January 25, 2015

Oil, Stocks, Bonds: An Historical Comparison

In a post a few days ago, I noted that the gold:oil ratio had reached an extremely high level of 28 to 1, such that one ounce of gold would suffice to purchase 28 barrels of oil. That has occurred three previous times over the last 25 years, in early 1994, in late 1998, and in mid-February 2009. It's of interest that all of these occurred right around the beginning of the new calendar year. In 1993-94, the high occurred on December 30, but was retested on February 15. Almost exactly the same pattern occurred in 2008-09, with a high at the end of the year and a retest in mid-February. In 1998, the high was reached on December 12; it was not retested.

I was curious what happened in the subsequent relative performance of stocks, bonds, and oil in these three previous episodes (when the gold:oil ratio touches 28). Herewith a series of charts showing the denouement.

For 1993, the chart below shows a ratio between the price of oil and the price of stocks. The second frame shows a ratio between the price of oil and the price of bonds.  As these charts show, oil outperformed bonds handily. It did so for stocks in the ensuing year, but then fell back.

Here's the same chart for the period from 1998 to early 2002.

As previously discussed, a ratio chart comparing the price of stocks with the price of oil , as these charts do, can be misleading in its practical implications. What Jeffrey Gundlach calls "investible commodities" don't correspond with a simple price chart. Still it is impressive that in both these prior instances the relative performance clearly favored oil as against both stocks and bonds over the ensuing 12-15 months. This is so even if we substitute a bond fund for the bond price, as in the following for 1993 to 1996:

For 2008 and 2009, the first chart below shows not the price index of $WTIC but the exchange traded fund USL. And I compare this to SPY (whose price reflects dividends) and AGG (a total bond  fund whose price reflects interest payments received). Just as the price charts for 1994 and 1998 don't reflect dividends and interest, the commodity prices do not reflect the transaction costs of commodity funds. That changes the implied ratio, by how much is the great question.

The above chart looks very unimpressive, especially in comparison with the price charts. The USO chart is even worse, though I forbear to show it here. The price of oil, as the chart below shows, bounced much higher than the exchange traded funds, even one, like USL, supposedly constructed for the very eventuality that transpired.  Why this happened is not clear to me; I suspect is is partly related to the incredible volatility all markets displayed during the financial crisis, greatly increasing transaction costs, not simply to the issues associated with contango and backwardization..

In conclusion: it's a mixed bag. I think oil's bottom in relation to gold is close. Once it bottoms, oil will inexorably rise relative to other financial instruments, but "investible commodities" are a pretty unsatisfactory means of expressing this, as they are handicapped by various deficiencies. Despite these deficiencies, USL looks good here relative to other financial assets; it may go down further, but over the next year I think it likely it will hold its value against other assets and will probably surpass them.

January 23, 2015

The World's Worst Investment . . . Is Looking Pretty Good Right Now

In the first decade of this century, when commodity prices were strong, there were many promoters of the idea that passive investment in commodity funds, tracking the futures prices, ought to be a key portion of any investment portfolio. Anyone who acted on that idea, however, has fared badly in the years since 2008. As far as asset classes go, funds that hold commodity futures contracts have been just about the world’s worst investment since the summer of 2008. 

There are lots of reasons why, in normal circumstances, such investments are inferior to stocks, bonds, real estate, or precious metals, but these are not normal circumstances. The precipitous collapse in the price of oil, far below the cost of production for “new oil,” makes these funds an intriguing proposition these days. To make the case for them, we shall take a look not only at the history of commodity prices as such, but also at the relationship to other asset classes as well. On the theory that what goes way, way down, must come up, we will rest our case.

First, here’s a survey of the overall carnage. The index below is the Goldman Sachs Commodity Index Fund (GSG). Because it is  heavily weighted toward energy, it has had more extreme price movements than other commodity indexes, but all the commodity indexes rose and fell along similar lines over the past two decades. 

Now let's look at a couple of ratio charts, The first chart shows the ratio between commodities and bonds, in this example the ratio between GSG and long term US Treasury bonds. 

If you started out in 1999 thinking that an investment in commodities would put the kids through college, that looked like a really good idea over the next nine years. Then it became a very bad idea and you realized you needed a second job at McDonald's to swing it. From early 1999 to mid 2008, commodities were very good and bonds were very bad. Then the relationship reversed in the years thereafter. 

The same story may be told for the ratio of stocks and commodities, though this is even more lopsided in the denouement. The following chart shows the ratio between GSG and SPY (an exchanged traded fund showing the total return, including dividends, of the S and P 500). 

Here's another that looks at the ratio between GSG and the Vanguard Total Return Bond Fund, making the picture even worse than the earlier ratio chart comparing GSG with US Treasury prices. 

The general collapse in commodity prices is especially striking in light of expectations prevailing only a short while ago. In 2011, the investment guru Jeremy Grantham produced a chart showing the movement of commodity prices over 110 years, beginning in 1900. Grantham titled the essay in which the chart appeared "The Great Paradigm Shift." Its argument was that "this time is different"--that is, that the general movement downward in commodity prices that had occurred over the preceding century had been reversed by a series of shortages so severe that the trajectory of prices was almost certainly upwards. 

