Agcapita March 2011


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With the recent unrest in some of the world’s most critical petroleum producing regions I thought I might spend some time on the topic of oil prices. However, rather than engaging in what I believe is the largely futile exercise of attempting to predict the price of oil next week, next quarter or even next year, I want to try to address two more fundamental questions. What is the long-term risk to real oil prices from 1) a further economic downturn and at the other extreme 2) accelerating growth in the emerging economies? Agcapita is Canada's only RRSP and TFSA eligible farmland fund and is part of a family of funds with over $100 million in assets under management. Agcapita believes farmland is a safe investment, that supply is shrinking and that unprecedented demand for "food, feed and fuel" will continue to move crop prices higher over the long-term. Agcapita created the Farmland Investment Partnership to allow investors to add professionally managed farmland to their portfolios.

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Agcapita March 2011

  1. 1. Agcapita UpdateMarch 2011
  2. 2. Agcapita UpdateOIL PRICES, POSITIVE FEEDBACK LOOPS AND THE BACKOF AN ENVELOPE...With the recent unrest in some of the world’s most criticalpetroleum producing regions I thought I might spend some timeon the topic of oil prices. However, rather than engaging in whatI believe is the largely futile exercise of attempting to predict theprice of oil next week, next quarter or even next year, I wantto try to address two more fundamental questions. What isthe long-term risk to real oil prices from 1) a further economicdownturn and at the other extreme 2) accelerating growth in theemerging economies?Research from Cambridge Energy Research Associates providesthe answer to the first question. By comparing the cost ofproduction of the various sources of supply that make up currentdaily production volumes you find that demand would have todrop by approximately 15 million barrels per day (around 20% ofdaily consumption) to create sustained $60 per barrel prices.The reason for this is straightforward - the seventy millionremaining barrels of daily supply would be unprofitable belowthis price. It is the incremental barrel that sets the market priceand as we are in an environment where the production costs oflarge amounts of incremental oil are very high (think offshore andoil sands) prices must to remain high otherwise supply is shut-inand disappears due to lack of profitabilityOf course, most analysts have given up forecasting largedemand drops for now - certainly not on the order of the 20% itappears is required to create sustained $60 per barrel oil pricesagain.What is receiving a significant amount of attention is the natureof the energy demand emanating from the emerging economies- it has surprised most analysts in being both large and resilientover the last 3 years. And now for that “back-of-the-envelope” 1
  3. 3. Agcapita Update (continued)analysis promised in the title. Is it possible to quantify its “Energy Outlook 2030” BP predicts that Chinathe effect of the emerging economies on oil prices will be the largest source of oil consumption growthover the next decade? Here is a simple thought over the next 20 years - increasing consumptionexperiment using Chinese demand to generate some by 8 million barrels per day to 17.5 million barrelsrough numbers: per day - overtaking the US as the world’s biggest oil consumer. According to the report, developing– China moves from 3 barrels per person per year nations, accounting for 93% of global energy growth to the South Korean level of 17 barrels per person over the next 20 years, will drive global energy per year consumption.– Transition takes 30 years– Consumption changes are linear In much more detail, according to a report by Joyce– No peak in global production Dargay and Dermot Gately: “Two liters a day - that’s what per-capita world oil demand has been forIn next 10 years we would have to find 44 million forty years. Yet this constancy conceals dramaticbarrels of oil per day (“BOPD”) or around 50% of changes. While per-capita demand in the OECDcurrent production - 26 million BOPD to maintain and the FSU have been reduced - primarily due tosupply and 18 million BOPD to keep up with demand fuel-switching away from oil in electricity generationincreases. Now superimpose peak production and space heating, and by economic collapse in theon top of this demand profile using the following FSU - per-capita oil demand in the rest of the worldparameters: has nearly tripled, to more than 1 liter per day. In addition, the rest of the world’s population has grown– Oil demand elasticity of -0.3 much faster than in the OECD and FSU (1.85% v.