Month: May 2008

Until recently, strategists agreed that rapid economic growth in the emerging economies was good news for everyone. Their stock markets boomed and cheap exports tamed inflation in the west.

The US Federal Reserve was able to reduce interest rates to unusually low levels, to reboot economies after the 2000 to 2003 equity bear market. The resulting supply of credit fuelled a consumer boom which helped every asset price to boom.

But every action has an equal and opposite reaction. As a result of economic growth in the past few years, companies and their customers are consuming commodities at a rate that puts the Earth’s resources under strain.

According to a survey produced for Robeco by research group Iris, we have entered an era where there will be an “abundance of scarcity” which could lead to a revolution in investment thinking. High commodity prices have started to fuel costs. The latest data from China suggests that its inflation rate has hit an 11-year high of seven percent.

Inflationary concerns have persuaded the Bank of England and European Central Bank to keep interest rates as high as they dare. Rising prices, illustrated by a rise in the cost of beer to £4 a pint, will lead to higher wage demands in due course.

Aggressive
The Federal Reserve has only cut US rates aggressively, due to the parlous state of the local housing market. Fear of rising inflation has been the result. Increased market volatility is set to become permanent as central banks struggle to contain inflation and prevent recession. The Vix index, which expresses the volatility of the S&P 500, has risen from nearly 10 to 25 over the last 12 months, and touched much higher levels.

Pension schemes with longer-term liabilities will need to consider switching out of bonds.

Seasoned hedge funds, stocks and commodity futures look increasingly attractive. Sector specialist Dawnay Day Quantum has estimated that 10 percent commodity allocations could be justified.
The market jury on the outlook for natural resources is still split.

Some back strategist Jim Rogers in his conviction that commodities prices will move higher. Others back sceptics led by US equity manager Bill Miller of Legg Mason, who reckons commodity booms go as often as they come.

But the argument that the world needs to face up to a sustained rise in commodity prices is starting to gain the upper hand with investors. Data supplied by RCM, the fund management arm of Allianz, shows over-the-counter commodity contracts boasted a sixfold rise in value in the three years to 2007. Investors are net long and commercial producers are net short.

In the latest Barclays Capital Equity Gilt survey, Tim Bond and Nicholas Snowdon take their cue from Thomas Robert Malthus, who argued in the 18th century that physical constraints would put a limit on economic growth.

The theories of Malthus became discredited because he failed to anticipate the volume of the Earth’s resources, and mankind’s use of technology to harvest them effectively.

Think-tank
But Bond and Snowdon argue that Malthusian limits to growth are now within sight. The global population, for example, has risen from 2.5 billion in 1950 to 6.7 billion. It could hit 9.2 billion in 30 years. The Optimum Population Trust, a think-tank, argues that the Earth cannot safely sustain more than 5.1 billion.

Its calculation takes account of the rapid rate at which increasingly prosperous individuals are using up resources. According to the World Bank, individuals in the middle and upper classes increased consumption by more than 200 percent between 1960 and 2004, against 60 percent for those on lower incomes.

Barclays Capital points to the escalating demand for meat, which uses up far more agricultural resources than grain. In 1990, Asia consumed 16.7 kilos of meat per person. By 2002 the total had risen to 27.8 kilos. People in high income economies increased their consumption by eight kilos to 93.5 kilos.

Consumption of every conceivable resource is particularly noteworthy in China. In the decade to 2004, there was a 50 percent increase in its energy demand per capita, which has gone on to escalate further.

African economies are being boosted by the desperate search for resources. Demand for aluminum, corn and soybeans has multiplied several times over. Chinese consumption helps to explain why the lifespan of copper resources has fallen by a third in the 10 years to 2006.

Supply and demand
The International Energy Agency, not renowned for scare-mongering, has suggested that demand for oil could lead to a supply-demand crunch in 10 years if there is a delay to drilling projects.

Barclays Capital says the crunch could happen as early as next year if regions outside the Organisation for Petroleum Exporting Countries fail to meet targets that look increasingly ambitious. Small wonder the price of crude is back up to $100 a barrel.

Investec Asset Management has warned that commodity prices will rise further in the longer term, citing under-investment as well as demand.

Elsewhere, the rapid production of carbon dioxide by fast-growing economies is putting a strain on the climate, with an eventual rise in temperatures of a damaging four to five degrees not impossible. If left unchecked, economic dislocation will result. Bad harvests, such as those which just caused a 25 percent jump in the price of wheat, will become more frequent.

There is even a link between the rising demand for commodities and the credit crunch. When the going was good, consumers benefited from cheap finance supplied by the Federal Reserve to dig the business community out of a hole. Since 2000, the ratio of US household debt to GDP has risen by 67 percent to 98 percent.

