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Counterpoint: Middle East Turmoil is Bullish for Oil

Lou Gagliardi is Hedgeye's Managing Director of Energy Research.  The following is a note he published yesterday in response to Daryl Jones' note "Could the Turmoil in the Middle East be Bearish for Oil?"


At Hedgeye, we emphasize risk management; that entails encouraging different perspectives and in-house debate to ensure our clients are presented with a breadth and depth of thoughtful research. In the pursuit of that goal, my colleague Daryl Jones, our Macro Managing Director, this past Friday wrote a compelling and thoughtful view titled “Could the Turmoil in the Middle East be Bearish for Oil?’


In the spirit of debate where reasonable men may disagree, I will present a counter view.


Daryl is right; “fear” is driving the price of oil in the markets. But it is a credible fear. As I wrote this past Friday, “The market has seized upon the reality that these Mid-Eastern regimes are vulnerable and could collapse, and to which political wind is uncertain. Who will control these significant global energy supplies is still unknown. This new realization breeds uncertainty in the market.” That uncertainty breeds oil price volatility.


Whether these political regimes collapse or not, and to which political view, is not my focus here, nor is whether political liberalization could actually support growing production. Indeed, incremental production can grow under any political persuasion. Political liberalization will be good for the people of the Mid-East, and for international relations. It will calm the oil markets and remove much of the “fear” premium recently baked into oil prices. It can also create a more positive environment to grow global production supplies. But political liberalization will NOT over the long run be a catalyst for lower crude prices. Why? Because incremental production from Mid-East is “insufficient” to arrest global crude oil production decline and meet growing global consumption. The next three charts highlight these points.


First, the major global crude oil basins are in significant decline: Mexico, Venezuela, U.K., Norway, Nigeria, Alaska North Slope, U.S. lower 48 conventional, and Canadian conventional.


Counterpoint: Middle East Turmoil is Bullish for Oil  - lg1


Global crude oil consumption continues to outstrip global production: global consumption since 2000 has averaged about 1.1% per annum; global production has grown at about 0.7% per annum.


Counterpoint: Middle East Turmoil is Bullish for Oil  - lg2


Lastly, the major global oil basins in decline are the major global crude oil exporters: since 2004 the combined average drop off in production for only the UK, Norway, Mexico, Nigeria and Venezuela has been over 622,000 b/d per year, or 3.1 MM b/d in total production lost, and increasing.


Counterpoint: Middle East Turmoil is Bullish for Oil  - lg3


On closer examination, Russia is not a clear example of what Iraq can do with production growth; its growth will depend on its reservoirs and the laws of physics. According to the BP Statistical Review of World Energy and the IEA, Russian oil production peaked in 1987 at 11.484 MM b/d, reached a low of 6.114 MM b/d in 1996, ramped up to 9.287 MM b/d by 2004, and hit 10.150 MM b/d in 2010 – a 1.5% per annum increase from 2004 to 2010. As I wrote in an energy note on Jan 7th, “Can Russia Maintain Oil Production at 10 MM b/d?” Russia has struggled to return to its production level of 10.45 MM b/d in 1990, and twenty years is a long time; Russia has never returned to Soviet era levels. Indeed, since 2005 Russia’s year-over-year crude production rate has steadily declined, as seen from the graph below.


Counterpoint: Middle East Turmoil is Bullish for Oil  - lg4


Why has Russia struggled despite its “political liberalization”? Recall Yukos and Mikhail Khodorkovsky as a prime example that Russia’s “democracy” is not exactly comparable to western standards.  First, Russian oil fields were opened up to Russian bureaucratic cronies, not to the Western Multinationals (IOCs). Secondly, Mother Nature, or the natural laws of physics, has hampered growth. Once Russian fields were privatized, albeit to Russian insiders, economic incentives became the production drivers; Russian fields registered a significant uptick in production growth as secondary recovery techniques were applied to Russia’s aging Western Siberian fields. The rate of production growth began to increase in 2000, peaked in 2003, and the rate of growth has declined ever since. The difficulty in sustaining an increasing rate of growth is due to the natural rate of decline in oil and gas fields, and economics. The marginal cost of investment begins to erode the marginal return from mature Russian fields, even at high oil prices.


These are the same issues that Iraqi production growth faces today. First, as to claims that Iraqi production could eventually hit 12 MM b/d: since 1965 the highest Iraq production has ever been is 3.489 MM b/d in 1979; no country produces at 12 MM b/d, not even Saudi Arabia (today at ~8.9 MM b/d). The last country to come close to 12 MM b/d, Russia, fell short by roughly 500,000 b/d and has taken over twenty years since 1990 to get back to 10 MM b/d.


Furthermore, higher production that leads to lower crude prices is not in Iraq’s national interest, and the country knows this. Their goal is not to maximize production, but to maximize revenue.  The dilemma the Iraqis will run into is dealing with a“mutually exclusive” choice: you maximize production or you maximize ultimate recovery, you cannot have both unless you alter the laws of physics. When you run the reservoirs hard to speed up production, in the long-run you impair reservoir pressure and limit ultimate resource recovery; and that, in the long-run, limits ultimate revenue as barrels are lost.