As Grantham explained, the GMO Commodity Index equally weights 33 different commodities, so it is measuring different things from the GSG index. Summarizing its significance, he argued: "The prices of all important commodities except oil declined for 100 years until 2002, by an average of 70%. From 2002 until now, this entire decline was erased by a bigger price surge than occurred during World War II. Statistically, most commodities are now so far away from their former downward trend that it makes it very probable that the old trend has changed – that there is in fact a Paradigm Shift – perhaps the most important economic event since the Industrial Revolution." 

This chart was produced shortly before the huge break in the commodities market in the summer of 2011. Grantham emphasized that his argument was about the medium to long term. In the short term, he acknowledged, a bust was possible, after which would come the mother of all buying opportunities. Grantham's is a proprietary index and I have not seen an updated version, but the following chart of the Greenhaven commodity index (GCC) is probably a reasonable proxy for the GMO Index. It gives a much heavier weighting to agricultural commodities as compared with the GSG, which helps explain the big rise from late 2008 to 2011. Given its relative under-weighting of energy, it hasn't fallen as far as the GSG, but it's still packing a lot of hurt in the last few years. 

The conclusion I draw from these various charts is that investing in commodity funds has indeed been an extremely bad idea since the great blowoff of 2008. Since mid-2011, everything has gone down, with oil leading the pack of late. Investment firms have pronounced the end of "The Great Commodity Supercycle." Huge investments were made in oil, cooper, iron ore, gold, silver, corn, and soybeans. And they have just about all come a-cropper. 

As we said at the outset, however, what goes way, way down must come up at some point. The firms which made these investments may have lagging share prices for some years; by the same token, however, the prices of the underlying commodities are likely to recover before the share prices do, and with greater relative vigor. (It was observed recently by an oil expert that the share prices of the major oil companies reflect a long term oil price of $75-85. The price at this writing is $46). Another objection is that the funds tracking energy commodities will probably lag a simple price index, because the futures markets are in contango. True enough, but these deficiencies of commodity funds did not prevent the out-performance that occurred between 2000 and 2008. Whereas there are reasonable arguments that both stocks and bonds are in a bubble, the same cannot be said about commodities. They are definitely in bust mode, oil most of all. (James Paulsen has a recent piece in Barron's summarizing the data on the pricey character of US stocks. 10 year US treasury bonds, by the same token, have a yield of 1.90%.). Most convincing of all is that the marginal cost of "new oil" is within shouting distance of $100 a barrel. Unless the world faces another Great Depression or, better yet, The Apocalypse, the price has got to recover. 

One more point. One of the things that the promoters of investment in commodity funds always emphasized was that commodities have not been especially correlated with stocks and bonds. They therefore help balance out a portfolio and make it less susceptible to wild swings. As the following chart shows, however, that is not always true. Stocks continued to go up during the commodity bust of 1998, but beginning in 2001 there was a fairly tight correlation for the next ten years. That has now broken apart. While the 1998-99 precedent does command some respect (and while stock prices rose after the oil price collapse in the mid-1980s), the chart also suggests the existence of a Great Divergence. Both commodities and bonds are forecasting a recession, whereas the stock market sees only sunny vistas ahead. Something has got to give.  

All in all, I think it a decent bet that our miserable companion in this journey through commodity history, the GSG, will outperform either stocks or bonds over the next three years. It might outperform both. The former possibility (outperforming one or the other) is of a sufficiently high order of probability as to justify some inclusion in an investment portfolio (anywhere, say, from 5 to 10%). If economic activity is as poor as the markets in both bonds and commodities are saying, stocks would have great difficulty maintaining their current valuation. Since oil has borne the brunt of the recent decline, the oil fund USL(holding futures contracts over 12 months)  looks like a more eligible instrument than GSG for playing a rebound in commodity prices. [I am much more confident about USL than GSG, as explained below, but its trading history only goes back to late 2007 and thus can't be shown on the long term charts used above.]

There are certain perils in this strategy. You would be trying to catch a falling knife; there's an old saying (especially among momentum investors as opposed to the value mavens) that you shouldn't try to do that. Secondly, the process may take several quarters to play out, so cost averaging into the position would definitely be the prudent course even for impulsive types. Third, as a general rule, most commodity mutual funds have high expenses, front end loads, and returns that fall well short of a pure price index; they are, as a rule, poor instruments that are more valuable to their administrators than their clientele. I guess that leaves us all dressed up and nowhere to go--that is, convinced of the overall merit of the analysis favoring commodities, especially oil, but rather perplexed over how to implement it.

* * *

Update 1/25/15: By way of further caution, here's a chart provided by Jeffrey Gundlach in his recent investor presentation, notes of which are available at Business Insider. "The white line is the commodity index, the yellow line is the commodity index you can actually invest in. Investable commodities have been losers for years. Gundlach says you lost 800 basis points per annum over the last 10 years investing in commodities."

