How Fracking Saved the U.S. Economy

The modern economy is a function of cheap, easily-accessible energy sources. The modern transportation, technology, healthcare, and agricultural industries cannot function without a cheap and reliable source of energy–in fact, our survival depends upon it. Beginning with the Industrial Revolution, the vast majority of U.S. economic growth was predicated on an exponential increase in energy consumption. This demand was met by the growth in global energy supplies, the rise of natural gas as a fuel source during the 1970s, and now alternative energy sources such as solar, wind, and biofuels. Surprisingly, efficiency breakthroughs did little to counteract the insatiable demand for new sources of energy (e.g. each die shrink in the modern-day CPU created even more demand for computers and computing power). This means that future U.S. and global economic growth can only be guaranteed through new sources of energy–i.e. greater efficiency and recycling can only achieve so much.

Since 2012, we have argued for a “U.S. Energy Renaissance” through the advent of hydraulic fracturing (“fracking”), horizontal drilling, ultra deepwater drilling in the Gulf of Mexico, as well as the commercialization of alternative energy solutions and more efficient battery storage. Recent evidence suggests our thesis continues to be true. In fact, the latest energy (especially crude oil) production statistics show that tight oil production (through fracking in shale fields such as Eagle Ford (TX), the Bakken (MY & ND), Spraberry (TX & NM Permian), Bonespring (TX & NM Permian), Marcellus (PA & WV), etc.) is still hitting record highs, surpassing many analysts’ expectations.

Figure 1: The Exponential Increase in U.S. Shale Oil and Shale Gas Production (source: EIA)


As recent as October 2012, the Energy Information Administration (EIA) projected U.S. crude oil production to rise from 6 million barrels/day to just 7 million barrels/day by 2020 in its base case. Only in its most optimistic scenario did the EIA project U.S. oil production to hit 8 million barrels/day by 2020. Shale oil production, however, has surpassed even the most optimistic projections from just 20 months ago. Today, U.S. crude oil production has already surpassed 8 million barrels/day (8.3 million barrels/day during May 2014), and is now projected to rise above 9 million barrels/day by the end of 2015–close to the record high of 9.6 million barrels/day production in 1970.

Figure 2: EIA’s U.S. Oil Production Forecast by Region (million barrels/day)


We contend that the tremendous increase in U.S. oil and gas production over the last several years has single-handedly saved the U.S. economy and employment picture from a potentially catastrophic outcome. According to the EIA, the U.S. trade deficit resulting from oil imports reached a record high of $452 billion during the third quarter of 2008 as the spot price soared to nearly $150 a barrel. As recent as the second quarter of 2011, the U.S. oil trade deficit sat at $346 billion. As of the end of 2013, the oil trade deficit has shrunk to $203 billion and is projected to shrink to less than $170 billion by the end of this year. This shrinkage in the U.S. oil trade deficit added a full percentage point to U.S. GDP (as well as added a record number of jobs in Texas and North Dakota), but more important, helped secure U.S. energy and national security for years to come.

Figure 3: U.S. Oil Production Growth Has Slashed Our Trade Deficit by Nearly $200 Billion a Year…


The Important Knock-on Effect on Global Oil Supply from Shale Production Growth: Less Resource Protectionism

Paradoxically–as U.S. reliance on foreign oil supplies dwindles–we expect foreign oil production growth to exceed current expectations, Iraq’s geopolitical turmoil notwithstanding. As oil prices rose from <$40 a barrel over the last decade, many countries such as Russia and Mexico have resorted to a parasitic policy of resource protectionism to maintain national control over its oil supply/infrastructure. This has resulted in anemic global production growth at best, as many oil-exporting countries had no incentive to invest in future oil production growth given the rise in oil prices every year.

The decline in Petroleos Mexicanos’ (Pemex’s) production due to the lack of R&D and capital expenditure spending is a prime example. Just last week, Pemex lowered its 2014 production forecast from 2.5 million to 2.41 million barrels/day, its lowest in at least 24 years. As long as oil prices were rising, the Mexican government did not have much incentive to invest in future oil production growth. Now that global oil prices are expected to remain flat over the next 5-10 years (due to the ongoing shale revolution), the Mexican government has no choice but to execute a 180-degree turnaround to compete for global oil market share. For the first time since 1938, the Mexican government has invited foreign capital back into its oil industry; consensus expects this landmark law to bring in $50 billion of annual foreign private investment by 2020 (as a comparison, Pemex’s 2015 capital expenditure budget is estimated to be $29 billion, up from $27.7 billion this year).

Going forward, we expect global oil production growth to exceed expectations–thanks to the direct and knock-on effects of the U.S. fracking revolution.

Emerging Markets’ Desperate Need for Renewables

In our October 28, 2013 commentary (“An Early 21st Century Narrative: The Age of Renewables“), we asserted that–due to increasing domestic crude oil production and the ongoing adoption of renewable fuels–U.S. energy independence on a national level is a foregone conclusion. The Energy Information Administration (EIA) chronicles that last year, as much as 84% of total U.S. energy demand was fulfilled by domestic sources, the highest level in 30 years.

Exhibit 1: U.S. Energy Production at 30-year High Relative to Consumption


Interestingly, 10% of our domestic energy production now comes from renewables (including hydro, solar, wind, biofuels, and thermal). We believe government agencies in general are too pessimistic regarding the trajectory of the increasing impact of renewables on U.S. and Developed Markets’ energy production. For example, Germany (a country not known for its sunshine) recently generated over half of its electricity from solar for the first time, while Great Britain’s installed solar capacity doubled over the last year–none of which anyone has foreseen. Because of the rapid adoption of renewables, as well as the ongoing shale revolution, we continue to believe that U.S. energy independence on the national level is a foregone conclusion.