Generous terms were offered through operators in the capital markets who overlooked the poor quality of loans in their pursuit of a decent spread. Expansion financed by cheap debt went on to fuel the consumption of commodities across the world.

According to Barclays Capital: “The bubble in credit expansion ended because central banks needed to raise rates to deal with high inflation pressures, most of which had originated in the natural resource market.”

Higher interest rates eroded confidence that asset values, particularly housing, would keep going up and a credit crisis fuelled by mortgage sub-prime lending resulted.

Local demand
But the momentum behind the consumption of commodities is still in place as Asian economies seek to generate local demand to make good any loss of business caused by recession in the west.
These events represent bad news for bonds and a mixed future for equities, although the latter can perform well in a period of moderate inflation, particularly where dividend yields provide support.

Robeco argues that long-term value is on offer from equities exposed to natural resources, food, water, environmental and health care, where expenditure is not discretionary. Hedge funds capable of profiting from up and down markets are also worth a look.

Commodity futures are likely to gain much greater institutional attention, although consultants tend to be wary of their volatility. Putting money behind an experienced futures trader might be a better bet, although investors who yearn for a quieter life might prefer to opt for agricultural land. 

Manas Petroleum’s focus since the company began just four years ago has been the exploration and development of giant hydrocarbon assets in Eastern Europe and Central Asia with the aim of building the next great global oil company. This has principally involved operations in countries which were formerly part of the Soviet Union or its satellites, which are now growing more moderate under the influence of Western Europe and China.

During this process, two critical elements remain for what the Manas management views as an historic opportunity to discover and develop major oil assets. The first is that although Russian exploration and development concepts and technologies were previously decades behind that of the West, Soviet record-keeping of geological results was excellent. An overview of Soviet Kyrgyz production and drilling records, for example, reveals an obvious trend towards larger fields as depth increased.

It also indicates that more large discoveries should occur as deep tests continue. Reinforcing this conclusion is the recent re-interpretation of other meticulously-kept Russian records relating to Soviet 1980s-vintage Kyrgyz seismic operations. The results that Manas and its partner have obtained indicate the existence of numerous, large, deep under-thrust, potentially oil-containing, undrilled structures.

State-of-the-art
Manas has consistently built a team of geologists and executives who are experts in this area and have demonstrated they have access to much of this information. This enables them to examine archived data using state-of-the-art Western concepts and technologies in their search for evidence of colossal oil deposits.

The second element is that many former Soviet Union (FSU) and Eastern European nations’ business environments are beginning to show dramatic improvements, which makes operating within their borders extremely attractive.

A key to the Manas success story is the fact that its executives are extremely well-acquainted with all the nuances of FSU and Eastern European political realities. They have a proven record of being able to operate and acquire world-class assets there and they know which countries are evolving in a pro-oil business fashion. They also possess crucial geological expertise which enables them to act immediately when opportunities arise.

Since Manas was founded as a private company, with headquarters  at Baar, in central Switzerland, it has assembled a well-diversified portfolio of high impact exploration plays spanning two continents and five countries. It includes agreements on and varying interests in more than five million acres of land in Central Asia and Eastern Europe. In a new departure, the company was recently  awarded an exploration license for the Magellan basin in southern Chile, an area fast becoming one of South America’s oil and gas exploration hotspots.

The company’s first project was its Kyrgyz Republic Fergana basin oil exploration play. It was a logical opening move because Manas’ ex-CEO Dr Alexander Becker received his PhD in structural geology at Kyrgyz Republic’s Frunze Academy of Science (Bishkek) before going on to discover two significant oil fields and being named the area’s top mapping geologist by the Soviet authorities.

In 2006, British-based engineers Scott Pickford estimated that part of Manas Petroleum’s Kyrgyz Fergana holdings had a P50 an in place resource of 1.2 billion barrels of light oil – an estimate the company is confident will be significantly upgraded.

On the southeastern border of the Kyrgyz Republic is China’s Tarim basin, where the massive Xinjiang field is estimated to supply a fifth of China’s total crude demand. Kazakhstan, home of the super-giant Tengzig, one of the world’s ten largest oil fields, is directly north. The Manas concessions are in an area which shares the same oil saturated geology as China’s Tarim. Both the Tarim and Fergana basins are part of an oil-saturated belt which extends westward and ends at the massive Caspian oil basin. All three areas were first known for their shallow oil production.

Superbly defined
Elsewhere, Manas sees huge oil and gas potential in Albania. The company has production sharing contracts there which cover more than 3,000 square kilometres, and an independent study by American-based engineers Gustavson Associates describes Manas’s oil and gas prospects as “superbly defined virtually drill ready.”