As Gundlach's chart suggests, the really big hit that occurred in this regard was from the summer of 2008 to the summer of 2011. Since that time the two indexes have tracked pretty closely. This is shown in a ratio chart of USO with WTIC (that is, the etf holding near month futures contracts) and the price of oil. Interestingly, both USO and USL have outperformed $WTIC since the summer of 2013. As the ratio chart of USO:USL shows in the bottom frame, USO has been the consistent underperformer of USL (holding 12 month contracts), especially of late. Weirdly, USO is traded far more frequently than USL (a recent figure shows 40 million contracts for USO, only about 100,000 for USL), and this despite USL's clear superiority based on the historical record and the fact that, logically, USL is the far better instrument when the oil market is in contango, as now. (See this very useful primer at Seeking Alpha)

Another note of caution comes from Steve Briese, a commodity market specialist who has been bearish on oil prices the last year and has been cited in several pieces in Barron's. In a January 10, 2015 followup at Barron's, Briese argues that oil could fall as low as $20 a barrel. He puts emphasis on the very large long positions that commodity funds still hold in oil futures, and draws an analogy with the crash of oil prices that occurred in 2008-09. "From the peak in July of last year, the funds have liquidated about 25% of their long positions. But their positions are so large that, even if they liquidate another 25%, they would hold a significantly greater number of contracts than they did in the bear market of ’08."

Briese's thesis raises an important question about the impact of "financialization" on the commodity markets, a subject I delved into a few years back. Briese's forecast of $20 a barrel oil seems absurdly low to me, but the general argument that these commodity funds matter for the movement of prices is undoubtedly sound. (If it were to fall to that level in a general liquidation, it would indubitably constitute the mother of all buying opportunities. Given the danger of a further fall in prices, I guess right now we're at the stepmother of all buying opportunities.)

One final series of charts suggests that, if you were to play this dangerous game, USL looks to be the most eligible instrument. It is a series of ratio charts comparing the price of USL with other commodity indexes. USL is much less exposed to the contango issue than USO or GSG, and these ratio charts suggest support levels right about here relative to just about every other commodity index.

January 21, 2015

Gold-Oil Ratio at Extreme Level

One of the most reliable of financial indicators has just reached a crucial level, indicating a likely turn in the markets. I speak of the gold/oil ratio, an idea first introduced to me back in the 1980s in a book by John Dessauer (the title of which escapes me). The long term gold-oil ratio is something like fifteen. As the following chart indicates, it has reached a level just shy of 28. Over the last twenty years, it reached this level three separate times, and on each occasion fell promptly back to earth.

Those inclined to immediately rush out and buy oil and sell gold may duly be warned that the gold-oil ratio did reach nearly 33 on two occasions in the 1980s (though in neither case was it there for very long). However, it is rather impressive that in late 1993, in early 1999, and in early 2009, it reached the precise level at which it now sits, and that in each case the 28 level constituted the turning point  in the price action. This must surely count as an extremely strong line of resistance.

But there is another anomaly that makes the picture even more interesting from a financial standpoint. Though gold is extremely expensive in relation to oil, gold stocks are still very cheap in relation to oil stocks. Consider the following chart looking at the ratio of the $HUI, a gold stock index, with the $XOI, an oil stock index. The data here go back to 1996:

Given what has happened to the gold-oil ratio, one would think that the gold stock-oil stock ratio should be closer to the top of the chart than to the bottom. For gold miners, oil is a very considerable cost of doing business, so a decrease in oil prices increases their profit margins (at least, what there is of them). As the chart shows, there has been a very considerable rally in the gold stock-oil stock ratio, from .10 to .16 over the last six months, but these were from very depressed levels. Given the gold-oil ratio in the first chart above, this suggests that the gold stock-oil stock ratio has much further to run, that is, that gold stocks will do much better than oil stocks over the next year or so.

The conclusion suggested by these two charts is that one should go long oil and short gold, and long the gold stocks and short the oil stocks.

Just to round out our look at these various ratios, here's two other charts that reinforce the conclusion that oil is a lot cheaper than the oil stocks, and that gold stocks are a lot cheaper than gold.


One note of caution. Going long oil is tricky because the oil market is in contango. That is, the contracts further away from the immediate month are more expensive. The most widely traded oil fund (USO), an etf that tracks the daily movement of the oil price, will not keep pace with the futures contract when the futures curve is in contango. A way around this is another etf, USL, that buys contracts in equal amounts over the next twelve months, but the gold-oil ratio is not as extreme in the outer months, so it is not clear whether that is the better strategy.

One final chart that puts together these various relationships. Let's call it The Grand Anomaly, a testament to the inefficiency of markets.

I cannot depart the subject without recalling Adam Smith's observation in The Money Game, a popular market book from many years ago. Anyone who has a desire to speculate in the commodities markets should take a nap until the feeling goes away.

