The pre-market stock futures were down and getting worse in very early pre U.S. trading. The U.S. Dollar was mixed. Asian markets were down. European markets were falling hard. U.S. Treasury bond yields were steady. The U.S. Ten Year note was trading with a yield of 3.77% in electronic trading. Crude oil was trading above $37. Gold was trading above $410.
The economic calendar for March 22 had no major releases scheduled.
When It All Goes Wrong...Simultaneously
OPEC is on the spot. According to Dow Jones Newswires: "International Energy Agency Chief Claude Mandil said Sunday that OPEC should take action to reduce the high oil prices that are ["bad for everybody."] The report added that "Mandil, head of the Paris-based energy watchdog, told Dow Jones Newswires that prices are ["too high"], which he hopes the Organization of Petroleum Exporting Countries will take into account at its upcoming March 31 meeting in Vienna.
A steady drum beat has been building of late for the notion that oil prices have been high enough for long enough to lead to an economic slow down. Readers of this space are familiar with the notion, put forth by Fed Chairman Alan Greenspan, that every major recession in the U.S. in the recent past has been preceded by high oil prices.
The current situation should not be a surprise to those who follow the oil markets, even with casual interest. Regular readers of this column will recognize our view that the potential for a long term energy crisis in the United States is rising. We base this on three factors: 1) The easy to find oil has been found. 2) OPEC's production capacity is maxed out. And 3) The U.S. refining capacity is shrinking.
Thus, of late we have been looking for evidence of where oil prices are going. And although we have found that some the usual signs of a top are in place, oil prices continue to move steadily higher. That, of course, suggests that something else is clearly in progress.
First, we note that there is now an increasing call for investigation of the oil industry, such as recent events in Florida, where the Attorney General there called in oil companies to explain rising gasoline prices in his state. This is fairly standard Attorney General and Congressional procedure, and is often a sign that a top is near, since politicians are not known for fixing problems preemptively, and tend to jump on issues when they are likely to profit from them most with regards to their re-election. Thus, the oil industry is usually a good target.
And second, and perhaps more important is the fact that as the temperature warms up, the traditional fall in oil prices begins, and it is not happening.
Thus, at least for now, this time is different.
Supporting our view on the production and refining side of the equation, the Wall Street Journal, on 3-22 reported that: "The nations belonging to the Organization of Petroleum Exporting Countries are hitting their limit to produce light, sweet crude, the preferred grade of oil used to make gasoline, especially in the U.S. Capacity limits also plague the petroleum industry's so-called downstream end, which refines oil into essential consumer products such as gasoline. By one estimate, global refining capacity could fall behind world demand as early as this year."
And more dramatic is the fact that "oil prices reached their modern-day high in 1979, when they spiked to about $44 a barrel. Of course, when inflation is considered, energy prices from that era are much greater. A $44 barrel in 1979 would fetch more than $100 at today's prices."
In effect, due to the logistics of production, decreasing capacity, and rising demand, a perfect storm is brewing in the oil markets. "Strong demand growth in the U.S., China and elsewhere is bringing the trillion-dollar-a-year global petroleum industry closer to the limits of its ability to supply, refine and transport oil. OPEC can pump more oil. But cartel officials say members have hit the limit of their ability to pump light, sweet crude in particular. ["We have more capacity, but it's not the right stuff,"] says a senior OPEC official. Light, sweet crude remains in many corners of the world, but the energy industry doesn't have the capacity to pump it."
The Royal Dutch Shell Game: A Situational Analysis
But beyond the day to day operations of the oil industry and indeed related to point number 1) above, is the fact that Royal Dutch/Shell is once again cutting back its reserves estimates. According to a Wall Street Journal report on 3-19: "the Group cut its estimate of reserves for the second time in three months and pushed back its year-end filings with the Securities and Exchange Commission, adding to the cloud over the energy giant and the way it accounted for its oil and natural-gas holdings." The article added that "the cut was small compared with its January disclosure that it would slash its tally of reserves by 20%."
Shell's management seems to be getting into deeper water, with each subsequent announcement. According to the Wall Street Journal: "Jeroen van der Veer, Shell's new chairman, raised fresh questions about whether current senior managers, including himself, knew about serious reserve problems well before Shell's surprise move in January to slash its tally of energy reserves." Van der Veer, answering reporter's questions, said that he did not know about the reserve controversy, but acknowledged that as early as 2002, "internal documents circulated among top executives, including himself, pointed to ["exposures,"] or possible reserves that didn't match SEC definitions.