What we are more interested in–as investors and global citizens–are two more ambitious goals: 1) energy independence at the community or household level through microgrids and a “smart,” decentralized distribution system, and 2) bringing electricity and heating to more undeveloped areas of the world. The International Energy Agency (IEA) estimates that 1.3 billion people today are still without access to electricity, while 2.6 billion people have no access to clean cooking facilities.

This is a glaring social problem not just in Sub-Saharan Africa but in other developing countries/regions, such as India, China, and Developing Asia. e.g. The IEA contends that as much as 25% of India’s population today have no access to electricity. A country where a vast segment of its population is disenfranchised is both a significant impediment for future economic growth and social harmony.

According to the IEA’s 2014 World Energy Investment Outlook, global policy makers and corporations are projected to invest $40.2 trillion into our energy production and transportation infrastructure from now till 2035. 59% of these funds will be used to maintain current production, while 41% will be for new development. Two interesting trends are expected to continue over the next 20 years:

  1. There is a decisive trend towards investing into renewables and efficiency programs in both developed and emerging market countries;
  2. The role of public policy makers in shaping global energy policy has been on the rise, and will continue to rise for the foreseeable future as governments set goals for renewables adoption (e.g. California’s 33% renewables goal by 2020) and new efficiency standards.

Within the developed world, these two trends are driven by environmental and domestic energy security concerns. Within Emerging Markets, however, these are driven by more fundamental concerns. For example, economic growth and the rising cost of energy has led to a significant deterioration of China’s and India’s trade accounts in recent years. The rising cost of energy (combined with significant gold imports) was instrumental in causing India’s financial crisis last summer.

Exhibit 2: Oil Import Bills of Net Importing Developing Countries on the Rise (source: IEA)

oilimportbillEMSince 2011 (the IEA’s last study on Emerging Markets’ energy imports), energy dependence in countries like China and India has continued to rise. In fact, China’s oil imports are projected to rise above that of the U.S. sometime this year. As such, investments in renewables in both China and India are not only necessary due to environmental concerns, but national security concerns as well.

Finally, as discussed above, there is also a dire need to empower those who currently have no access to electricity in many developing countries, including India. This is crucial to sustain high economic/productivity growth, as well as for long-term social cohesion (having electricity inherently increases access to education, knowledge, and healthier lifestyles). The IEA estimates that an additional $641 billion in investments is needed to achieve universal access to electricity by 2030, $135 billion of which is needed in India. In light of the $40.2 trillion of projected investments in the global energy sector over the next 20 years, $641 billion is achievable. However, the IEA also stresses that much of these investments would need to be made in rural areas with little or no access to any existing infrastructures (e.g. power lines or even paved roads). Since the costs of building a centralized grid (or expanding the current grid) to rural areas are prohibitively high, the only alternative is to install microgrids or roof-top solar in such undeveloped rural areas. The age of renewables will thus not only bring U.S. energy independence, but increased energy access to the rest of the world as well.

 Exhibit 3: Additional Investment Required for Universal Access to Electricity ($billion in year 2010 dollars; source: IEA)


U.S. Shale Depletion Worries are Overblown

Note: Drilling in the Lower Tertiary over the last three years indicate an additional 15 billion barrels of recoverable oil remain in the Gulf of Mexico. To put this in perspective, the EIA estimates U.S. total oil reserves of 26 billion barrels. An additional 15 billion barrels of reserves will propel the U.S. from 14th to 10th in a global ranking of countries with the most recoverable oil reserves. Because of this, Wood Mckenzie projects oil production in the Gulf of Mexico to reach 2 million barrels/day by 2020–up from 1.3 million barrels/day to a record high. As we have mentioned, the days of U.S. energy independence–fueled by a renaissance in domestic production, as well as significant investments and breakthroughs in renewable energy–are inevitable. Drilling and production in the Lower Tertiary is simply another part of the energy independence equation.

Onto our main commentary: The worries over oil and gas well depletion rates are nothing new. During the 1970s, natural gas wells in Texas only averaged a 16% first-year decline rate. By the late 1990s, this hit an all-time high of 56%. As a young natural gas analyst in Houston, TX during 2000-01, I was stunned by these high depletion rates, and was convinced that domestic natural gas production would more than halve over the next decade.

TX Decline RatesSource: Oil & Gas Journal, Gary S. Swindell & Associates

At the very least, such depletion rates, even with flat demand growth, would require a substantial amount of Canadian and LNG imports. Obviously, this turned out to be a false assumption, courtesy of the adoption of horizontal drilling rigs and the commercialization of shale fracking. Here’s what I learned: Higher depletion rates were not a function of less productive wells; rather, they were a function of better extraction technologies, as well as investors’ demand for higher IRRs at the expense of higher long-term production if short-term production was capped (IRRs increase substantially if production, and thus monetization, is front-loaded). We simply turned into a culture where we could and did suck out the oil and gas faster than ever before.

Make no mistake: It is important to track and analyze depletion rates in the six most prolific shale areas–the Bakken, Eagle Ford, Haynesville, Marcellus, Niobrara, and Permian–as these six key fields accounted for nearly 90% of domestic oil production growth, and nearly 100% of all domestic natural gas production growth during 2011-12.

dpmapv3-wtitleTo that end, the Energy Information Administration (EIA) publishes a monthly “Drilling Productivity Report” that tracks depletion rates of legacy fields and initial production rates of new fields in these six key shale plays. As long as initial production on new fields outpaces the decline in production of legacy fields, the increase in oil and gas production in these six shale plays will continue. The latest evidence suggests this remains true. For example, early indications in the Eagle Ford Shale suggest that both oil and natural gas production rose to another new high this month, as production from new wells outpaces the decline in legacy production.