December 20, 2014

Stranded Assets

Leonardo Maugeri is gloating these days, having warned over the last few years of the possibility that the massive increases in oil supply capacity “could lead to a glut of overproduction and a steep dip in oil prices” ("The Oil Crash: Why I Was Right," October 21, 2014). Maugeri, a former executive at the Italian oil company Eni and now a researcher at Harvard, detailed in his 2012 study, “Oil: The Next Revolution,” the huge increases in investments that were occurring worldwide:

From 2003 on, oil exploration and production (E and P) worldwide entered a new, impressive investment cycle, encouraged by ever increasing crude oil prices, private companies’ desperate need to replace their reserves, the re-emergence of Iraq as a major oil player, and the inaccurate but still widespread perception that oil is bound to become a rare commodity.
That cycle reached the status of a boom between in 2010 and 2011, when the oil industry invested more than $1 trillion worldwide to explore and develop new resources. According to Barclays’ Upstream Spending Review, 2012 might represent a new all-time record since the 1970s in terms of E&P investments, with a conservative estimate of slightly less than $600 billion. . . .
My field-by-field analysis suggests that worldwide, an additional unrestricted supply of slightly less than 50 mbd is under development or will be developed by 2020. Eleven countries show a potential outflow of new production of about 40.5 mbd, or about 80 percent of the total. After adjusting the world’s additional unrestricted production for taking into account risk-factors, the additional adjusted supply comes to 28.6 mbd , or 22.5 mbd for the first eleven countries – as shown in Figure 3.
Maugeri’s main conclusion was as follows (italics in original):
[T]he single most important issue that emerges from my analysis is that, from a purely physical and technical point of view, oil supply and capacity are not in any danger. On the contrary, they could significantly exceed world consumption needs and even lead to a phase of oil overproduction if oil demand does not exceed a compounded rate of growth of 1.6 percent each year to 2020.

More recently (October 21, 2014), he writes:

After a cycle of strong investments in oil and gas exploration and development started in 2003, since 2010 an investment super-cycle took shape: over four years, national and international oil companies spent more than 2,500 billion dollars just in the ‘upstream’ hydrocarbons sector (oil and gas exploration and production).
That was an absolute historical record for the sector, even in the presence of a specific inflationary pressure which more than doubled upstream costs in the course of a decade. Much of that investment has produced, or will produce, results with a considerable time-lag, since in the oil industry it takes years to bring a given field to production.
The result is that new production capacity, or simple resilient capacity from mature fields, is progressively made available just while oil demand remains weak due to a still gloomy economic outlook – and will continue to do so. Other factors contribute to worsen the situation. . . .[T]he overall effect . . . is that global oil production capacity has been growing too rapidly – and still does: It has already exceeded 100 mbd (including biofuels and natural gas liquids), whereas demand is hovering around 92-93 mbd.
In an essay at The National Interest  (“Frack to the Future”), published in March-April 2014, Maugeri insisted that the shale-oil boom was transformational and not a temporary bubble: “Even with a steady decline of crude-oil prices (for example, from $85 a barrel in 2013 to $65 a barrel in 2017), the United States could be producing 5 million barrels per day (MBD) of shale oil by 2017.” Taking together output of biofuels and natural gas liquids, “the United States could become the leading oil producer in the world by the end of 2017, with an overall oil production of about 16 MBD and a sheer crude-oil production of 10.4 MBD.” [The difference between "overall" and "sheer" presumably is made up by biofuels and natural gas liquids.] Shale oil requires intensive drilling. Maugeri notes that there were 45,468 wells completed in the United States in 2012, whereas the rest of the world (excluding Canada) only completed 3,921 wells. Given the long time required to build people-expertise and equipment in other countries, plus the very different tax and subsurface ownership regimes, Maugeri doubted that the shale revolution would be exportable, or at least that much would have to change to make it so.

Despite these cornucopian forecasts, Maugeri noted how it all might unravel. He explained in The National Interest that Saudi Arabia is “the central bank” of world oil production. Its choice was either to cut back production to maintain prices (as it did in the early 1980s) or engineer a price collapse (as it did in 1986). We now have the results of that Saudi deliberation in its decision to maintain production, with the resulting collapse in prices. That scenario, Maugeri noted, “would put in danger both U.S. shale oil and the more expensive Canadian oil sands. The final result would be highly detrimental to U.S. energy security.”
Though Maugeri saw, as few others did, the growing imbalance between supply and demand and noted that the oil sector would be vulnerable to a collapse in prices, his 2012 analysis of worldwide additional supply seems not to have been predicated on that scenario. Having seen the future of low prices, he did not integrate that into his analysis of worldwide production increases. In his 2012 exploration of production in the Western Hemisphere, for example, he noted, "The growing output of Canadian tar sands, the huge ultra-heavy oil resources of the Venezuelan Orinoco Belt, and the recent discoveries of Brazil’s ultra-deep offshore pre-salt formations, are all pieces of the unconventional oil mosaic that, by 2020, could deliver more than 10 mbd from the Western Hemisphere alone." He ought to have said that much of this effort would be deeply uneconomic and would pose a risk to the financial viability of firms and oil exporting countries worldwide. What he was really describing in the figure and table reproduced above was not the future of world oil production but the vast number of stranded assets that were looming on the horizon, made uneconomic by oversupply.

Joseph Schumpeter noted somewhere in Capitalism, Socialism, and Democracy that one of the great oddities (and virtues) of capitalism is that most entrepreneurs work for free. That is, most businesses fail after their originators devote untold efforts to making them successful. Something like this has occurred in the energy industry. $2.5 trillion in investments in the four years from 2010 to 2014 have brought low prices for consumers and losses to the companies responsible for them. The outcome is astonishing. Digesting its significance will take years.