The Journal added that: "The new revisions include natural-gas reserves associated with a large project at Ormen Lange, offshore northern Norway. Shell said in February that it prematurely booked Ormen Lange reserves but planned to include them again in the company's 2003 figures. Malcolm Brinded, Shell's new head of exploration and production, said yesterday that much of the reserves related to Ormen Lange were still out of line with current SEC guidelines and, therefore, wouldn't be booked after all. The company attributed the change to its reliance on three-dimensional seismic technology in evaluating the property instead of drilled wells."
And there is more trouble brewing. Shell announced recently that it is the subject of an insider trading investigation in the Netherlands. Reports have also surfaced that the U.S. Department of Justice has begun to investigate the company.
The big question facing investors is whether Shell is lying, or whether it is following what some would describe as a set of outdated and mostly useless rules for its accounting of reserves. On 3-22, the Wall Street Journal noted that, there is a discrepancy in what the SEC wants oil companies to do, and what the companies actually do to account for its reserves. “The discrepancy underscores the apparently stark differences in interpretation of reserve-accounting rules and SEC guidelines among oil companies. It also further muddies the water for investors, who typically look to a company's reserve tally as an important gauge of recent performance and future value. Some industry observers have also complained that the SEC's guidelines haven't kept up with technology already widely used by oil companies to determine reserves."
The battle lines have been drawn, though, as this recent quote of J.J. Traynor, a Deutsche Bank oil analyst, in an e-mail message to clients late last week, reflecting the view of some on Wall Street indicates: ["We believe SEC standards look outmoded, and not always evenly applied by the oil companies, which in itself makes the oil sector risky in the current climate."]
The other view point is from the government, as "SEC engineers have countered the criticism. In an October forum of the Society of Petroleum Evaluation Engineers, Jim Murphy, a petroleum engineer at the SEC, blamed a reliance on ["can't-miss technology"] for a number of reserve write-downs by companies, according to a published account of the meeting."
The bottom line is multifold and complex, which suggests that foul play, and funny accounting, etc, could be involved. This conclusion is based on the information provided by sources deemed to be credible. We should make it clear that we are not defending or accusing any entity, public or private, in this report, but only providing analysis which may be crucial to our subscribers.
First, it is obvious that something has been amiss for a long time, and that we may be at the cusp of its breaking. The widely diverging viewpoints on Wall Street, the oil industry, and the U.S. Government, suggests that when the levee breaks, the flood will be all consuming. This is even more potentially dangerous in an election year, when the Democrats continue to look for ways to implicate the White House, and especially former Halliburton CEO, Vice President Cheney in any scandal that they could find.
And second, in the short term, it is clear that Shell is losing its credibility, one creaky step at a time, and is on the verge of the inevitable slippery slope, which leads us to agree with the Wall Street Journal when it concluded that "Shell's decision not to re-book 220 million barrels of oil equivalent for 2003 will cut Shell's annual reserve-replacement ratio -- an important indicator of an energy company's performance -- to 82% from 98%. That indicates the company isn't doing nearly as well as investors had thought in replacing the reserves it depletes by pumping its oil and gas. The reduction also boosts Shell's costs of finding and developing oil and natural gas for the year to $6.40 (€5.23) a barrel from $5.50 a barrel, according to Wood Mackenzie, an Edinburgh energy consultant."
But the facts are at least worthy of a goodly raised eyebrow.
What is known is that a major oil company, by its own admission, has a lot less oil and natural gas in reserve than it claimed that it could extract in the near future, just a few months ago. What could be lurking is that there are others who may have to make similar claims, at a time when the geopolitical situation is heating up.
This much is clear. The energy industry, as a whole, surprisingly escaped any industry wide scandal, when the Enron situation broke. But, if the Royal Dutch situation turns out to be the tip of the iceberg, which is only a possibility at this point, the resulting mayhem could be even worse, given the potential for other companies to reveal similar problems to Shell, and for the repercussions on the oil markets.
The Russia House As usual, there are winners and losers in the game of life, as well as the oil markets.
So while OPEC is steadily working its way to becoming the international scapegoat for higher oil prices, and could be facing even more problems, as we describe below, it is interesting, that a few days after Russia's newly re-elected President Putin won a critically panned, at least by international observers, landslide election, Russia announced that its own oil production is about to rise some 11% in 2005.
According to Reuters, and the Moscow Times: "Pipeline monopoly Transneft sees Russia's oil output rising to 10 million barrels per day as early as next year from 9 million this year, Kommersant reported Friday. The newspaper quoted the head of Transneft, Semyon Vainshtok, as saying the monopoly would export 4.8 million bpd this year to Western Europe and neighboring ex-Soviet states."
