Zaks Investment Advisory Service

Price and Cost Considerations, Alternative Sources of Oil and Synthetic Fuels

Today, we will continue our series of programs dedicated to energy, and first of all, oil. I would like to remind you that in previous programs we talked about how oil prices changed over the past 60 years, about natural gas and coal, about how much energy we receive from various sources, and also about how much more energy-efficient our economy has become. We used a fairly large number of statistics, which may be difficult to grasp by ear. In the Notes section of our site we have posted charts reflecting the price changes of the various energy sources. These charts provide a good understanding of the prices of oil, natural gas and coal in a historical perspective. These charts are, in a certain sense, unique: you are unlikely to find energy source prices compiled for the past 60 years, in today’s dollar terms, anywhere else. In our previous program, we also started talking about alternative energy sources, such as the oil sands of Canada. You may read our previous programs in the Radio section of our site.

The Canadian oil sands – even though relatively expensive to produce oil from – serve as something of a ceiling on oil prices: they may temporarily reach fairly high levels, but if they settle there permanently (above $80 per barrel, for example), investments will start flowing into companies producing oil from Canadian sands, and the amount of oil on the market will rise sharply. This will lead to a subsequent reduction of prices to a certain equilibrium. It is fairly hard to say where that equilibrium might be, but we will try – in our next show.

But now I would like to remind you that Canadian oil sands are not the only alternative source. Huge amounts of energy, in the form of so-called shale oil, are also concentrated in the shale deposits of Colorado and Utah, mostly in the so-called Green River Formation. Clay shale potentially holds 1.5 trillion barrels of oil. For comparison: the confirmed oil reserves of all OPEC member states add up to about 900 billion barrels. The problem with shale oil, as it is with the oil sands, is that it is difficult to produce. Shale rock is buried 200 feet underground, and extremely expensive infrastructure must be created in order to get production up and running. In the late 1970s, Exxon invested billions of dollars in the development of shale rock. But in 1982, when the price of oil began to fall, it completely halted all development, deciding that production from shale could not be profitable. In retrospect, Exxon’s decision looks reasonable: in one of our previous programs, we mentioned that in today’s dollar terms, the price of oil has dropped from $101 per barrel in 1980 to $14 in 1998. Now, however, with oil prices holding fairly steadily above $60 per barrel, companies are again beginning to invest money in research projects, trying to find the most effective technologies. Their goal is to produce oil at a cost of no more than $30 per barrel. We should hope they succeed, but even the most optimistic forecasts presume that industrial production will not start for another eight years.

Another extremely tempting technology is the process of turning coal into liquid fuel. This technology isn’t new: it has existed since the mid-1930s, created by the German chemists Fischer and Tropsch. South Africa used this very technology during its embargo. The world’s coal reserves are gigantic, and by today’s estimates, should last for several centuries (presumably over that stretch, we should master new energy sources about which we have no notion today). If it were possible to process coal into liquid fuel in relatively cheaply, we could use it instead of gas and diesel fuel, thus considerably reducing our crude oil demand. But the problem with coal liquefaction is the same as with oil production from shale. This process is expensive. Besides, it also produces a lot of carbon dioxide, a byproduct that due to global warming we treat like the plague. If the refining process is changed to have carbon dioxide collected under the surface of the earth, it becomes even more expensive. Without tax breaks and certain set-price purchase guarantees, this process is not economically viable at today’s fuel prices. But our Congress is extremely interested in any opportunity to become less dependent on OPEC states. There is thus a possibility that companies producing liquid fuel from coal might earn subsidies. Should this happen, shares in companies such as Peabody Energy, the largest producer of coal in the US, will get a big boost. As a matter of principle, subsidies are a bad idea. Thirty years ago, when Jimmy Carter was president, our government created the Synthetic Fuels Corporation. It survived for five years and, having squandered billions of dollars, was disbanded. Usually, when the government gets involved in the workings of the market, it all ends in tears. On the other hand, calculations show that should oil prices stay above $60 per barrel for an extended stretch of time, production of fuel using coal liquefaction processes would be profitable. The problem, of course, is that no one knows what the oil price will be in, say, five years.

We described three alternative energy sources: Canadian oil sands, the oil shale of Colorado and Utah, and the “coal to liquid” process. All three alternatives could be cost-effective – if we only knew the future price of oil. Next time, we will talk about how experts forecast prices of various energy sources, as well as whether we, as investors, could somehow use this information.

But now I would like to remind our listeners that on the Portfolios page of our site www.zaksinvest.com, we provide information about three model portfolios, and compare their performance to that of the market. Compare the return of your investments to our model portfolios. If you do not know what the return of your portfolio is, contact us and we will calculate it for you. This was Sergey Zaks. Thank you for your attention and until next time.