Unplanned Oil Production Outages

These two charts from the Energy Information Administration (December 2014) show unplanned disruptions to oil production for OPEC and non-OPEC countries. Looking at these charts alone, one would surmise an upward rather than downward pressure on prices. 

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Energy Information Administration, Short Term Energy Outlook, December 2014

Breaking Even in Oil Country

The collapse of oil prices (from $107 in June to $55 in December) has raised a big question of which marginal producers will survive the coming austerity. The share prices of energy service firms and off-shore drillers have practically been annihilated, with falls of 80 percent not uncommon among the smaller firms. In assessing the geopolitical fallout, much depends on the cost of production, not an easy matter to determine. Herewith a series of charts attempting to shed light on that question.

The first is from an August 2014 study, “The Economic Impact of the Permian Basin’s Oil and Gas Industry,” produced by a team of researchers in the department of Petroleum Engineering at Texas Tech University. It estimates that average breakeven costs for shale plays have declined by 10 percent since early 2012 and now average $55 a barrel.

The Wall Street Journal took up the question in October, before the rout in prices. It notes that many exploration and production companies have already “sunk millions into buying land and securing licenses and access to infrastructure,” making the “real benchmark for drilling . . . the return from that point on.” It cites Paul Goydon, a partner at the Boston Consulting Group, who argues that “production in the three big shale basins—Bakken, Eagle Ford, and Permian—breaks even at $60 a barrel or less.” Two years ago, the break-even price was $75. Canada’s oil sands are much more expensive. Though projects already underway can keep operating in the short term with oil at $40 a barrel, new projects require a break-even price of nearly $90 a barrel. (Surely this will have an impact on the economics of the Keystone Pipeline.)
Another estimate prepared by Morgan Stanley appears to give breakeven prices for North American shale at a higher level than the Texas Tech experts. This chart, reproduced by Business Insider, should be compared with one produced a few years ago by the French oil major Total, which showed estimates for oil shale at over $100 a barrel, well above oil sands and Arctic exploration. The estimates plainly are something of a moving target. 

The following chart, also from Business Insider, is even better, showing the breakeven cost for every international oil company project through 2020. (The chart was taken from a presentation by Ed Morse, an oil economist for Citigroup.) This plainly shows that oil cannot stay at $55 a barrel indefinitely, that price being well below the breakeven for most international oil company projects.

One more chart from the New York Times reinforces the message from the foregoing. About 80% of planned oil projects would be uneconomical with prices at $60 a barrel. Notes the Times: "A recent study by Goldman Sachs estimates that many large new oil and gas projects being planned around the world will not be commercially viable with oil at $70 per barrel. 'The shale revolution is making $1 trillion worth of new oil projects potentially obsolete,' said Michele della Vigna, a London-based Goldman analyst. 'The industry needs to reduce costs by 30 percent to go ahead with these projects at the current oil price.'”

Given the severity of the price decline, one might surmise that oil production and consumption is badly out of whack. Estimated in news reports at 1 to 2 million barrels a day, the imbalance between production and consumption is barely noticeable in this chart from the Energy Information Administration. The EIA explains: "EIA estimates that global consumption grew by 1.3 million bbl/d in 2013, averaging 90.5 million bbl/d for the year. EIA expects global consumption to grow by 1.0 million bbl/d in 2014 and 0.9 million bbl/d in 2015. Projected global oil-consumption-weighted real gross domestic product (GDP), which increased by an estimated 2.7% in 2013, is projected to grow by 2.7% and 2.9% in 2014 and 2015, respectively."

The breakeven costs are also reviewed in a Goldman chart that is (wittily) annotated by Tom Randall of Bloomberg. Randall explains: "The chart below shows the break-even points for the top 400 new fields and how much future oil production they represent. Less than a third of projects are still profitable with oil at $70. If the unprofitable projects were scuttled, it would mean a loss of 7.5 million barrels per day of production in 2025, equivalent to 8 percent of current global demand."

Another chart in Randall's piece shows the impact of $75 oil on shale production. It's not clear what $55 oil would mean for the America's shale revolution, but the $75 level shows only a 40% drop in growth, not an absolute decline.

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For links to several of these charts, a tip of the hat to Mr. Cain Thaler, "My Worst Day in Three Years," ibankcoin.com, November 28, 2014

The 2C Red Line

This piece by Justin Gillis of the New York Times is part of a series on the most recent climate negotiations in Lima, Peru. The result of the meeting was preliminary language intended to keep warming from rising more than 2 degrees Celsius (3.6 degrees Fahrenheit) beyond the average global temperature at the beginning of the Industrial Revolution. Gillis explores where that figure came from, noting its emergence in the 1970s in the work of Yale economist William Nordhaus and its endorsement in the 1990s by the German government, the latter among the most active governmental campaigners for action on climate change. Gillis emphasizes the importance of the figure in relation to the melting of the Greenland ice sheet, and notes that some scientists believe that it is already beginning to break up.