The report added that "A further boost in Russia's output, which has been rising since 1999 and increased by 50 percent to the current level of slightly below 9 million bpd, will be a major blow for the Organization of Petroleum Exporting Countries."
And a clue as to what the future holds for the Russian oil industry can be found in the following: Vainshtok said that "Russia, which has always been exporting at capacity, should take Saudi Arabia as an example and build more big pipelines to ensure flexibility in production and exports. He also said the state should more strictly regulate oil exports depending on market conditions. "The state should determine how much oil Russia will export each year. I believe that the current situation, when private oil firms decide on the volumes of exports on their own, is not right. Vainshtok, who worked for LUKoil before joining Transneft, said he was against the idea of private pipelines in Russia. ["Oil firms do not know how to design, build and use trunk pipelines. They know how to produce oil, they do it well, so why don't they stick to that?"]
The Royal Dutch Nigeria Connection
What makes the entire story more troubling is a report from Stratfor.com, which puts the spotlight back on Royal Dutch Shell: "documents leaked to The New York Times on March 19 indicate that 60 percent of the total reclassification (of reserves) -- approximately 1.5 billion barrels -- is within Nigeria. Of the 2.52 billion barrels that Royal Dutch/Shell initially booked for that country, only 990 million barrels clearly meet requirements."
What the Times reported on 3-19 was this: "The Royal Dutch/Shell Group has kept secret important details of its sharp reduction in oil and gas reserves, particularly in Nigeria, for fear of damaging its business relationship with the government there and the Nigerians' desire to produce more oil, internal company documents show."
More damaging is this: "While Shell has acknowledged that the biggest adjustments in reserves include those in Nigeria, it continues to conceal the extent of its problems. But confidential documents from late last year show Shell concluded that more than 1.5 billion barrels, or 60 percent of its Nigerian reserves, did not meet accounting standards for ["proven reserves."]
The Times also hinted at a major cover up at Shell when it wrote: "The oil company's executives are acutely aware of the potentially explosive political effect of their cutting the estimates of Nigerian reserves. A report dated Dec. 8, 2003, and prepared for senior executives by Walter van de Vijver, then the top official for exploration and production, recommended that the revised Nigerian reserves remain ["confidential in view of host country sensitivities."] Even more damaging could be the Times assertion that: "The (internal Shell, our parenthesis) document recommended that ["any debooking of proved reserves"] in Nigeria ["not be identified publicly with Nigeria"] but classified under a wider geographic area.
The Times continued with: "Protecting Nigeria's negotiations with OPEC may not be the only reason Shell has not been more forthcoming about its reserves there. The report said the publication of too much information could jeopardize the company's negotiations with Nigeria over $385 million in bonus payments. In any case, the documents about Nigeria offer a far bleaker assessment of Nigerian operations than the company's public disclosures."
If the Times article is correct, significant portions of oil that would be otherwise retrievable, may not be extracted due to technological or logistical problems. "Nigeria, has called for an end to the practice of flaring, or burning off, natural gas that is a byproduct of oil production; two billion cubic feet of natural gas are burned this way in Nigeria every day, and this has become an environmental and political issue. Shell's Web site says ["this opportunity"] to gather gas ["is going well."] But the Shell documents present a different view. A high-level review in December found that many oil field projects did not include plans to gather natural gas, and that ["oil production would have to be shut in,"] or stopped, unless the company found a way to use the gas. Shell could sell it in Europe or the United States, but natural gas is expensive to transport across the ocean."
Stratfor added the following: "Nigeria has been trying for years to radically increase its OPEC quota in order to boost its petroleum income. Oil and natural gas exports currently account for some 90 percent of government revenue, and one of the few things that hold together the fractious mélange of religions and ethnicities comprising Nigeria is a steady supply of oil money passing from hand to hand. Few countries in OPEC regularly adhere to their quotas; Nigeria never adheres to its quota. The country has been pumping for the past year and a half at its maximum output of 2.3 million bpd. As of April 1, its official "approved" quota will be only 1.936 million bpd."