Finally, current rig counts and recent productivity gains in both the Bakken and Eagle Ford regions suggest new production growth should comfortably offset future decline rates. In addition, production growth actually accelerated in the Niobrara and Permian. In other words, there is ample evidence suggesting that shale oil and natural gas production in these six shale areas will continue to grow–and to drive U.S. energy independence–for months, if not years to come.


An Early 21st Century Narrative: The Age of Renewables

Brazil recently auctioned off the rights to its giant Libra oil field, and practically no-one attended the party. Any American under the age of 25 cannot imagine a world where half of the population lived under the follies of central planning; and any American under the age of 20 cannot imagine a world without the internet or instantaneous global communications.

Similarly, any American born in the year 2013 would not be able to imagine a world where there is even a debate on the viability of renewable fuels vs. fossil fuels. To them, it is a foregone conclusion that renewable fuels will be the main lifeblood of 21st economic growth and prosperity. We assert that much of the early 21st century narrative–particularly the years 2014-2020–will be driven by the “coming of age” of renewable energy sources, particularly solar, wind, battery storage technologies, and eventually, bio-fuels.

We have kept track of the energy industry since the end of the boom, when I worked as a natural gas & oil analyst in Houston, Texas. In an August 29, 2004 commentary (when WTI traded at $45 a barrel), I argued that WTI could be trading at $80 to $100 a barrel, while U.S. gasoline prices could top $4.00 a gallon over the next five to six years. The study of renewable fuels is an extension of this–the study of the evolving energy regime is important as energy forms the lifeblood of any modern economy, and to this day, still dictates much of global geopolitics. But more important, we believe renewable fuels will drive much of the growth in U.S. and European energy production from now until 2020. Power grids will become more decentralized while households will be subject to less power interruptions. U.S. energy independence at the national level is a foregone conclusion–what we are trying to achieve is energy independence down to the community or neighborhood level. This may be a more difficult feat given the entrenched interests of U.S. utilities, unions, and the amount of capital costs required to construct microgrids across the country. We also believe that this boom in renewable fuels production/infrastructure growth will coincide with the next secular bull market in venture capital and public equities.

Energy historians (e.g. Daniel Yergin–his Pulitzer-prize winning book “The Prize” is a must-read ) in 2020 will look back at the disappointing auction of Brazil’s Libra oil field as a watershed event in the global energy regime. The failure of the Libra field in generating much excitement heralds the beginning of the end of the “Age of Oil,” and not coincidentally, the shift of economic power from the “BRICS” and OPEC countries back to the United States as the latter, especially the state of California, invest substantial amounts in renewable fuels technology and infrastructure. Sure, the commercialization of the Libra oil field has been beset by political and ownership disputes, as well as overshadowed by the commercialization of U.S. shale. But the collective yawn by energy analysts and the U.S. population would have surprised me just a few years ago, when Petrobras’ stock price was still riding high.

Today, we are no longer as surprised. A recent (which I would label as conservative) study by Citi Research projects that $9.7 trillion of infrastructure investments will be made in the global power industry from now till 2030. Over 60% of this new power generation will come from renewables, including wind, solar PV, biomass, and hydro. As shown in the following charts, the majority of renewable investments would be in Developed Markets (U.S., Germany, the UK, etc.). In fact, Citi Research expects 40% of all incremental Developed Markets’ energy consumption during 2015-20 to originate from renewables (excluding hydro).


There is already plenty of evidence suggesting this projection may be conservative–the U.S. shale boom notwithstanding. Within the U.S., there is still an ongoing chorus to drill for more shale, including the Monterey Shale in California (if all of the Monterey Shale is commercialized, California’s oil production will surpass that of Texas). But this chorus is being gradually displaced by a broader movement to commercialize alternative energy sources across the world–e.g. the broader support for Tesla and its planned build-out of super-charger stations across the country, rooftop solar panels on new homes in California, and–as Citi Research points out (see below chart)–the displacement of peak generation by solar in Germany.


The penetration of wind and solar in Germany is expected to double in three years. This means in three years (and some of this may occur by summer 2014), wind and solar will “eat up” the vast majority of Germany’s baseload power generation during the middle of a sunny Saturday or Sunday afternoon. Installing battery storage technologies (Arizona is beginning to do this) will eventually allow German households to consume solar-generated power in the evenings as well.

We have come to a turning point in how our world (especially in Developed Countries) view, produce, and consume energy. We have detached ourselves from nature in every aspect since the beginning of the First Industrial Revolution in the late 1700s. Individuals no longer witnessed how we produced our energy on a daily basis. Points of production and power grids became centralized–dominated by giant corporations and sovereign entities. This too, shall pass. The Age of Renewables will usher in a new age of harmonization–driven by a secular bull market in cleantech and technology venture capital.

The New Energy Regime: The Diffusion of Power

While the civil society is often relegated to the back tier of social life … it is the primary arena in which civilization unfolds. There are no examples that I know of in history where a people first set up markets and governments, and then later created a culture. Rather, markets and governments are extensions of culture … The civil society is where human beings create social capital, and which is really accumulated trust–that is invested in markets and governance. If markets or governments destroy the social trust vested in them, people will eventually withdraw their support or force a reorganization of the other two sectors.” — Jeremy Rifkin, author of “The Third Industrial Revolution” and “The Hydrogen Economy.”

40 years ago this Wednesday, OPEC instituted its first embargo on countries (the U.S. and Netherlands) that supported Israel during the Yom Kippur war. WTI crude prices shot up by 400%. The 1973 OPEC Embargo represented a watershed in the global energy regime in two important ways: 1) It made clear to the world that America’s hegemony on oil policy and prices has ended. The “oil weapon” was successful in that it heralded an irreversible shift of oil policy and price setting power from the Texas Railroad Commission to OPEC (at its peak, the TRC controlled over 40% of U.S. crude oil production; ironically, the TRC’s prorationing model served as a blueprint for that of OPEC); 2) It made clear to the Nixon Administration that a coherent national energy policy is needed–made all the more urgent as U.S. crude oil production peaked in 1970 (although we won’t know that for some time).