– Current production 84 million BOPD 0.74% annually). As a result, the rest of the world’s– Assume pre-crisis starting price of US$ 80 per total oil consumption has grown seven times faster barrel (4.4% annually, versus 0.6% in the OECD and FSU)– Peak production 100 million BOPD - increasing from 14% of the world total in 1971, to– Post peak decline rate of 3-4% 39% today. If annual per-capita oil demand growth rates to 2030 were assumed to be held zero in theBased on the foregoing, oil prices would increase OECD, 1% in the FSU, and at its 1971-2008 historicalapproximately 250% in real terms over next 10 rate (2.54% annually) in the rest of the world, total oilyears - obviously something would have to give in demand will be 138 million barrels per day in 2030 -the global economy long before that point and that about 30 million barrels per day greater than what issomething would be demand. projected by DOE, IEA, and OPEC. By 2030 the rest of the world’s per-capita demand would be almost 2Just how realistic is it to assume such an enormous liters/day, and its share of total world demand wouldaffect on the markets from China at the margin? In increase from 39% now to 58%.” 2
  4. 4. Agcapita Update (continued)Clearly we have some grave challenges building on easing - to translate for uninitiated, our centralthe supply side. Let’s now delve into another part of bankers are saying that they will need to print morethe oil price issue that receives far too little attention money in order for us to pay our oil bills. The thoughtin the mainstream media - rapidly depreciating fiat that it is the rampant debasement of the world’s fiatcurrencies and developed nations that for the most currencies that is lurking behind oil’s rise over the lastpart must import large amounts of oil to satisfy 6 months seems never to enter their minds. Pleasedomestic consumption and maintain an energy feel free to contact your local central banker with theintensive way of life. For example, the US must definition of a positive feedback loop as I think theyimport around 10 million BOPD (over 10% of global may be about to have one demonstrated to them in aoutput). very graphic and grizzly fashion.How is it possible for western nations to pursue weak In any event, given the reckless behavior of thecurrency policies while remaining highly dependent developed world’s monetary authorities and theon imports to satisfy domestic oil demand? I often supply/demand fundamentals in the oil markets Iwrite about the law of unintended consequences believe we will continue to see upward pressure onas is fitting in a time of unprecedented intervention prices - certainly in nominal terms and most likely inin the operation of the free markets by non-profit real terms as well. For this reason I remain interestedmaximizing state actors. Today is no exception. in direct investments in physical production assets over the long-term. Direct ownership of productionZero interest rates and their associated money supply assets removes the risks and costs bound up in oilexpansions may yet serve to bail out the insolvent equities with their need to engage in exploration tobanking sector but will severely impact the western, maintain reserve levels. In addition, direct ownershipmiddle class way of life via escalating food and of production assets eliminates a number of criticalenergy costs. counter-party and agency risk issues, provides recourse to a physical asset and the returns are ofChanneling the spirit of Rudolf Havenstein, the course commodity linked but with ongoing cash flow.president of the Reichsbank who oversaw theGerman hyperinflation of 1921-1923, US Federal Kind RegardsReserve officials have recently been saying that higheroil prices may be the catalyst for further quantitative Stephen Johnston 3
  5. 5. DISCLAIMER: The information, opinions, estimates, projections and other materials contained herein are provided as of the date hereof and are subject to change without notice. Some of the information, opinions, estimates, projections and other materials contained herein have been obtained from numerous sources and Agcapita Partners LP (“AGCAPITA”) and its affiliates make every effort to ensure that the contents hereof have been compiled or derived from sources believed to be reliable and to contain information and opinions which are accurate and complete. However, neither AGCAPITA nor its affiliates have independently verified or make any representation or warranty, express or implied, in respect thereof, take no responsibility for any errors and omissions which maybe contained herein or accept any liability whatsoever for any loss arising from any use of or reliance on the information, opinions, estimates, projections and other materials contained herein whether relied upon by the recipient or user or any other third party (including, without limitation, any customer of the recipient or user). Information may be available to AGCAPITA and/or its affiliates that is not reflected herein. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice or as a recommendation to enter into any transaction. Additional information is available by contacting AGCAPITA or its relevant affiliate directly.#400, 2424 4th Street SW Tel: +1.403.608.1256 www.agcapita.comCalgary, Alberta T2S 2T4 Fax: +1.403.648.2776Canada