* * *
. . . A decade of subsequent research added scientific support to the notion that 2C was a dangerous threshold. Experts realized, for example, that at some increase in global temperature, the immense Greenland ice sheet would begin an unstoppable melt, raising the sea by as much as 23 feet over an unknown period. Their early calculations suggested that calamity would be unlikely as long as global warming did not exceed about 1.9 degrees Celsius.
 “Risking a loss of the whole Greenland ice sheet was considered a no-go area,” said Stefan Rahmstorf, head of earth system analysis at the Potsdam Institute for Climate Impact Research in Germany. “We are talking about really sinking a lot of coastal cities.”
As the economic and scientific arguments accumulated, the Germans managed to persuade other countries to adopt the 2C target, turning it into official European policy. The proposal was always controversial, with African countries and island states, in particular, arguing that it was too much warming and would condemn them to ruin. The island states cited the potential for a large rise of the sea, and African countries feared severe effects on food production, among other problems.
But as a practical matter, the 2C target seemed the most ambitious possible, since it would require virtually ending fossil fuel emissions within 30 to 40 years. At Cancun in 2010, climate delegates made 2C one of the organizing principles of negotiations.
The talks culminating in Paris next year are seen as perhaps the best chance ever to turn that pledge into meaningful emissions limits, in part because President Obama has gone far beyond his predecessors in committing the United States, the largest historical producer of greenhouse gases, to action. That, in turn, has lured China, the largest current producer, into making its first serious commitments.
Yet even as the 2C target has become a touchstone for the climate talks, scientific theory and real-world observations have begun to raise serious questions about whether the target is stringent enough.
For starters, the world has already warmed by almost one degree Celsius since the Industrial Revolution. That may sound modest, but as a global average, it is actually substantial. For any amount of global warming, the ocean, which covers 70 percent of the earth’s surface and absorbs considerable heat, will pull down the average. But the warming over land tends to be much greater, and the warming in some polar regions greater still.
The warming that has already occurred is causing enormous damage all over the planet, from dying forests to collapsing sea ice to savage heat waves to torrential rains. And scientists realize they may have underestimated the vulnerability of the ice sheets in Greenland and Antarctica.
Those ice sheets now appear to be in the early stages of breaking up. For instance, Greenland’s glaciers have lately been spitting icebergs into the sea at an accelerated pace, and scientific papers published this year warned that the melting in parts of Antarctica may already be unstoppable.
“The climate is now out of equilibrium with the ice sheets,” said Andrea Dutton, a geochemist at the University of Florida who studies global sea levels. “They are going to melt.”
That could ultimately mean 30 feet, or even more, of sea level rise, though scientists have no clear idea of how fast that could happen. They hope it would take thousands of years, but cannot rule out a faster rise that might overwhelm the ability of human society to adapt.
Given the consequences already evident, can the 2C target really be viewed as safe? Frightened by what they are seeing, some countries, especially the low-lying island states, have been pressing that question with fresh urgency lately.
So, even as the world’s climate policy diplomats work on a plan that incorporates the 2C goal, they have enlisted scientists in a major review of whether it is strict enough. Results are due this summer, and if the reviewers recommend a lower target, that could add a contentious dimension to the climate negotiations in Paris next year.
Barring a technological miracle, or a mobilization of society on a scale unprecedented in peacetime, it is not at all clear how a lower target could be met.
Some experts think a stricter target could even backfire. If 2C already seems hard to achieve, with the world on track for levels of warming far beyond that, setting a tighter limit might prompt political leaders to throw up their hands in frustration.
In practice, moreover, a tighter temperature limit would not alter the advice that scientists have been giving to politicians for decades about cutting emissions. Their recommendation is simple and blunt: Get going now.
“Dealing with this is a little bit like saving for retirement,” said Richard B. Alley, a climate scientist at Pennsylvania State University. “All delay is costly, but it helps whenever you start.”
* * *
Justin Gillis, “3.6 Degrees of Uncertainty,” The New York Times, December 15, 2014


December 19, 2014

China's Global Reach in Agriculture

This article by a Chinese diplomat, Loro Horta, details China’s growing turn to overseas farming. These excerpts are from Yale Global Online, December 16, 2014

* * *
China is home to 22 percent of the world’s population, but possesses around 7 percent of its arable land – 334.6 million hectares. However, in recent years the county’s arable land has been shrinking as a result of serious environmental damage such as soil erosion, deforestation and pollution of rivers and lakes. In November Chinese officials reported that more than 40 percent of China’s arable land is suffering from degradation.

The combination of rising food demand and reduced arable land makes it difficult for China to feed itself in the not so distant future. In the past decade China has experienced hikes in food prices and shortages of certain products.
China has no choice but to turn to overseas farming. In 2013 China imported 4 percent of the world’s grain and this figure is likely to rise in coming years.

Several Chinese government officials have also talked about the overseas option as a complement to strengthening domestic production. In 2010, Chinese Minister for Agriculture Han Changfu said, “The time is ripe for the country’s agricultural companies to embark on a go outward strategy.”
In recent years Chinese investment in overseas agriculture and land leases has steadily increased. Chinese companies began investing in neighboring Laos and Cambodia farmland in the early 2000s and slowly ventured further afield. Chinese-owned or jointly owned farms are in several African countries including Mozambique and Ethiopia.