Ever since the 1973 and the 1979 OPEC oil embargoes, the U.S. leadership has sustained the country’s energy needs through a combination of drilling more wells, better drilling and extraction technologies (e.g. horizontal drilling and shale fracking), importing more oil, and–at various times–experimenting with alternative sources such as wind, solar, biofuels, and even geothermal energy (California is the leading source of geothermal energy). In other words, there has been no national, coherent policy (aside from massive fuel-switching from oil to natural gas by U.S. utilities during the 1980s) other than continuing the old oil-based energy regime. The forays into what we called “alternative energy” have been half-hearted–in many ways, a gimmick to satisfy the growing chorus of Americans demanding cleaner energy and self-sufficiency. The fact that many of these technologies were not economically efficient did not help either.

This chorus grew louder as U.S. oil imports and crude oil prices continued to rise–peaking at over 10 million barrels/day in 2005 for the former, and nearly $150 a barrel in summer 2008 for the latter. The constant calls for a new energy regime is more than just a yearning or a tactical business decision for more efficient energy production.  Yes, as financiers, we need to be cognizant of economic returns and protecting our investors. And, for the first time ever, CB Capital is seeing sound investment opportunities in various “clean technologies” areas that are already or soon-to-be economical (more in latter blog posts and research reports). Rather, this ever-louder chorus–which began with a group of highly-committed “green” minority in the wake of the OPEC crisis and environmental movement–has turned into a broader social movement occurring in significant parts of U.S. civil society (in particular, the best-educated and most collaborative, the Gen-Ys). To paraphrase Jeremy Rifkin, the civil society–which is the foundation of our present form of government and dictates how our market functions–is setting the stage for the complete transformation of how Americans think about energy, and consequently, how we produce and consume energy in the future.

We contend that the 1st Energy Regime lasted from the beginning of recorded human history to the beginning of the First Industrial Revolution (1760 to 1780). Humans derived much of our energy sources from the sun–whether it is directly or indirectly (photosynthesis) through the consumption of plants or the burning of wood. Humans were more or less harmonized with nature on a daily basis. Societies that did not respect nature or who consumed resources in a non-sustainable manner simply disappeared (e.g. the Rapa Nui people on Easter Island). The 2nd Energy Regime–which began with the adoption of the steam engine and the replacement of wood by coal as a primary energy source–transformed how societies thought about and produced/consumed energy. Humans and societies became more disassociated and de-harmonized with nature. We no longer witness on a daily basis how our energy was produced (or how our cattle is slaughtered). We know that the production of fossil fuels has brought with it an environmental price–but as they say, out of sight is out of mind. We also became de-sensitized to wars and conflicts fought in the name of energy and oil security. It is also sheer madness that the U.S. is still deriving much of our crude oil imports from oppressive regimes and areas whose collective consciousness are still stuck in the pre-Enlightenment Middle Ages.

The U.S. is now ready for a 3rd Energy Regime–driven by both American civil society and sound economic principles. This 3rd Energy Regime has been 40 years in the making. By its 50th anniversary, we expect the U.S. energy infrastructure to have been completely transformed. We have in the past discussed the ongoing U.S. Energy Renaissance driven by horizontal drilling, fracking, and Lower Tertiary drilling; as well as more efficient energy consumption through the commercialization of additive manufacturing, self-driving cars, better battery storage technologies, and the eventual commercialization of the quantum computer. In ten years time, I expect a much-higher adoption of renewables (California is on its way to sourcing 33% of our energy through alternative sources), which would include solar, wind, and perhaps the re-introduction of hydrogen fuel cell vehicles into our auto fleet. While companies such as Google are continuing to make substantial investments in solar (over the last three years, Google has invested over $1 billion in solar generation), the largest clean tech investors are companies such as GE (which is known for only investing in high ROE projects), and interestingly, traditional fossil fuel companies. According to the Cleantech Group, three of the top ten largest corporate investors in clean tech are traditional fossil companies (see below table).

corporate clean tech investment

More importantly, commercializing technologies such as rooftop solar, more efficient battery storage, and smart grids would transform the U.S. power grid from a centralized to a decentralized one (see below diagram). In other words, power would literally flow back to individual family households. The Jeffersonian ideal and myth of the American self-sufficient yeoman farmer will thus come closer to realization.  We have argued that part of the 21st century narrative is a diffusion and democratization of power from governments, institutions, and corporations back to the individual–as long as said individual utilizes the tools and global networks available to him. The diffusion and democratization of power began with the Internet Revolution in the late 1990s. The commercialization and adoption of alternative energy in the second decade of the 21st century–what we call the New Energy Regime–will not only provide a more sustainable source of power and lifestyle to Americans, but will further empower the individual. We believe the concept of U.S. energy independence is not a pipe dream. In fact, U.S. energy independence is not good enough. We believe we could achieve energy independence down to the individual community or even household level as the energy grid is decentralized–as long as the American civil society continue to embrace renewable energy sources.

Natural Gas: Fueling the U.S. Energy Renaissance

We argued in our recent commentaries and newsletters that the U.S. is in the midst of a major technological revolution. The United States, staying (somewhat) true to her capitalist and entrepreneurial roots, is finally awakening–much like the way she awakened in the aftermath of the Pearl Harbor attack, as well as during all of the young Republic’s technological waves since her founding (starting with the construction of canals in the 1820s, railroads in the 1830s, and the telegraph in the 1840s).

