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Coping with the Ugly Old Energy World
At present, the culprit—the tentacle reaching out from that old difficult world—is the tension surrounding Iran's nuclear ambitions. Because the United States and others believe that Iran is developing a nuclear arsenal and because Iran has shown considerable belligerence toward the West and its neighbors, Israel prominently, the Persian Gulf is full of warships. Meanwhile, Israel has threatened a unilateral strike on Iran's nuclear facilities. Credible rumors abound that the United States will make such an attack. Neither President Obama nor the Secretary of State John Kerry will discard the military option. Iran has threatened retaliation and even preemptory attacks. The threats all around have convinced global oil markets that the Persian Gulf could plausibly become a battle ground, cutting flows of not only Iranian oil and gas from world markets but also oil and gas from Kuwait, Qatar, Bahrain, Oman, and the oil emirates, all of which ship through the Gulf. However different the more distant future promises to be, right now more than a quarter of the world's supply passes through this body of water. The loss of those supplies could raise prices to $150 a barrel for West Texas Intermediate and more for Brent crude.2
Actually the price could rise almost that much even in the absence of open hostilities. A notching up in tension, especially more open threats by Iran to close the Strait of Hormuz at the head of the Persian Gulf, could bring prices up almost as much as an actual shooting war would. In such an environment, insurers would worry enough about their potential liability to raise premiums substantially or even refuse to insure tankers in the Persian Gulf altogether. Either action could stop the flow of oil just as surely as if the Strait were mined. Faced with this threat—but not yet its reality—prices have risen part way to where they might go. West Texas crude sits in the low $90s per barrel and Brent crude at about $115.3 Their immediate direction from here depends almost entirely on the geopolitics of these highly unstable circumstances in this equally unstable region.
Clearly, matters could easily shock already weakened world economies and continuously nervous markets. And present prospects of relief on this front look slim. If a price hike lasts long enough, Europe, already in recession, would sink deeper, and the United States, though so far able to sustain a mediocre growth rate, would likely lose ground, as would Japan and emerging economies as well. Except in the most extreme of outcomes, the economic and attendant market setbacks of such heightened tension would likely fall short of the damage experienced during the 2008–09 financial crisis, but it would set back economies significantly nonetheless and, obviously, bring down the prices of risk assets as well, in just about every market and asset class. Even the pressure of the last few months, slight by the standards of what could occur, has crimped consumer spending in the United States during these early months of 2013, though some of the consumer shortfall also reflects the end of the partial payroll tax holiday.
Looking to a Brighter New World
If investors and economies still clearly have to cope with these kinds of threats, the good news is that they will likely fade over time. Though peace in the Middle East is as distant as it ever was, three kinds of technologies—extraction, exploration, and efficiency—have made the difference with regard to the future of energy. All three developed directly or indirectly in response to the insecurities and price gyrations associated with the dependence on Middle Eastern oil—and that still dominate for the moment. Interestingly, some 20 years ago the Saudis warned their colleagues in the Organization of Petroleum Exporting Countries (OPEC) of just such technological responses should they gouge consumers on price or make the developed world feel too insecure.4 Doubtless now the Saudis take only small comfort from having been correct.
The most exciting aspect of this technological revolution is the success of hydraulic fracturing, or fracking, as it is commonly called. This extraction technique has enabled drillers to bring oil and gas to market that was formerly trapped in shale deposits. To date, its largest application has occurred in the United States, allowing overall U.S. oil and gas production, virtually stagnant for decades, to leap almost 18% in just the past two years. What is more significant, the IEA calculates that the growth likely will persist for quite some time to come, until 2020, in fact, and then plateau at that heightened level for decades. The net effect not only will significantly increase global supplies but also it will diversify them away from the Middle East. By 2020, the IEA calculates, the United States will be an exporter of fossil fuels, adding to world supplies instead of drawing on them, as it does now. The difference could amount to as much as 7% of world usage.5 What is more, fracking-accessible deposits exist elsewhere, including Western Europe, Canada, and Australia. There is every reason, then, to expect, as refinements in the technology remove environmental concerns, that these similar overseas sources of oil and gas will join those flowing from the United States, further enhancing world energy supplies and more thoroughly diversifying them away from the Middle East and the Persian Gulf.