In Mozambique, a Hubei-based company has invested $250 million in a rice farm in Gaza province. In November 2013 the country’s state-owned newspaper Notícias cited Raimundo Matule, a director at the ministry of agriculture, reporting that several Chinese conglomerates were expected to invest up to $2.5 billion in the country’s agricultural sector. In Angola Chinese state-owned giant CITIC pledged to invest $5 billion in agriculture in addition to its current lease of 20,000 hectares of land in the former Portuguese colony.
Mozambique and Angola in particular are large countries with immense tracks of fertile land and a small population. Angola has a land area of 1.24 million square kilometers and a population of 16 million.

China’s ongoing tensions with its Southeast Asian neighbors make other parts of the world even more attractive, and Africa could emerge as a major provider of agricultural products to China in coming years.
Chinese business interests have also leased tracts of land in Brazil, Peru Argentina and Mexico. China is also reported to be acquiring land in the sparsely populated Russian Far East just across the border from heavily populated northern China. Chinese companies are reported to have leased 1 million hectares of land through Russia. China’s most ambitious investment in the sector is a land lease deal with Ukraine for 3 million hectares to produce grain and raise pigs. In 2010 Chinese companies were reported to have requested the lease of 1 million hectares from the Kazak government to plant soybeans and wheat. In 2010 China was believed to have leased or bought over 2 million hectares of land abroad. In 2011 China’s largest agriculture group, Heilongjiang Beidahuang Nongken, announced that it was investing $1.5 billion to develop 300,000 hectares of land in Rio Negro province in Argentina .

However, the overseas option China is pursuing carries risks as well as promises of reward. As shown by recent events in the Ukraine, once a relatively stable part of the world, nothing is guaranteed. Land is a sensitive issue that touches upon our most primordial fears. In Kazakhstan there is widespread concern, sometimes bordering on paranoia, that China is grabbing the country’s vast and sparsely populated land by bribing local officials. In Brazil several officials including former Minister of Agriculture Delfin Netto have accused China of carrying out a stealth land grab. 
In Mozambique a Chinese land lease in the Limpopo valley is reported to have displaced 80,000 people, while in Cameron tribal chiefs and local NGOs have protested against land acquisitions by Chinese companies. In Angola there have been allegations of physical assault against African farm labors by their Chinese managers, while such incidents have been isolated cases. Angola has bitter memories of Portugal’s brutal plantation system in which the chicote, or whip, was widely used.

China is not alone in its interest for African farmland. Brazil, Japan, South Korea and several Gulf States have leased large tracks of land in Africa. Brazil seems to have been far more successful than China, at least in Mozambique, having acquired 500,000 hectares of land in the country’s north. Brazilian land deals have been far less controversial than Chinese ones and elicited less suspicion. Brazilian companies are reported to be producing soybeans in Mozambique, and for several years, Brazil has been main supplier of this product to China. It seems that the Brazilians have stolen a march on the Chinese.
Despite these risks Chinese investment in overseas agriculture is likely to continue. China has little choice but to turn overseas to sustain its growing food needs.

However, one must be cautious not to see Chinese acquisitions of overseas farms as a mere land grab. The issue is far more complex. China has invested hundreds of millions of dollars in agriculture research centers throughout Africa that have greatly increase rice and other crops production and alleviated food shortages. Hundreds of Chinese agriculture scientists are working in Africa and elsewhere to improve efficiency. While Africa and other parts of the world are supplying China with products such as grain, soybeans and meat. China may also contribute to consolidating food security in Africa and other regions with its investment and expertise. China’s long-term strategy may be to boost Africa’s capability to produce agriculture surplus, both addressing the continent’s chronic food shortages and China's demand for imported food.
Chinese investment in overseas agriculture can bring significant benefits provided such investments are done in an open and transparent way and with respect for local communities. Indeed, certain countries – particularly Angola and Zimbabwe, to mention a few – are keen on such investments. China and the host countries for such investments can benefit tremendously – if both sides have the imagination to build mutually beneficial partnerships. 

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Lora Horta, Chinese Agriculture Goes Global, Yale Global, December 16, 2014

December 18, 2014

Oil Bust

The collapse in oil prices since the summer of 2014, accelerating over the last month, promises to have lasting affects on international politics. Provoked by Saudi Arabia's determination to drive down the world price, the oil price collapse is sending out rippling waves that touch the entire planet. Herewith a series of charts intended to put what has happened into perspective.

First off, the fall in prices itself. This chart shows West Texas Intermediate Crude, the benchmark U.S. price. Brent (traded in Europe) was a few years ago at a spread of over $20 dollars a barrel, but the spread is now only 3-4 dollars. Here is a twenty year chart of the price of U.S. oil, followed by a two year chart

Recall that only a few years ago the cost of the marginal barrel of oil was approaching $100, and one gets a sense of how many projects are rendered uneconomic by a price at $55 a barrel. For projects already underway, of course, on which the capital has already been spent, the marginal cost of operating a well is far lower. The longer a low price regime lasts, paradoxically, the greater is likely to be the spurt upwards when it occurs (since future supply will be reduced by the paring back of investment programs in the here and now).

