roaring '20s, and just a garden variety recession was going on in the economy.  In fact, we were recovering from this recession when the real trouble started. What happened to cause something more was the involvement of the banks with Wall Street in all this reckless speculation, and the fact that many banks lost so big in the stock crash.  This giant problem led to the Glass-Steagall Act of 1934 that put up a wall between banks and investment - no mingling of depositors' money and speculation.  More than any other factor, this banking illness induced one of the mega bull markets in gold mining.  In historical context, it looks like this:

Looking at the historic gold miner climb "A":

 Here we must use Homestake Mining as our index (since none existed back then) but other giant gold miners such as Dome Mines did a similar thing.  Please note that in the years 1924 to 1929, both the gold miners and the stock market were bulls, which isn't supposed to happen, but it does all the time.  Also note that the huge miner move wasn't some baseless fear contagion without a dime of fundamentals behind it. The above chart has the earnings and dividend payout yearly, and as you can see, these did a monstrous climb as well. But perhaps most noteworthy about this chart is that the horrible stock market crash of 1929 barely caused a ripple in gold mining shares.  It was the approaching bank problems that sent the miners into a much higher gear.

Another bout of serious banking problems hit during the Savings and Loan Crisis of the 1980s. Before this was over, nearly 1 out of  3 Savings and Loans went under at a horrendous bail-out cost.  Despite all the supposed protections built into the system, this speculation mess cost every tax paying American over $1000 chipped in from their own wallets.  This was during a grinding bear market in gold after the 1980 bull market peak, but the gold miners did a spectacular climb at the peak of the bank failures:

There was the stock market crash of October, 1987, but the gold miners got clobbered along with that, and the only other significant thing going on in that year to cause a whopping 100% gain in the XAU miner index in a gold bear market in less than a year was the severe trouble in the banking world.

At the Federal Reserve History web site, the piece "The Banking Panics of 1931-1933" blatantly said that gold responded to the banks:
On September 21, 1931, Great Britain left the gold standard—that is, withdrew its promise to provide a specific amount of gold in exchange for its bank notes (Wicker 1996).  Foreigners became concerned the United States would do the same and began converting their dollar assets to gold. This external drain caused a large reduction in the US gold supply.  At the same time, depositors became concerned about the safety of banks and withdrew currency from their accounts, creating an internal drain on the banking system (Friedman and Schwartz 1963).  Together, these external and internal drains reduced the money supply, deepening the deflation which propagated the depression.

Can such a horrible thing happen again?  Don't we have the FDIC to protect us?  If a mass withdrawal panic were to happen again, the FDIC would cover about the first 1% of failure.  At the leading edge of negative interest and the other bank destroying avant-garde measures is Japan, and there we see home safe sales are soaring.  This is not a good pied piper to be following.

You may have noticed on the above chart of bank failures that a boiling pot of trouble comes along every 36 years, but at the 1944 juncture, just the opposite happened - a virtual disappearance of bank trouble - for 36 years.  What strange thing happened here, and what does it have to do with gold?  Bretton Woods happened and it had everything in the world to do with gold.

This was a conference in July, 1944 in Bretton Woods, New Hampshire, where 730 delegates from  over 40 nations came together because they were all sick of the banking and currency troubles that had beset the nations ever since we strayed from monetary gold and silver starting in the late 1800s.  We created the Federal Reserve System in 1913 thinking we had little need for precious metals in our modern economies.  And we had experienced a world war and a punitive treaty against Germany that resulted in an inflationary destruction of that nation.  This had led to yet another world war.  And in the meantime, we had allowed wanton speculation in the bank world to take depositors' life savings and demean our whole economy into an unnecessary depression.

We fixed all that.  Glass-Steagall was put into effect in the mid '30s to protect our banks from the careless speculators, and Bretton Woods was signed in 1944 to strictly tie the world's finances again to gold. The goal was to prevent competitive currency devaluations and over leveraged Wall Street (vs real economy) investing.  Does this sound familiar ?  By Wikipedia's account,
In the 1920s, international flows of speculative financial capital increased, leading to extremes in balance of payments situations ... Flows of speculative international finance were curtailed [ by Bretton Woods ] by shunting them through and limiting them via central banks. This meant that international flows of investment went into foreign direct investment (FDI) - i.e., construction of factories overseas, rather than international currency manipulation or bond markets
This sounds like all the things that need to be stopped today.  At Bretton Woods, the upshot of their wrangling was that the US dollar was strictly set to convertibility to gold, and the rest of the world's currencies strictly (+ or - 1%) set to the US dollar.  Could such a thing even really work? Well, judge for yourself:

Duh - yeah, I'd say it could work.  It worked until Richard Nixon in 1971 and Bill Clinton in 1999.  President Nixon undid the gold part.  And now the rats have been let back out of their cage and are well on their way to ruining the world again.  In 1971:
A negative balance of payments, growing public debt incurred by the Vietnam War and Great Society programs, and monetary inflation by the Federal Reserve caused the dollar to become increasingly overvalued.  The drain on US gold reserves culminated with the London Gold Pool collapse in March 1968.  By 1970, the U.S. had seen its gold coverage deteriorate from 55% to 22%.  This, in the view of neoclassical economists, represented the point where holders of the dollar had lost faith in the ability of the U.S. to cut budget and trade deficits.

In 1971 more and more dollars were being printed in Washington, then being pumped overseas, to pay for government expenditure on the military and social programs ... In response, on 15 August 1971, Nixon ..."closed the gold window", making the dollar inconvertible to gold directly, except on the open market.  Unusually, this decision was made without consulting members of the international monetary system or even his own State Department, and was soon dubbed the Nixon Shock.
Then, president Clinton undid the Glass-Steagall part.  And we have had one banking crisis after another ever since with the biggest one probably yet to come.

Regarding the historic panorama of bank failures shown above, you may notice that the great gold bull market of the 1970s had no correlating bulge of bank failures.  We can actually explain that in just three words - Richard Mischievous Nixon.  He said he wasn't a crook, but his Watergate lying was just the tip of the ethics iceberg.  He passed himself off in elections as a fiscal conservative, but per the account at Investopia "The Great Inflation of The 1970s":
Nixon ran budget deficits, supported an incomes policy and eventually announced that he was a Keynesian ... John Maynard Keynes was an influential British economist of the 1930s and 1940s. He had advocated revolutionary measures: governments should use countercyclical policies in hard times, running deficits in recessions and depressions. Before Keynes, governments in bad times had generally balanced budgets and waited for malinvestments to liquidate, allowing market forces to bring a recovery.

 "Malinvestment" is the key word David Stockman now uses in describing the unprecedented problems banks face today, where natural market forces have been obliterated.  Stockman was Reagan's Office of Management and Budget (OMB) chief and wrote the recent best seller "The Great Deformation" describing this historic destruction of free market forces.  He greatly helped us get out of Nixon's '70s mess.  Going into the 1972 election, Nixon wanted cheap money no matter what:
President Nixon's primary concern was not dollar holders or deficits or even inflation ... Nixon fired Fed Chairman ... Martin, and installed presidential counselor Arthur Burns as Martin's successor in early 1971.  Although the Fed is supposed to be solely dedicated to money creation policies that promote growth without excessive inflation, Burns was quickly taught the political facts of life.  Nixon wanted cheap money: low interest rates that would promote growth in the short term and make the economy seem strong as voters were casting ballots.
Nixon got his cheap money and the election.  He said "We'll take inflation if necessary, but we can't take unemployment".  We soon had both after he was bounced out of office.  Jeremy Sigel (Stocks For The Long Run author) is quoted as rating this "the greatest failure of American macroeconomic policy" since the Depression.  And although Americans generally think of this dark period as the fault of the OPEC oil shocks, The Wall Street Journal is quoted as saying, "OPEC got all the credit for what the U.S. had mainly done to itself."

So the 1970s saw a great gold bull market, no bulge of bank failures, but all the key things that cause bank failures, dished out by Nixon, were there.  The gold market knew this. The banks, however had just been through the massive strengthening measures of nearly 30 years of Bretton Woods and had withstood the relatively brief onslaught by Nixon after he did the hatchet job on the agreement in 1971.  Thus, no bank failure bulge on the map above.  We are in a far, far different situation today with our banks.

Actually, the actions of Nixon did have their ultimate impact on banking, for it was the destabilized interest rates he caused that were a prime cause of the Savings and Loan Crisis.  It just took about 10 years to boil up.