In the initial years, Iraq will see a significant uptick in production as the Russians did, coming off a low base and as the dramatic effect of secondary enhanced recovery techniques kicks in. But successive increases in growth rates will become increasingly difficult to maintain, as natural reservoir decline accelerates due to falling pressure. Increasing capital investment to increase reservoir pressure and arrest natural decline will run into the wall of the laws of diminishing returns, as the cost of the incremental barrel exceeds its incremental return.


Today, Iraqi production is at 2.7 MM b/d with 2.75 MM b/d targeted at the end of this year. To hit 12 MM b/d within a decade demands a ~16% per annum compounded growth rate, and if they could attain it, it would require massive inflows of capital. Most of the Majors have avoided Iraq’s initial offering of licenses, due to unprofitable terms. This is a prime example of“Resource Nationalism.” Will Iraq invite the Majors back by offering better terms? They may, but, that means less for Iraq which they will seek to offset through higher oil prices. Iraq will get higher prices through production cutbacks – basic supply/demand/price levers. Greater capital investment will flow to Iraq only if commensurate returns increase, and that demands higher oil prices.


Understanding what is at stake for Iraq and many of the other oil-rich Mid-East nations cuts to the heart of the issue. Higher production is to whose benefit? The West? Or the local people, for whom it is intended? The road through greater oil wealth lies through less oil supply, which drives prices higher; even the Iraqis understand this, despite public relations statements to the contrary.


In conclusion, supply will remain increasingly constrained due to natural global decline, higher costs, inadequate infrastructure, accelerating demand from the developing world, continued geo-political tension, and “national self-interest”; combined these catalysts will limit global oil production and inevitably fuel higher prices.


From the Oil and Gas Patch,


Lou Gagliardi


Kevin Kaiser


Yesterday, government data showed that real spending slipped in January as rising prices and bad weather discouraged spending on nondurable goods. 


In aggregate, spending on durable goods increased more slowly and “real spending” was reduced across the major types of discretionary services. Importantly, real expenditures on “food served at restaurants and hotel accommodations” declined by 0.6%, which was the sharpest drop among all categories of service.


The consumer is better off today than in January 2010, but as the January data showed, spending remains sluggish.  Also, increasing food and energy prices create further risk, particularly on discretionary items.    In 2010, DPZ did an amazing job transforming the business in the USA, but the suggestion that DPZ is going to go on a 4-5 year run like MCD is very unlikely.  In fact, DPZ is likely to report negative same-store sales growth in 1Q11.




Howard Penney

Managing Director


Notable news items/price action over the last twenty-four hours.

  • DPZ reported EPS ex-items of $0.40 cents versus the street at $0.40.   Domestic, company-operated comparable restaurant sales came in at 5.4%, implying a sequential slowdown in two-year average quarterly trends of 175 basis points.
  • WEN’s for-sale concept, Arby’s, has introduced an Angus beef sandwich, the first in what the chain expects to be in a line of premium offerings.  I maintain my positive outlook on WEN, and view the sale of Arby’s as a positive move for the company.
  • PZZA announced that David Flanery is retiring as CEO and Lance Tucker will take over following a transitional period.  The stock traded up 60 basis points on strong volume yesterday.
  • An article on CNNmoney.com published yesterday discussed the increase in weatlhy consumers frequenting low-cost, fast food restaurants.
  • An article on the New York Times’ online “opinionator” blog shed some light on MCD’s oatmeal and the ingredients therein.  According to the article, “Incredibly, the McDonald’s product contains more sugar than a Snickers bar and only 10 fewer calories than a McDonald’s cheeseburger or Egg McMuffin.”
  • COSI outperformed the space yesterday, gaining 2.1% on the day.  I believe this stock price will gain further in the coming months.
  • In general, yesterday, restaurant stocks traded very thinly with volume down across the board.



Howard Penney

Managing Director

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The Macau Metro Monitor, March 1, 2011



On 2/9/2011, LVS received a subpoena from the SEC "requesting that the Company produce documents relating to its compliance with the FCPA (Foreign Corrupt Practices Act). The Company has also been advised by the Department of Justice that it is conducting a similar investigation.  It is the Company’s belief that the subpoena emanated from allegations contained in the lawsuit filed by Steven C. Jacobs described above." 


The FCPA "generally prohibits U.S. companies and their intermediaries from making improper payments to foreign officials for the purpose of obtaining or retaining business."  LVS said any FCPA violation would have a material adverse effect on their financial condition.


Greek Mythology Casino in Taipa may complete a revamp by end of the year and will prioritize the development of VIP business to drive high‐end players.  The company expects monthly turnover will grow to MOP70 billion from the current
MOP15 billion.


February GGR came in at 19.28BN HKD (19.863BN MOP, 2.48BN USD).  This represents 47.7% YoY growth.



