Tuesday, June 17, 2008

Wyoming Wheat and Canadian Crude: The Myth of the Straight Line

I went out to Wyoming a couple of weeks ago for an annual trip to a modest (140,000 acre) ranch to do a little shooting and have some fun. Wyoming is a very cool place: there are more pronghorn antelope than people, there’s no income tax and everything is far away (like the beer store is 46 miles from the bunkhouse). Every other time I’ve been, you could have an official Wyoming coloring book with two colors: blight blue for the sky and brown for the ground. This time it was quite a bit different. First, they had some massive spring rains, which made everything lush and green. It looked like Nebraska. The second thing was more impressive. On all my former trips, the terrain was sagebrush and pasture. Now for miles and miles, there were wheat fields.

I asked the ranch manager (manager is a stretch, think head cowboy) what was up. In normal Wyoming cowboy fashion he looked at me and said: “I’d think you’d get this: Wheat’s up, so we make more money on wheat than on grazing land. With corn through the roof, everybody has been planting corn instead of wheat. Corn don’t grow good here, but wheat does. So, we like to make money.” Well you can go to the University of Illinois and get historical agriculture price (what a surprise!). And wheat prices stumbled around $1.80-$1.25 until a little tiny energy crunch in about 1973, then wheat went up 300%. No surprise here, oil is up, fertilizer is up, fuel is up, hence wheat is up. Wheat dropped back to about $2 a bushel, then took a run again in 1981, this time about a 250% increase (again oil prices up). Run out to about 1996, another run, and now 2008, where wheat went from $2.93 a bushel in spring of 2005, to about $24 a bushel in February of 2008 (at the time of this blog, wheat is back down to about $9.25 a bushel, still historically high).

Now wheat and corn and any growing crop is subject to vagaries of weather, government subsidies and a whole range of external factors. But the plain truth is as Joel the cowboy put it: ‘If we can make money on it, we’ll find some way to get it.’ This subtle nuance is the foundation of economics for 20,000 years. If you can make money on something, whether a commodity, real estate, or whatever; capital and resources will be drawn to it, and eventually, the price will decrease when demand and supply stabilize (Sorry for the painful reminder of economics class).
Take oil (please). Oil prices are through the roof, today the futures are over $140 a barrel. In 1955 (a very good year), crude was $2.93 a barrel ($23.47 in inflation-adjusted terms). In 1972, crude was $3.60 (only $20.48 in inflation-adjusted terms), and I was driving a 1955 Buick Roadmaster that was big enough to take me and about 6 friends out on the town. By 1975, crude had surged to $12.21, almost tripled, and by 1981, Crude was $35.75, or dectuple the price nine years earlier. (Actually 1980 wins for high inflation adjusted price). By 1998, crude had dropped back down to $11.91 a barrel, ($15.70 inflation adjusted, or cheaper than any previous year since 1946!)

So the chart shows the ugly truth that oil is at an all-time high and the price is way up. Heck it looks like 1977 all over again. But then I like to look at what happened after 1977. After 1977, the price dropped, and dropped and dropped. Why? I can think of a whole bunch of reasons, but two come to mind as possible (and one of them was not the ‘Windfall Oil Profits Tax of 1976’). I think the price came down because we cut back on our consumption (decreased demand) and went out and found more (increased supply). On consumption, have a look at the table below. It shows that 1973 started a decline in consumption, which then went up through about 1979 (when our gas guzzler wore out and we bought Pintos) and consumption dropped from a high of about 21 million barrels a day in 1978 down to about 15 million barrels a day in 1983. A 6 million barrel a day drop in consumption is significant: That’s 150% of Iran’s daily production, or one-fifth of OPEC’s production, or 240% of Venezuela’s production. If we used oil at the rate we did in 1983, we could tell Iran and Venezuela to kiss off (a concept I like to envision). It’s not a hard concept: gas is expensive: drive less and find alternate means of energy usage.

The consumption chart is part of ‘the Myth of the Straight Line’. Someone, usually a journalist, takes a chart like the one above and looks at 1991 to 2007, and draws a straight line through the middle (If they took statistics, they use something called the ‘least mean square’ method which draws an accurate straight line through the middle.) Oil consumption is going up, the Chinese are using it all, the Indians are using it all and our consumption is continuously rising. Ask Ford how many Expeditions they sold in 2008 so far, or ask GM how many Suburbans. The stark truth is that the US uses more barrels of oil a day than China, Japan, Germany, Russia and India combined. If we had our usage the same as we did in the early 80s, the US would basically be able to have 15.7 million barrels of oil a day from our own production, Canada and Mexico. Imagine the fascinating geopolitical repercussion of North American using only its own oil and no mid-east imports.

The second leg of oil prices is supply. There’s a lot of oil in the world, about 1,200 billion barrels. Some is easy to get, like in Saudi Arabia, or Texas. Some is tougher, like getting oil from coal, or tar sands or oil shale. There are some big reserves, like ANWAR (10.3 billion barrels) or offshore West Africa (100 billion bbl). The notion is that there’s $15/barrel oil and $40/barrel oil. However, at $140/barrel, there’s a lot of oil. Take the country with the world’s second largest oil reserve, Canada (that’s right, Canada has more oil than Iran or Iraq, and more oil than Venezuela, Russia and Nigeria combined). In the Athabasca oil sands, it takes about $30 -$40 a barrel oil price to make oil sand production feasible. With oil prices where they are, Canada has increased investment in oil sand projects by $100 billion. Canada’s production is forecasted to increase through 2020. Another simple indicator is the number of drilling rigs in use. I like to read Barron’s magazine and I always look at the ‘economic barometer’ section where it tells about the week’s numbers on paper usage, gas, timber, housing starts, and number of drilling rigs in use. In 1991, when oil prices were low, it wasn’t surprising that a lot of drilling rigs were sitting dormant. As prices rise, more people look for oil (like Wyoming ranchers planting wheat) and the supply goes up. Here’s chart showing the number of rigs:

Notice anything with the lines? The number of rigs went up dramatically as prices rose in the 70s. Notice that the peak number of rigs was after the peak in prices. And do you notice the number of rigs now? From June of 2007 to June of 2008, the number of oil rigs in the US has gone up 36.5%! Oil exploration and drilling is up, and supply will increase.
The myth of the straight line is that a trend will continue. We’ve seen this countless times, from the notion that Internet stocks would continue to rise through the late 90s, to oil prices in the 70s to real estate in the 2000s. The simple truth is that the laws of economics have an eerie way of righting themselves. Wheat goes up, farmers plant more wheat. Oil goes up, we use less oil and drill for more. My bottom line: this energy crisis will fix itself. Crisis’s always seem to do that.

But I am enthralled with the idea that the US, Canada and Mexico could basically become energy self-sufficient. Have an ethanol cocktail (shaken, not stirred) and drive slow.