So will we have a return of the 36 year cycle of banking trouble start to boil again in 2016, 36 years after 1980 and the start of the last banking failure debacle?  We have been papering over banking problems since 2008 with an unprecedented blizzard of measures unhinged from gold.  The gold miners have certainly looked at the bank world this year and clearly do not like what they see there.  As seen above, their market signal has been reliable in the past.  It isn't really a secret that bad energy company loans issued in the aberrant zero interest frenzy of the last several years are a problem right now for banking.  And many are saying it's just a passing energy sector thing, contained, like sub-prime was to be.  But if you dare to peak at a broader picture of this bad loan thing, you see this:

Looking at all loans, we are entering a very typical pattern of a long bottoming of bad loans now sharply ramping up into the recession zone.  But I think the gold market could be looking at something more ominous than this - the out-of-control derivatives books of the web of major banks, especially in Europe.  There is a danger that continued commodity weakness, especially in copper and oil, could bring on another derivative storm, as happened in 2008, only with much more derivatives in a much more unstable environment in interest rates - what 75% of derivatives are based on. We have gone from projecting four interest increases this year to now projecting zero and resorting to helicopter money in the space of less than one year. This is not a stable environment for the $700 trillion derivatives hot potato to be tossed around in.  It is the banks primarily playing this game of hot potato to the detriment of us all.

But as I said in my recent article on Jim Grant's helicopter money call and its relation to gold:
The printing presses can seemingly fix anything forever, but the ultimate in all this may be evident at what Jim Grant referred to above as the leading edge of all this monetary lunacy, Japan.  There we see home safe sales are skyrocketing.  And in another avant-garde corner, we have a recent piece on Italy's banks and who and how to bail them out of their mismanagement and insolvency.  After exploring all the "emergency liquidity" options, the article concluded:
The real threat is if the local population wakes up to the risk of holding their savings in a financial system that is now teetering on the edge, something Renzi [ Italy's prime minister ] himself admitted when he said that he "hoped to use a liquidity backstop to contain investor panic, which could result in a run on deposits and affect banks’ liquidity." Because even if it buys up every bond, loan and stock in the world, the ECB will not be able to fix the public's loss of trust in fractional reserve banking.
Gold and bank troubles are strongly linked, and both appear poised for bull markets.

Thursday, July 28, 2016

The Helicopter Paradigm

Jim Grant made a most  interesting call on the markets back in September.  He is something of a perma-contrarian residing out of the box in his thinking.  According to a recent article  in the Dallas Morning News "Wall Street Stars Look For Truth In Packaging" Jim Grant and his Interest Rate Observer have a "star quality" track record.  Of Will Danoff, editor of the Observer, it said he:
manages Fidelity’s $110 billion Contrafund and has one of the best track records on Wall Street over the last 25 years
So what did Jim say recently that was so interesting?  Clear back in September, 2015, when everyone and their dog was debating the only important topic of the day - how many times and when will the Fed hike rates because the economy is so good on its own now - Grant wrote an article titled "Jim Grant On Helicopter Money And The Comeback Of Gold".  Mind you this was back when gold was still dead, buried, and detested, and very few were buzzing about helicopters.  On the free credit binge of recent years leading to malinvestment and mismanagement, resulting in mass loan troubles resulting in more stimulus needed, he said this:
So it’s seemingly a never ending, circular process of so called stimulus leading to still more stimulus and unconventional ideas leading to radical ideas. I dare to say that we have not yet seen the most radical brainwaves of the mandarins running our central banks.

What do you think this will look like?  They don’t keep those things as a secret. They talk quite openly about "direct monetary funding" which is what Milton Friedman had in mind when he coined the phrase “helicopter money”.  So the next idea is just bypassing the banking system altogether and mailing out checks to the citizens.

Would something like that even work?  All this monetary stimulus does two things in a reciprocal way:  It pushes failure into the future and brings consumption into the present. Providing marginal businesses with very cheap credit is inviting companies that have passed their useful days of their commercial lives to pretending some kind of an afterlife thanks to the subsidies from the central banks.  But capitalism is inherently a dynamic system based on entrepreneurship and to new inventions. It’s a little bit like the forest for the trees: You need life but you also need death.  Without death there is no room for a new generation and what you get is Japan ...
According to Grant, we have arrived at what Marc Faber has been projecting in monetary policy now for the last 15 years, and I've been writing articles about for the last 7 years - something he has been calling "zero hour", where a law of diminishing returns for each new monetary debt dollar added gets lower real economic return, which goes to zero in 2015.  It has happened to the year per Faber's projection 15 years ago! In the September, 2015 article, Grant said:
This is a monetary moment. I think we are looking at the beginning of the world’s reappraisal of the words and deeds of central bankers like Janet Yellen and Mario Draghi.  What we’re waiting for is a sufficient recognition of the monetary disorder.  You see monetary disorder manifested in super low interest rates, in the mispricing of credit broadly and you see it in the escalation of radical monetary nastrums that are floating out of the various central banks and established temples of thought: Negative real rates, negative nominal rates and the idea of helicopter money.  So you need some hedge against things not going according to the script and that makes gold and gold mining equities terrifically interesting now.
"Now" meaning September, 2015 and he was so right.  There are many now saying that the coming helicopter era means a booming stock market again, and this must be the end of gold's upstart bull market.  This is the old teeter totter thinking on gold and the stock market.  If one goes up the other must go down.  I beg to differ.  It's not that simplistic and history proves it. There are many different gold measures over history. You could just look at the gold price, but before 1971 you had a government set gold price and the only investment available was the gold miners. All the miner indices have originated long after 1971 except the Barron's Gold Mining Index BGMI.  So to compare apples to apples, let's look at this index:

Here we see two cases of raging bull stock markets being shaded only by two raging bull gold markets.  The 1960s stock market was glorious, rivaling any period in history.  During this time, gold was set at $35 an ounce, but was highly sought after for currency purposes.  It was becoming more and more of a strain to gold back currency until, finally, Nixon "closed" the gold window and gold was set by market forces. Here was a clear case of the miners strongly leading the metal price. It was a currency thing back then.

Another case of gold bull and stock bull living in harmony was this:

A five year bull market existed from 1924 to 1929 in both stocks and gold miners. The BGMI didn't exist back then, but Homestake Mining was a behemoth that represented what the miners did.  Dome Mines was another giant that was a remarkable performer during those years.  Here again, as FDR confiscated and revalued gold, it was a currency thing.

In the 1990s, the Alan Greenspan Fed made loose money and the "Greenspan put" the modus operandi of the markets, including the housing market.  During 2002 to 2008, as this currency debasement proceeded into a debt crisis, it was again a currency thing.

Now with helicopter money, it looks to be yet another currency thing that will drive gold, and again we see the miners very strongly leading the metal price, just as they did in the above graph going into the banking failure epidemic of the early 1930s.

It seems more likely that, instead of a simplistic teeter totter relation between the stock market and gold, we will see the more historical relation play out.  Jim Grant was spot on with his September call on the turn to helicopters and gold, and that relationship will probably continue.

So we would be "pushing failure into the future" as Jim Grant puts it, but how far into the future?  Well, all kinds of instability develops with all this pushing.  Deutsche Bank is often discussed as the "too systemic to fail" entity.  Doesn't this just guarantee a helicopter bail out, even though it's supposed to go directly to the people?  The people will have to be protected against frozen ATMs won't they?  DB is a bank, and it is just the poster child for all the big banks, and in our digital, derivative laced world, all of our banks. The people will function only if their banks function. The bank stocks, by the way, have sunk far, far below their all time highs, and many critical bank shares are falling fast.

So how far can all this go?  I don't know, but I can't help but consider a simple thought experiment. Picture if you will, the following scene. You are taking your hard earned money to your trusty bank and are greeted with the pretty sign out front that says something like "Yada Yada Bank and Trust".  That's what banking is all about, you know - trust.  When you sign to create your account, the fine print actually says you are giving your money to them as their property to do with as they please. Traditionally, this meant the bank loaning it out and making profits with interest, and giving you back your money, all of it, whenever you say.  In this post Glass-Steagall, negative interest rate age, it doesn't mean that anymore.  It means they are thinking, as they are in that bold frontier in creative socialism, Greece, that a bank's depositors are legally bound to bail a management sinking from derivatives gone awry or whatever other problems crop up from their stupidity. "Bail-in" is the new buzz word for it. They used to call it bank robbery.

So as you stroll past your bank's trust sign, now picture a helicopter chopping the air, and you see that it is unloading an emergency treatment of money to your trusted bank.  This is because the trusted management of your trusted bank has so screwed up that the chopper load is its only way to survive.  As you carry your load past the sign, with the helicopter landing on the roof, you hesitate with your bundle of hard earned money.

The printing presses can seemingly fix anything forever, but the ultimate in all this may be evident at what Jim Grant referred to above as the leading edge of all this monetary lunacy, Japan.  There we see home safe sales are skyrocketing.  And in another avant-garde corner, we have a recent piece on Italy's banks and who and how to bail them out of their mismanagement and insolvency.  After exploring all the paper-over "emergency liquidity" options, the article concluded:
The real threat is if the local population wakes up to the risk of holding their savings in a financial system that is now teetering on the edge, something Renzi [ Italy's prime minister ] himself admitted when he said that he "hoped to use a liquidity backstop to contain investor panic, which could result in a run on deposits and affect banks’ liquidity." Because even if it buys up every bond, loan and stock in the world, the ECB will not be able to fix the public's loss of trust in fractional reserve banking.
A new paradigm may not fix what depositors will think of the helicopters on the roof.