A Singapore Parliament member, Denise Phua, argued that over-reliance on gaming revenue would hurt Singapore over time.  She suggested that the casino entry levy (S$100) be tripled, the S$2,000 annual levy be abolished, and that a permanent a cap of 2 be placed on the on IRs.



According to the China Real Estate Index System, residential property prices in 100 major Chinese cities rose 0.48% MoM in February, slowing from January's 0.95% MoM growth data provider.


Flash estimates compiled by the National University of Singapore Institute of Real Estate Studies show the overall Singapore Residential Price Index rising by 2.6% MoM.  This is more than double the 1% MoM increase in December.

Mr. Money Man

This note was originally published at 8am on February 24, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“If history is any guide, this scenario will develop not gradually but abruptly.”

-Barry Eichengreen, (“Exorbitant Privilege” page 165)


Evidently a lot of investors didn’t prepare their portfolios for The Inflation. Some reconciled this mother of all inflation shocks in food prices as “supply and demand” imbalances. Some said everything was going to be fine because The Ber-nank said so. Some even said $4-5 at the pump is fine.


We’ve said that as Global inflation Accelerates, Global Growth Decelerates. This might be a little easier to see when you have a $100 handle on the price of oil per barrel. Inflation is both a policy and a consumption tax. Global inflation is also priced in US Dollars.


Sadly, with stock markets around the world getting rocked this week, the US Dollar continues to be debauched. There was a time when America’s independent price stabilizer (Paul Volcker) treated the US Dollar with respect. Today, our Almighty Central Planners are willing to watch the Buck Burn.


The math doesn’t lie here folks; professional US politicians do. For the week-to-date, here’s your US Dollar/Commodity Inflation score:

  1. US Dollar Index DOWN -0.33% for the week-to-date (down for 7 out of the last 9 weeks)
  2. CRB Commodities Index UP +1.7% to 347 (making a series of fresh weekly closing highs all the while)

Sure, there’s a nut-job out there in Libya, but there’s also a very blunt instrument that can take his grandstanding on “fighting to the last drop of blood” away – a STRONG US DOLLAR policy.


Most American stock market fans definitely don’t want the short-term tough love associated with that. If anything, the perma-bulls are already cheering The Ber-nank on to implement Quantitative Guessing III (QG3) as a weapon against Gaddafi’s self-destruction.


The reality is that if The Ber-nank and Timmy Geithner woke up this morning and unilaterally raised interest rates and took a whack out of this Disaster Deficit, the US Dollar would strengthen and the price of oil would drop in a straight line.


This, of course, isn’t going to happen. Instead we are fostering a finger pointing and unaccountable political leadership class that continues to frustrate Americans to the core.


While Timmy Geithner was self-aggrandizing himself yesterday with his banking cronies from Dollar Destruction Inc., someone asked him what he thought about the price of oil’s impact on the US economy – and I couldn’t make this up if I tried, but he said that the economy that he helped put into crisis (before he helped saved us all from it) “can handle it.”


The Twitter-sphere lit up like a Christmas tree after Timmy said that – and The Rest of The World erupted in laughter. He must have been joking, but Bloomberg reporter Rich Miller didn’t seem to think so - and I couldn’t make this one up if I tried either – as Miller recapped the Geithner Groupthink session yesterday with this morning’s Bloomberg headline:




On top of what? The Disaster Deficit, The Burning Buck, or the resume pile to go join the Pandit Bandit at Citigroup? The manic media pandering to the political winds of Washington, DC access is both frightening and sad. Arianna Huffington, nice sale!


Don’t worry, I can answer the Wall Street question on, “how do you make money on this”? I laid this out in Friday morning’s Early Look note titled “Hawkish Winds” and my Global Macro positioning in being bullish on The Inflation remains the same:

  1. LONG - Dollar denominated food and energy Inflation
  2. LONG - Currencies of countries with hawkish central banks
  3. LONG - Financials in socialized countries that have made banks too big to fail
  4. SHORT - Sovereign Bonds of countries with deficit and currency devaluation central planners
  5. SHORT - Currencies of countries with dovish central banks
  6. SHORT - Emerging Markets

As for managing around the implied mean-reversion risks associated with the institutional investment community in America chasing the “flows” rather than the Global Macro fundamentals, my strategy on US Equities is this – trade them like the Price Volatility Casino that your central bankers sponsor.


After all, as Timmy reminded his fans at the “Bloomberg Breakfast” in Washington, DC yesterday, “central bankers have a lot of experience in managing these things”!


Indeed they do Mr. “Money Man”, indeed.


My immediate term support and resistance levels for the SP500 are 1306 and 1330, respectively. If 1306 in the SP500 doesn’t hold on a closing basis, I think this -3% correction in US stocks starts to resemble a February 2008 like crack. That wasn’t a good crack.


Best of luck out there,



Keith R. McCullough
Chief Executive Officer


Mr. Money Man - oo1


Mr. Money Man - oo2

CHART OF THE DAY: The "Flowwwzzz" Work Both Ways (see: 2008)



CHART OF THE DAY: The "Flowwwzzz" Work Both Ways (see: 2008) -  chart

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