The report adds: “A 2005 light oil discovery by Occcidental Petroleum approximately 50 kilometres south of the Manas blocks has established that the same thrust sheet as the Tirana sub-thrust anticline is Ionian and in fact does contain oil. This substantially reduces the A,B,D,E blocks’ exploration risk as it greatly increases the probability that the giant anticline outlined by Shell and Coparex is in fact the oil-saturated Ionian formation.”

No matter how promising the Albania project might be, Dr Becker is quick to point out that there is always the potential for disappointment with explorations. “We know the prospects’ reservoir capacity is very large and that there is oil in the system,” he says. “But we will never really know for sure if some unexpected geological event has intervened until the prospects are drilled.

“We are getting other companies to take on most of the risks and pay the bills. We may end up with less of a project but we also get to play safe and smart by spreading our risks among many great high potential projects. And that’s how we plan to build a large oil exploration company.”

For further information
Tel: +41 (0) 44 718 10 30
Email: eherlyn@manaspete.com
www.manaspete.com

A barrel of oil now costs twice what it did a year ago, and four times what it cost in 2002. Real prices are now higher than they were at their last peak – 1980 – and look like climbing further still. Plenty has been said about the global economic pain that trend is causing. But the price of oil is not just high, it is volatile, too, and that causes problems of its own.

“Volatility is worsening and the fluctuations are more pronounced than they were in the 1990s,” says Yan Wang, senior economist at the World Bank Institute. Wang says that unlike previous oil shocks, which were largely supply induced, recent price increases reflect growing energy demand in emerging markets, especially China and India. International capital flows seeking investment opportunities in the face of a declining dollar have also played an important role.    

Prices have gone up even though oil stocks around the world are not critically low.

Oil output by the Organisation of the Petroleum Exporting Countries (OPEC) has recently edged higher, and OPEC has “tremendous potential” to increase supply, says World Bank senior energy economist Shane Streifel.

Volatile prices make it harder for oil importers to budget for energy costs. Volatility also hurts economic growth, investment and trade, says the World Bank – several developing countries have lost ground in the fight against poverty as a result. The Philippines reckons 4 million people slid back into poverty in 2006 because of rising oil prices and a higher cost of living.

Oil exporters also face challenges managing revenues and planning development.

A booming oil sector and rising currency may mean other sectors in the economy fail to grow and develop. Volatile oil prices have put pressures on developing countries to look for ways to smooth out the bumps in the market.

The World Bank published a study in 2006 – “Coping with Higher Oil Prices” – that looked at the experience of 38 developing countries that tried various ways of managing volatility. Chile, Malaysia, Thailand, Indonesia and others used “price-smoothing,” in which a country sets a target oil price. The government subsidises oil if the international price goes above the target, and imposes taxes if it goes below.

But such a policy often ends up encouraging more fuel consumption and subsidising the rich. In Indonesia, the government reformed the fuel subsidies and compensated the poor by paying them conditional cash transfers.

Another technique identified in the report is hedging – using financial instruments such as futures and options and “collars” which could mitigate price risks at a cost. Countries can also build up oil security stocks that they can release to reduce the impact of a temporary shortage or a major price shock.

A longer term solution is switching to alternative fuels, including renewable or synthetic fuels, or reduce energy use through energy efficiency or by cutting the amount of energy used in production, which is becoming a priority. Energy switching is often from oil to much cheaper coal in developing countries in East Asia, worsening the environmental picture.

If the reasons for the changing supply and demand levels are well understood, the more interesting question is whether the forces shaping the demand and the supply curves will shift. World Bank managing director Graeme Wheeler addressed this point in a recent speech on oil price volatility. Some big variables are in play, he said.

On the demand side, the energy intensity of production in OECD economies has diminished markedly since the 1970s, argued Wheeler.

Greater efficiency and substitution into alternative energy sources will help to moderate oil demand, but Chinese demand for oil is currently increasing by 15 percent a year. The International Energy Agency (IEA) projects global energy demand to rise more than 50  percent between now and 2030 – with China and India accounting for almost half of this increase.

On the supply side, there’s limited excess capacity in oil producing countries and many potential new sources of supply carry considerable political risk, said Wheeler. “With the lack of net investment in oil refining capacity over the past two decades and the long gestation periods in installing new refining capacity, these supply constraints will be costly to rectify.” 

The IEA estimates that US$20 trillion needs to be invested in the energy sector over the next 25 years to secure sufficient supplies, he noted.

“There’s been considerable debate over the role that oil speculators and traders might have played in exacerbating volatility and inducing upward pressure on prices,” said Wheeler. “Some of this sentiment may date back to concern about the role that Enron’s energy traders played in manipulating the market for natural gas on the West Coast. My impression is that increased speculative activity in futures markets result from the high level of oil prices and uncertainty about forward prices, not the other way around.”