For years–aside from more stringent CAFE Standards–the U.S. has had no official energy policy. By 2007, domestic oil production has sunk to a 60-year low, while American consumption rose to a new high. In 2005-2006, the U.S. imported a record high 13.7 million barrels/day, with a significant portion coming from unfriendly or politically unstable countries such as Venezuela, Russia,  Iraq, and Nigeria.

Thanks to innovative techniques such as horizontal drilling, hydraulic fracturing, and innovations in deep-water drilling (e.g. drilling in the Lower Tertiary), U.S. oil production has bounced by more than 2 million barrels/day over the last five years. At 7.3 million barrels/day (average daily production during April to May 2013), U.S. oil production is at its highest level since 1991. With oil  demand having peaked in 2005 (gasoline demand peaked in 2007), crude oil imports into the U.S. has now sunk to just 10 million barrels a day–its lowest level since 1997.

Meanwhile, more efficient technology, along with the immense discoveries of shale gas, has led to a boom in domestic natural gas production as well. While the amount of U.S. crude oil reserves has steadily risen since 2007, the amount of natural gas reserves–due to the Bakken, Marcellus, Fayetteville, Barnett, and Haynesville formations–has literally exploded, rising from just 225 Tcf to 350 Tcf during the same time frame (U.S. annual natural gas consumption is 25 Tcf).

This ongoing “U.S. Energy Renaissance” means that the U.S. now produces 87% of our own energy needs, its highest rate since 1985. Over the next 5 to 7 years, U.S. oil production is set to rise by another 2 million barrels/day–excluding the possibility of the commercialization of California’s Monterey Shale (which could propel California past Texas to become the country’s number one oil-producing state). At $100 a barrel, this would add an incremental $73 billion a year to the U.S. economy–effectively shaving off nearly 20% of our current account deficit. Along with less U.S. driving (aging population, increase in railroad usage, etc.), higher CAFE standards, and rising electrification of the U.S. vehicle fleet, the idea of “U.S. energy independence” suddenly does not seem so far-fetched.  In fact, the boom in oil production over the next 5 to 7 years is projected to surpass the increase in oil production that powered the post-WWII U.S. economic boom well into the mid-1960s (again, not including the potential commercialization of California’s Monterey Shale).

The EIA projects natural gas production to be flat over the next several years. But we know that the EIA also has a dismal prognostication record, and that it is not taking into account important events such as: 1) the inevitable growth of the LNG export industry; the DOE recently approved its third export facility, the Lake Charles Exports LLC in Louisiana (with a capacity of 2 Bcf/day); 2) ongoing fuel switching from coal to natural gas by power generation utilities as more coal plants are retired and as “greener” policies make further inroads into U.S. politics; assuming Henry Hub natural gas prices stay in the $3.50 to $5.00/MMBtu range, this will be one of the dominant demand trends over the next several years; 3) the EIA has no expertise nor does it keep track of major socio-economic trends, such as the U.S. manufacturing, in-sourcing renaissance; the combined forces of the commercialization of 3-D printing, advanced robotics, and rising EM wages will lead to a further shift of manufacturing back into the U.S. (already, Foxconn is replacing a substantial number of its workers with robots).

While the EIA projects zero growth in natural gas demand over the next several years, Goldman Sachs projects an incremental demand growth of as much as 20 Bcf/day–equivalent to a 30% jump in natural gas demand (including LNG exports) over the next five years. The below chart (courtesy Goldman Sachs) shows a break down of the sources of demand growth–with base industrial demand, coal plant retirements, new power generation capacity, and LNG exports dominating demand growth over the next five years.


The surprising thing–as least to most Americans–is that the U.S. should have no trouble meeting this potential demand growth over the next five years. Already, Marcellus shale gas production is up 50% over that of last year–surpassing even the most optimistic forecasts. In the meantime, the ongoing rise in oil production is leading to increased production of “associated gas.” For example, over the last 18 months, one-third of all associated gas in North Dakota was flared or not marketed–resulting in a loss of $100 million a month to producers and the state. Both the state of North Dakota and producers are now working diligently to capture and transport this associated gas. The rise in Marcellus shale gas production, along with the increased production and capture of associated gas production, will drive U.S. natural gas production for at least the next five years. By 2018, we foresee the United States producing over 90% of her energy needs, with natural gas playing a substantial role. As such, it is not surprising to see U.S. stocks outperforming those of every major country (including Japan, on a US$ basis) on a YTD basis. We remain bullish on the prospects of the U.S. economy, especially if this energy revolution could be augmented by the electrification of the U.S. vehicle fleet, more stringent CAFE standards, increased efficiency in solar technologies, and breakthroughs in second-generation biofuels.

A Technological Revolution in the Making – The U.S. Giant Awakens

Note 1: We asserted in our June 18th commentary that WTI crude oil will definitively rise above $100 a barrel this summer, driven by the ongoing U.S. economic recovery, steady oil demand from China (the country’s short-term credit crunch is over), and pockets of strength in the Euro Zone. WTI crude oil is at $103 as I am writing this. And no, it is not due to unrest in Egypt, as Brent crude did not rise much on a proportionate basis. The narrowing of the spread between the price of Brent and WTI crude is also the best evidence of a U.S. economic recovery.