The following chart from the Financial Times (December 15, 2014) shows the dollar cost of net imports and exports from selected countries. The data, though labeled as 2014, comprises totals for the previous four quarters as of the third quarter of 2014. As most of the price drop has occurred in the fourth quarter of 2014, this will dramatically affect the amounts reported in the chart.

Probably the average price of oil over the next year (from the 4th quarter of 2014 to the 4th quarter of 2015) will be higher than $55, but it would not be unreasonable to forecast that revenues for exporters and costs for importers will be some 60-70% of the figures reported above.  Even if prices have rebounded six months from now, the interim period will throw the entire sector (and many countries) into crisis. It is in the nature of markets to overshoot; it is not inconceivable (though I think unlikely) that the lows of late 2008 ($35 a barrel) will again be tested.

More to come.

August 13, 2014

Ukraine's Gas Woes

James Stafford of Oilprice.com has the goods on Ukraine’s recent energy legislation: 

Ukraine doesn’t need Russia to take it down—Kiev is doing fine destroying itself, most recently with a new tax code that doubles taxes for private gas producers and promises to irreparably cripple new investment in the energy sector at a time when reform and outside investment were the country’s only hope.
Ukrainian President Petro Poroshenko on August 1 signed off on a new tax code that effectively doubles the tax private gas producers in Ukraine will have to pay, calling into question any new investment, as well as commitment from key producers already operating in the country.
The stated goal of the new tax code—a legislative package embraced by the parliament on July 31 with more than 300 votes--is to raise $1 billion, of which $791 million would go to fund the war effort in eastern Ukraine.
According to the Kyiv Post and Ukrainian law firms, the new code will remain in force until the end of 2014 during which time gas drillers will be required to pay 55 percent of their subsoil revenue for extracting under five kilometers. This is up from 28 percent--so it’s a significant hit for producers. Additionally, for any extraction beyond five kilometers, the tax will be 28 percent--up from 15 percent.
The only saving grace here is that this wasn’t the worst possible scenario: An early version of the bill called for a 70 percent tax on gas extraction.
Ukraine may have some of the most attractive gas prices in the world—the only thing that could have possibly lured investors there—but the new tax law renders this irrelevant, especially considering that in European countries, the tax does not exceed 20 percent.
The oil sector will also be hit with the new tax code, which increases rates to 45 percent for drilling under five kilometers—up from 39 percent. But it is the gas tax hike that will really cripple potential investment in Ukraine.
Private gas producers lobbied energetically against the new tax laws, arguing that it will crush investment and force investors to re-think their commitment to Ukraine. They also argue that it benefits some members of the political-business elite, and has nothing at all to do with funding the war effort in the east. Instead, it is the next phase in the battle among energy oligarchs to secure their interests in the dynamic political arena shaping up after the fall of President Viktor Yanukovych.
In an open letter sent to Parliament on July 29, a group of private producers stated: “The draft law may lead to a rapid increase in the tax burden on private gas producing companies, a significant decrease in project cost effectiveness in general (up to closing down due to unprofitability) and a general decrease in attractiveness of the Ukrainian market for foreign investors."
Speaking to Oilprice.com from Kiev, Robert Bensh—a veteran Ukraine energy executive and partner and managing director of Pelicourt LLC, the majority shareholder in Ukraine’s third-largest gas producer, Cub Energy—was highly critical of the new tax law and fearful of what it means for Ukraine’s future at such a critical juncture its energy dynamics.
“This law is dangerous to the long-term security of Ukraine. It adds little to the budget and discourages drilling and investment in the upstream oil and gas sector, as well as calls into question the ability to invest in Ukraine at all,” said Bensh, who has been one of the most visible lobbying forces against the law.
“No one will invest in a country that arbitrarily punishes investors who are creating value by increasing reserves and production, or who are paying taxes and employing hundreds of thousands of people. No one will invest in an industry with the risk that taxes will be double or triple within a few months,” he said.
Bensh called the bill “highly political” and pointed to its two key beneficiaries: energy magnates Rinat Akhmetov and Ihor Kolomoyski, who “either own oil or mining assets that were taxed immaterially and punitively taxed gas producers.”
According to OP Tactical’s intelligence wing, the tax code was clearly maneuvered by Akhmetov and Kolomoyski and should serve as the first sign that key reforms of the energy sector will be challenged at every step to ensure that these interests are secured at the expense of the state.
“The failure of Ukraine to develop gas supplies, either due to years of corruption and or failure to attract outside investment into the upstream sector, is a material factor in Ukraine's current economic crisis and issues with Russia. Ukraine has always sought the easy solution.  This tax and the failure to see the strategic impact upon the country is yet again another example,” Bensh said.
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James Stafford, “Who Needs Russia? Ukraine Will Destroy Itself with New Gas Tax,” Oilprice.com, August 7, 2014. Stafford has a August 12 update here, citing the protests of Cub Energy, Geo Alliance, Burisma, Kub Gas, and Regal Petroleum. They warn that “the 55 percent tax rate could ‘lead to the collapse’ of large- and medium-scale projects in Ukraine.”  Extension of the tax beyond the end of 2014 will lead these firms to leave Ukraine and mean “no further foreign investment in the country’s beleaguered gas sector.”