Whatever its sources, Wheeler said that high and volatile oil prices present challenges to governments in managing the terms of trade impact and its consequences for traditional macro-policy instruments, and regulatory and distribution policies. 

“Oil producers have often struggled with the effects of exchange rate appreciation on traditional export industries and the ensuing deterioration in governance – often characterised by growing corruption.  While GDP per capita in resource-rich countries increased by 50 percent in the four decades to 1998, per capita income growth for resource-poor countries was four times higher.”

Wheeler pointed to governance arrangements based on frameworks similar to those adopted by Norway and the State of Alaska that are beginning to emerge in several developing countries. 

The goal is to convert non-renewable resource endowments into permanent sources of investment income using diversified asset strategies and strict budgetary or stabilisation rules.

Sovereign wealth funds are relevant here. These funds currently manage assets of around US$2.5 trillion and some projections suggest that this could reach US$12 trillion by 2015.  The IMF, World Bank, and OECD are developing a code of conduct for these funds, including provisions on institutional structure, risk management, transparency, and accountability. That follows concerns that such funds will use their wealth to achieve political rather than investment goals.

“Some of the political rhetoric has become highly inflammatory, [but] there are some important issues here,” said Wheeler. “Given that these are state-owned investment vehicles, would it be appropriate for them to take an aggressive speculative position like George Soros’ hedge fund did in shorting sterling in 1992?”

Soros’ investment behaviour is widely credited with forcing the UK to leave the European Union’s Exchange Rate Mechanism.

“If used responsibly, commodity hedges and other risk management building blocks can help enormously in managing balance sheet risk.  Hence, it’s pleasing to see that financial market instruments and strategies are being examined,” said Wheeler. “Governments are keen to manage their balance sheet risks.  They do so through a range of mechanisms by, for example, being conscious of the currency exposure of their assets and liabilities, by building up foreign exchange reserves, privatising assets, and adopting sound principles of fiscal management – including managing contingent liabilities.”

In 2000, the World Bank introduced several hedging products to help developing countries manage their balance sheet risks.  With these products, countries have the opportunity to manage exchange rate, interest rate, and commodity price risk in the portfolio of loans that they receive from the International Bank for Reconstruction and Development (IBRD), part of the World Bank. “We can also use these instruments to transform their non-IBRD portfolios,” said Wheeler. However, he waned that governments using derivatives have to understand their pricing characteristics.  “We have recently seen how competitive pressures drove investors to take on greater risks in their search for high yield,” he said. “We saw dominant institutional investors investing in complex structured products with risk and return characteristic that they did not fully understand – even more so when market liquidity began to dry up with corresponding uncertainty on how to value underlying cash flows.”

Even with efficient financial markets, there remains a critical challenge for many developing countries.

“One of the cruel ironies today is the connection between rising energy and food prices,” said Wheeler. “This coupling can have devastating implications for global poverty and food security.  Higher energy prices have increased fertiliser and transport costs and stimulated bio-fuel production.”

In the US, for example, a quarter of the maize crop – representing over ten percent of global output – went into bio-fuel production last year.  Higher energy prices, drought, and rising demand have led to a 75 percent increase in the price of staples since 2005 – prices are at a 20-year high.

“Just as the poorest on this planet are the most exposed to the effects of climate change, they are also highly vulnerable to the effects of rising fuel and food prices,” said Wheeler. “Food and energy prices usually represent over 70 percent of the consumption basket of the poor. The long-term consequences are considerable.  Poor households will cut back on food consumption and education – and girls will invariably be the first withdrawn from schooling.  Reliance on traditional fuels will increase with obvious environmental consequences.”

“This leads to an important point.  The catalyst of globalisation will only be sustainable if it can create opportunities and benefits for all. Today, given  the recent revisions to purchasing power parities, well in excess of over a billion people live on less than $1 a day.”

That means “the benefits of globalisation are by-passing many of the poorest,” says Wheeler: they are in danger of becoming politically and socially disenfranchised and disconnected from global society.

“We have seen how their exposure to higher food prices recently led to riots in West Africa and South Asia. A world where a large proportion of the population remains trapped in extreme poverty and unable to share the benefits and opportunities of globalisation, carries unacceptable costs in terms of human suffering, economic losses and political tensions, and has important potential implications for security within countries and across borders.”

Wheeler said that concerns about the slowdown in industrial economies, should not cloud the benefits of globalisation and the ways in which trade had boosted investment, spread technology, and enabled labor mobility – all of which “are boosting productivity growth and delivering millions of people from poverty.”

That’s why the price of oil – and the ability to manage volatility in the price – is so important. Wheeler pointed to the “drami” or “the endless knot” – one of the eight lucky signs of Buddhist philosophy – as an illustration of the challenges of globalisation.  “It symbolises how citizens of the world – across countries and over time – are connected in a web of mutual interdependence,” he said.