Note 2: In our late January newsletter, we asserted that gold was due for a major correction. We advocated a short position in gold. With gold at $1,660 an ounce at the time, we argued for a 12- to 18-month price target of $1,100 to $1,300 an ounce. Today, the price of gold sits at $1,220 an ounce. In just five months, the price of gold has hit our price target. Bottom line: We are revising our price target for gold. Our new position calls for a 6- to 12-month price target of $1,000 to $1,200 an ounce. The two most reliable psychological indicators for a tradeable bottom in any asset class are: 1) Panic, or 2) Indifference. The best time to invest in any asset class is after years of investors’ indifference. That–along with other screaming buy indicators–was the reason why I invested in physical gold and unhedged gold miners at under $275 an ounce in late 2000. Of course–unless the U.S. mints a new currency–the price of gold will never see $275 an ounce again. So far, we haven’t witnessed much investors’ panic; nor indifference towards gold. With U.S. real interest rates (the ECRI Future Inflation Gauge just hit a 7-month low, even as long-term Treasury rates are spiking up) hitting new cyclical highs, we believe there is at least one more major sell-off in gold before there could be a tradeable bottom. The Dow-to-Gold ratio today sits at 12.4. I would only consider investing if the Dow-to-Gold ratio rises to 15, or above.  Avoid gold, for now.

Now, let’s get on with our main commentary. About 400 years ago, Descartes famously remarked “I think, therefore I am.” Descartes tried to prove his own existence by linking his thoughts to his consciousness. In other words, Descartes argued that because he cannot be separated from his thoughts–and because thoughts exist–therefore, he exists.

But Descartes was wrong. Equating one’s consciousness with one’s thoughts is mere identification with one’s ego–a path to endless pain and suffering. We are at our most enlightened state when we live in the present. A glimpse of a beautiful object, attending a concert, or seeing your loved one for the first time in a long time–these could all quiet our minds for just enough time to witness the beauty and truth in our own existence.  Unfortunately, human beings–just like Descartes–have equated our identities with our own, rigid set of thought/belief systems for thousands of  years. Such unconsciousness on a global scale has led to mass intolerance, discrimination and hatred, directly resulting in mass genocide, global wars, and witch-burnings–down to petty arguments over politics and household chores. It is sheer madness. A madness that many societies (e.g. the Middle East) still have not awaken from.

On a more practical level, an individual cannot invest successfully unless he awakens from such unconsciousness. Just like the natural laws of the universe, there are certain axioms any investor needs to follow; however, these axioms only provide the larger framework, and as of today, are not yet complete. Sir Isaac Newton explored the meaning of gravity, but lost his entire fortune in the aftermath of the Great South Sea Bubble. Investors are taught from an early age to follow benchmarks ranging from valuation ratios, cash flows, inflation, and GDP growth, to central bank policy, energy policy, technological breakthroughs, and finally to more esoteric indicators such as the VIX, various investment surveys (useful from a contrarian perspective), and sentiment data via Twitter feeds and Google Trends. An investor who is unconscious–i.e. one who follows a rigid set of thoughts and belief systems–cannot make outsized returns, since most investors follow such rigid thoughts, and by definition, most investors cannot beat the market. Sir Isaac Newton tried to follow such physical laws whilst speculating in South Sea stock. Both the final run-up and the subsequent collapse would catch him completely off-guard. Later on, he would remark “I can calculate the movement of stars, but not the madness of men.” The final exponential run-up in technology stock prices in early 2000 offered yet another example. Investors who failed to acknowledge this “New Era” missed the bull market in 1996, 1997, 1998, and 1999; many blue-chip funds under performed and numerous money managers lost their jobs because their rigid set of belief systems prevented them from owning technology stocks (at the peak in March 2000, the NASDAQ Composite traded at a P/E of 260). Of course, they were eventually proven right. But being “early” in the financial markets is just a nicer way of saying one was wrong. Similarly, many investors who were caught in the 2001 to 2002 bear market did not realize the rules have changed yet again.

I made this same mistake when I began investing in college. I tried to predict stock prices with factor models using linear regression analysis. I studied modern portfolio theory and was fascinated by real options valuation models. I thought the bull market in technology stocks would go on forever. I was unconscious. Thankfully, I did not remain unconscious for long. I managed to catch the tail-end of the technology boom; sold all my technology stocks in early 2000 (and warned others to do the same), and was 100% short the NASDAQ by late March 2000. The lesson I learned: Regimes come and go; belief systems are overturned (even thousand year-old systems such as the Chinese dynastic system in 1911); and something faster, crazier and more unbelievable will always come along.

A study of human history yields an endless chronicle of conflicts, wars, famines, mass slaughters, rape & pillage, and general misery. For sure, such a dismal record has been punctuated by glimpses of human goodness and progress in mass consciousness. e.g. The unprecedented prosperity and the promotion of peace during the “New Kingdom” period in Ancient Egypt, the export of Greek culture during the Hellenistic period, the harnessing and control of new technologies during the Han Dynasty in China, and of course, the European Renaissance and the Enlightenment. But it was not until the adoption of the United States Declaration of Independence–inspired by the writings of John Locke, and documents such as the Magna Carta, the Petition of Right, and the English Bill of Rights–did a major society finally begin to embrace the concept of human equality, freedom, and other basic, “inalienable,” rights.

In my opinion, the 56 delegates who debated and signed the Declaration of Independence as part of the Second Continental Congress represented the gathering of the most talented, progressive, and yet pragmatic, men in all of history. The Declaration of Independence–riding on concepts clarified by Enlightenment philosophers such as John Locke, Voltaire, and Rousseau–is the definitive document which defines the United States of America to this day. Yes, the U.S. falls short in many places; that is to be expected as the U.S. represents an ideal–an ideal that all of us should continue to strive for. It is thus no accident that the U.S. remains the most attractive center for entrepreneurs, hard-working immigrants, innovators, and the world’s best and most creative minds–despite our shortcomings.