Other technologies developed over the past three decades have at last allowed producers to bring the vast reserves embedded in western Canada's tar sands to market profitably. At the same time, other extraction technologies have enhanced the ability to recover oil and gas from conventional wells. The Saudis, for example, have applied many and are, according to admittedly spotty figures, pumping more oil than at any time in the last 30 years. There are indicators that the Russians, too, are trying to apply such technologies, with which, petroleum engineers estimate, they could double their output without any new finds whatsoever. Similar, if less dramatic, opportunities exist with other oil producers presently outside the loop of the most advanced technologies, though it will be a long time indeed before the likes of Iran will have access to them.
Exploration techniques have improved as well, so that entirely new fields have been discovered. One of them, though still far from developed much less in production, is the huge South Atlantic find by Petrobras, the Brazilian petroleum company. The field has been estimated preliminarily at the equivalent of 50 billion barrels, and once in production, promises alone to add more than 3% to the world's known reserves and regular production.6 A huge shale structure recently discovered in Australia promises the equivalent of 233 billion barrels of oil, almost 40% more than Canada's entire Athabasca tar sands, and carrying the potential to increase global supplies by 14%.7 These two finds in just the past two years signal that new exploration technologies might bring on other such discoveries in the not too distant future. But even as prudence warns against such hopeful speculation, these new techniques have reduced the risk of exploration enough to encourage Exxon, for example, to begin large-scale efforts in the Russian arctic, where, though no great announcements have as yet emerged, there are, engineers say, very promising signs.8
While all these changes have dramatically enhanced oil and gas supplies in the United States and globally, efficiency has worked on the demand side of the classic economic equation. For years, governments in the United States and elsewhere have demanded greater fuel efficiency of car and truck manufacturers. Competition from more efficient Japanese and other Asian producers has spurred on such efforts even more, some would say, than mandated mileage requirements, called CAFE [Corporate Average Fuel Economy] standards in the United States. Competitive efforts and compliance have made the U.S. auto fleet a third again more fuel efficient than they were 30 years ago. These, however, are not the only efficiencies at work. Power plants—coal, oil, or gas-fired—have become increasingly efficient, as have home heating and airplanes and other forms of transportation.
Further, the United States has reduced by almost half the amount of energy needed to produce a dollar of output. Some of this gain has emerged from the changed mix of the U.S. economy: away from energy-intense manufacturing toward services. But the efficiency gains have done the heavy lifting. Europe and Japan, always more energy efficient than the United States, have made less dramatic strides, but they, too, significantly use less energy for a unit of output than they did—and still they remain more energy efficient than the United States. Though this trend will likely continue, it will gain its greatest momentum globally as the emerging economies, presently only about half as efficient as Japan and the developed West, apply these fuel-conserving technologies. The still relatively high price of oil should spur that effort onward. These economies should also make strides faster than the United States and others have, because they need not develop new technologies. All they need to do is purchase and transfer such technologies and equipment.
Drawing the Two Threads Together
With energy use, consequently, growing more slowly than now-surging fuel supplies from all over the globe, regions such as the Persian Gulf and the Middle East generally will lose relative importance in the overall energy equation. According to the IEA, the traditional OPEC producers will see their share of global energy supply fall from more than 70% in the 2011, to about 60% in 2020, and likely drop below 50% by 2040.9 Especially since the Saudis are ramping up their production, Persian Gulf sources will lose prominence even more precipitously. So, even if the Iranian tension persists, it will over time have an ever-smaller impact on global petroleum pricing. If the threats implicit in that situation add some $30 to the price of a barrel of oil today, that premium could easily shrink to as little as $15 or less over the next few years.
For the moment, the Persian Gulf pressure is evident and will keep prices up. Since peace seems unlikely anytime soon, prices will likely stay up too, with a fairly serious threat to further increases in the coming year or two. Over a more distant forecasting and planning horizon, however, the opposite picture emerges, one with ongoing downward pressure on global fuel prices, except in the most extreme of scenarios, even if nothing improves in the Persian Gulf.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.