The Stratfor analysis, in combination with the New York Times article, both with Nigeria as a focal point, is particularly sobering because it offers a unique glimpse into why it could be lucrative for oil companies to lie about their reserves, and offers a plausible explanation that ties together several seemingly parallel and very loose threads. "Foreign firms such as Royal Dutch/Shell do the bulk of the heavy lifting in Nigeria. Most of the developments in the past decade have been -- and most of the expected developments in the next decade will be -- in Nigeria's offshore area, where cash and technology requirements limit development to outsiders. Firms have been skittish about dumping huge amounts of cash and time into OPEC members for fear that the OPEC quota system will prevent them from realizing their investments"
And the clincher: "Because OPEC quotas are based in part on reserve levels, Royal Dutch/Shell had a vested interest in making them seem as large as possible. A higher quota would mean more wiggle room for foreign producers; Royal Dutch/Shell's reclassification affects 4-6 percent of Nigeria's total. Nigeria has ambitions to double its production capacity by 2010."
That OPEC is feeling pressure is clear, as the New York Times wrote: "OPEC officials visited Nigeria last month and the organization will discuss a new formula for determining quotas later this year, an OPEC spokesman said. Proven reserves, the spokesman said, were part of the quota calculation. Oil yields 90 percent of Nigeria's export revenue, which was estimated at $17.3 billion a year in 2002. A doubling of its production, as it intends, could mean billions extra in annual income."
The Mother Lode of Gushers
So, the whole situation comes down to two things, according to Stratfor. Nigeria "can choose to stick with lower reserve estimates that are probably more accurate, and give up attempts to get their OPEC quotas revised upward. Without the higher reserves, Nigeria's hopes for a larger quota are pretty much dead, and with them most hopes of reaching their expansion goals. Such a decision would hamstring the country's petroleum expansion plans and derail Nigeria's gravy train."
The second fact is what could really upset the apple cart, and is something that we have said repeatedly in this space: "On the other hand, Nigeria can stop pretending: It could leave OPEC. Such a move would rock the oil markets in the short term and spark an impressive hissy fit from the remaining OPEC members. But from Abuja's point of view, much of the uncertainty that oil companies feel when dealing with Nigeria would evaporate, revitalizing investments in developing the Nigerian offshore assets, particularly into the joint development zones that Nigeria shares with Equatorial Guinea and Sao Tome and Principe. Nigeria would not be the first -- nor likely the last -- OPEC member to jump ship."
We could be witnessing the first act in a significant play which may rewrite the entire energy equation for the world. The demise of OPEC, a major cover up at Royal Dutch Shell, the re-balancing of the Russian private oil industry experiment, and the rise of oil prices above $40 a barrel for what could be an extended period of time.
And they said energy stocks are boring.
Stock of the Day
Watching The Energy Stocks
Technical tradition holds that commodity stocks precede the direction of the commodity. Thus, we like to watch oil, oil service, and natural gas stocks, in order to predict the future of the energy markets.
As we penned this report, CNBC's London office was showing a chart of Royal Dutch Shell (NYSE:RD). The stock was getting clobbered, as investors sorted through the latest round of bad news, some of which was chronicled above.
Oil prices were holding steady, but were not rising dramatically, as the $38-$40 price area continued to offer resistance.
But rather than looking at the major oil companies, we thought a look at oil service and natural gas would offer a cleaner picture of what the future may hold for energy.
Schlumberger (NYSE:SLB), the major oil service firm, looks to have made a top. In fact, the stock is now in a short term down trend.
Meanwhile, natural gas momentum bigwig Apache (NYSE:APA), also looks to have run into major resistance. A break below 40 on APA could take the stock into the high 30s.
Thus, the charts are pointing toward a slight decrease in the upward pressure of oil and gas prices.
This may change in the next few days.
But, as we write, there is no sign, that energy prices are going to collapse, as OPEC fears, and as normal seasonal tendencies usually deliver.
The Philadelphia Oil Service Index (OSX) failed to hold near 110. Whether this is a signal that the energy sector has made its seasonal high remains to be seen. A long term move, if this move gains momentum could take the OSX to 140. The index rallied smartly on 1-20, and has reached an important resistance level, but had remained flat. For more details on trading the energy sector visit our energy timing page, featuring our highly effective OIH timing model and our Top Ten Energy Stock List.
In the current market, we recommend a copy of Successful Energy Sector Investing: Every Investors Complete Guide. The book predicted many of the current developments in the economy and the energy markets, and provides an excellent set of benchmarks and trading lessons for what could be in store for the future.
The Amex Oil Index (XOI) has acted slightly better than OSX, as it has remained just below 600. For immediate analysis, including stock picks, and the latest in technical analysis of the entire energy complex, our subscriber section has a full complement of recommendations in oil service and the rest of the energy complex.
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