In the wake of the Pearl Harbor Attack by the Empire of Japan, Admiral Yamamoto is alleged to have remarked: “I fear all we have done is to awaken a sleeping giant and fill him with terrible resolve.” Ever since the collapse of the technology boom and subsequently, the events of September 11th, the U.S. has been rudderless. Over the last 12 years, both the U.S. political and corporate leadership have failed the world, and reneged on too many broken promises. However, not all was lost. There have also been flashes of brilliance. e.g. the completion of the Human Genome Project in 2003, D-Wave’s progress in the development of a quantum computer, the advent of 3-D printing (a trend which I have tracked since 2007), shale fracking and horizontal drilling in the energy industry, and nanomedicine and nanotechnology in general–leading to advances in targeted cancer treatments, more efficient conductors, and stronger/lighter-weight materials.

As we have covered in our newsletters and commentaries, we are confident that the U.S. is on the cusp of a new technological revolution. It takes strong leadership, a functional financial industry, the right markets, and a bit of luck to commercialize the many, revolutionary technologies that we have written about. The U.S. is already undergoing an energy revolution–the rise in domestic crude oil production over the next several years will surpass the last domestic oil boom in the 1950s and 1960s. The 1950s/1960s domestic oil boom drove U.S. manufacturing and industry to unprecedented heights–and led to the creation of the U.S. middle class. The rise of 3-D printing, along with advances in 3-D scanning technology, means we could create our own tailored t-shirts in our own homes. I envision a timeline of just five years. Eventually, we will be able to “print” more complex objects with more differentiated parts. Together with cheap natural gas prices, the U.S. is already experiencing a renaissance in “in-shoring” and “in-sourcing,” beginning with low-labor content goods.

Slowly but surely, the U.S. giant is awakening. The economic recovery since 2009 is merely a precursor–a big, giant yawn. Our expertise and networks in healthcare, technology, and energy has placed CB Capital right in the center of the next technological boom, driven by American ingenuity, focus, and honest hard work. We are looking forward to the ride.

Will the 2013 Hurricane Season Light up WTI Crude Oil Prices?

In our Match 17, 2013 blog entry, we asserted that WTI crude oil prices may be approaching a bottom (after declining from $98.00 to $93.50 a barrel in six weeks), given the strength in the CB Capital Global Diffusion Index (“CBGDI”). The CBGDI is an advance/decline line (smoothed on a 3-month moving average basis) of the Leading Indicators data for 30 major countries in the Organization for Economic Co-operation and Development (OECD), along with China, Brazil, Turkey, India, Indonesia, and Russia. The CBGDI has led or tracked the MSCI All-Country World Index and WTI crude oil prices very closely since the fall of the Berlin Wall. Historically, the rate of change of the CBGDI has led WTI crude oil prices by about three months, with an R-squared of 30%.

We argued that–despite the projected 1.4 million b/d increase in U.S. crude oil production over the next two years–oil prices will likely remain firm for the foreseeable future, given the strength in our leading indicators, as well as steady oil demand growth from countries such as China, and pockets of strength in the Euro Zone.

Like that of other commodities, the crude oil price is subject to periodic upward spikes (unlike stock market prices, which are subject to periodic crashes). Supply disruptions via embargoes, wars, and shut-ins related to hurricanes have been the norm. The major exception was the spike in summer 2008, when the breakdown in the hedging market–combined with unprecedented financial demand driven by commodity funds–drove WTI crude oil to $150 a barrel, even as the world was heading into a major recession.

Since our March 17, 2013 blog entry, the price of WTI crude oil has bounced to nearly $98 a barrel, despite the recent widespread sell-off in Asian currencies and financial asset prices. We believe WTI crude oil prices could head higher later this summer, driven by an ongoing U.S. economic recovery, a strengthening German economy, as well as escalating tension in Syria. We also do not believe the Federal Reserve will indicate a halt to its QE policies until later this year, the earliest being the FOMC meeting post-Thanksgiving shopping period.

Moreover, while it does not occur every hurricane season, we believe the possibility of a higher WTI crude oil price due to a hurricane-induced shut-in in the Gulf of Mexico cannot be dismissed. Firstly, on a historical basis, it has been five years since Hurricanes Gustav and Ike devastated the Gulf Coast, resulting in major shut-ins of both oil and natural gas production in the Gulf of Mexico, as shown in the figure below.


Immediately before Hurricane Gustav hit the Gulf of Mexico in late August 2008, WTI crude oil prices spiked by $5 a barrel, despite declining oil demand as the world entered a major recession. Despite the recent innovations in onshore horizontal drilling and shale fracking, the Gulf of Mexico remains a very important source of crude oil for the United States. According to the EIA, crude oil production from the Gulf of Mexico makes up 19% of total U.S. production last year–down slightly from 26% during 2007 to 2011. Any major shut-in due to an actual or fears of an impending storm could still have a disproportionate impact on WTI crude oil prices.

Secondly, NOAA–which publishes an annual outlook for the hurricane season in the Atlantic basin (including the Caribbean Sea and the Gulf of Mexico)–calculates a 70% chance of an above-normal hurricane season this year (based on 1950 to 2012 data).


There is a good chance hurricane activity could be higher than that in 2010, and 2008, when Hurricanes Gustav and Ike caused a collective shut-in of over 60 million barrels of crude oil. On the other hand, it is highly unlikely that hurricane activity could approach that of 2005, when Hurricanes Katrina and Rita caused a collective shut-in of over 100 million barrels (I fondly remember evacuating from Houston at that time). It is important to remember that Hurricanes Katrina and Rita were outliers–both in terms of intensities and the paths they had taken. Note that more than 70% of all oil and gas platforms in the Gulf of Mexico were affected by the paths of these two hurricanes. Since the 2005 hurricane season, oil and gas platform infrastructures in the Gulf of Mexico have been strengthened–meaning that any shut-in of production will not last very long. Nonetheless, the chance of a short-term price spike in WTI crude oil is higher than normal, given expectations of heightened hurricane activity this year. We thus believe that the price of WTI crude oil should definitively rise and stay above $100 a barrel this summer.


The Message of the CB Capital Global Diffusion Index: A Bottom in WTI Crude Oil Prices

Neoclassical economics cannot explain the spike in real global wealth per capita (nearly 10x) in the 20th century. The classic Cobb-Douglas Model attempts to explain global GDP growth through three major inputs: 1) “Total factor productivity,” 2) labor (L), and 3) capital (K). Both L and K can be quantified and explained. However, studies have shown that fully 70% to 80% of the increase in economic output during the 20th century came from “total factor productivity,” i.e. an exogenous factor that resembles technological growth and adoption—leading to increased overall productivity. Economists have a hard time explaining the origin of “total factor productivity.” We know that education (investment in human capital), venture capital, the capitalist system, and the sharing of ideas all play a role, but we do not truly understand why their benefits were unique to the 20th century (and to a lesser extent, the 19th century, when real global wealth per capita grew by 3x—please request a copy of our January 2013 newsletter for a more detailed analysis).

What we do know is that the vast majority of global economic growth in the 20th century was predicated on an exponential increase in energy consumption. In other words, productivity growth—20th century’s main economic driver—was mostly a result of increasing energy consumption. Every technological breakthrough, such as modern-day jets, computers, fiber optics, automobiles, etc. required the consumption of increasing amounts of energy. In some areas, we have made efficiency breakthroughs (e.g. the shrinkage of CPUs), but in other areas, not so much (e.g. the internal combustion engine). Such growth is especially amazing given the mass human failures of the 20th century, such as World War I & II, the rise of communism and Nazism, as well as the Korean and Vietnamese Wars. More important: If the 21st century global economy is to grow in the same trajectory as that of the 20th century, global leaders will need to find cheaper and alternative sources of energy—horizontal drilling and fracking notwithstanding.

In the meantime, global economic growth is still dependent on the consumption of fossil fuels, with crude oil being our main transportation fuel. As such, it is reasonable to conclude that—despite the increase in U.S. oil production—a rising global economy will lead to higher crude oil prices (China just surpassed the U.S. as the number one oil importer). A prediction for future oil prices thus requires an analysis of the performance of the global economy, given the globalized nature of oil. Using the Leading Indicators data for 30 major countries in the Organization for Economic Co-operation and Development (OECD), along with China, Brazil, Turkey, India, Indonesia, and Russia, we have constructed a “Global Diffusion Index” which have historically led or tracked the MSCI All-Country World Index and WTI crude oil prices since the fall of the Berlin Wall. We label it the “CB Capital Global Diffusion Index” (“CBGDI”), which is essentially an advance/decline line of the OECD leading indicators—smoothed on a three-month moving average basis. Historically, the rate of change  of the CBGDI has led WTI crude oil prices by about three months, with an R-squared of 30%, while tracking or leading the MSCI All-Country World Index slightly, with an R-squared of over 40% (not surprising, since stock prices are one component of the OECD Leading Indicators). Following is a monthly chart showing the year-over-year % change in the CBGDI, and the rate of change (the 2nd derivative) of the CBGDI, versus the year-over-year % change in the MSCI All-Country World Index and the year-over-year % change in WTI crude oil prices from March 1990 to February 2013. All four of these indicators have been smoothed on a three-month moving average basis:

CBGDI February 2013As noted on the above chart, the rate of change (second derivative) in the CBGDI (red line) has historically led the YoY% change in WTI crude oil prices by about three months. The major exceptions have been 1) the relentless rise in WTI crude oil prices earlier last decade (as supply issues came to the forefront), and 2) the explosion of WTI crude oil prices during the summer of 2008, as commodity index funds became very popular and as balance sheet/funding constraints prevented producers from hedging their production. The second derivative of the CBGDI troughed at the end of 2011, and has continued to rise—implying higher global stock and energy prices. While we recognize that U.S. crude oil production is set to rise by 1.4 million bbl/day over the next two years (not a trivial amount, as 1.4 million bbl/day is equivalent to total Indonesian oil consumption), recent strength in the CBGDI suggests that WTI crude oil prices have at least bottomed, for now. More important–unless celllulosic ethanol or second-generation biofuels are commercialized in the next several years (or unless room-temperature superconductors are discovered tomorrow)–this suggests that the secular bull market in oil prices is not over.

As we are finalizing this commentary, we understand that Cyprus may be experiencing a bank run, as the EU had suggested taxing bank deposits to pay for the country’s bailout. If implemented, this will set a very bad precedent and will have long-term (adverse) repercussions in the European banking system. Such a Black Swan scenario may weaken commodity and energy prices in the short-run, but we believe WTI crude oil is a “buy” on any further price weakness.

CB Capital’s 2013 Price and Risk Outlook for Major Asset Classes

Happy New Year. Following is our 2013 price and risk outlook for selected major asset classes. We are publishing our annual price and risk outlook for the first time, so a little explanation is required. Our rating score summarizes our view on where we believe prices will head over the next 12 months. A rating of “5” is considered neutral–close to the asset class’ historical median return. Our risk score summarizes the probability for significant deviation from our price outlook. For example, gold’s risk score of 8 suggests the significant possibility that the asset class could remain elevated near $1,700 an ounce (as opposed to our downward forecast), as the price/demand of gold depends on many differentiated factors, such as jewelry demand in China and India; as well as a reemergence of systemic risk in peripheral Europe. The outlook on global monetary, fiscal, and global bank regulatory/lending policy is anything but certain in 2013.

More details will be provided in our CB Capital’s inaugural monthly newsletter. It will be published in the next 7 to 10 days, and will be provided to selected clients. All the best for 2013.

2013 outlook