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  • A Scary Ratio

    Posted by David Foster on August 5th, 2008 (All posts by )

    Barrons (7/14) contains the following sentence:

    Even more impressive is the value of the oil reserves of petroleum-exporting countries, which now total an estimated $140 trillion, nearly three times the size of global equity markets, which have a combined market value of around $50 trillion. (emphasis added)

    There are a couple of things wrong with this comparison. It is not correct, IMNSHO, to compare a cash flow stream which will be recognized over years/decades to a current market value–the cash flow stream should be discounted to present value. (Equity market values already represent, at least in theory, the discounted present value of their corresponding free cash flow streams.) Also, I’m pretty sure reserve value is a gross value, which doesn’t take production costs into account. For a place like Saudi Arabia, these may be minimal at present, but they will not remain minimal over the life of the asset.

    But even after these adjustments are applied, you will probably come out with something like:

    The value of the oil reserves of petroleum-exporting countries is equal to the size of global equity markets.

    Think about what this means. Ownership of the land under which oil resides is roughly equal in value to ownership of the equity interest in all the world’s publicly-traded companies, with their factories, mines, brand values, and intellectual capital…the accumulated work and knowledge of centuries.

    This represents in a sense a return to the pre-industrial age, in which the ownership of land was the predominant form of wealth. If this situation is sustained, it will represent a tremendous change in the world economic order, and not at all a positive one.

    Will it be sustained?

    The industrialized world (and I include here the newly industrializing countries such as China and India) contains a tremendous amount of human ingenuity, and many people and organizations who are incentivized to find oil, conserve oil, and develop oil substitutes. Most of these countries are at least partly market-based, and markets respond to high prices and supply constraints very effectively. These market responses are certainly a major factor in the current retreat of oil from the $135 level which was assumed in the Barrons article. High prices lead to millions of individual decisions which counteract those prices–for example, Pratt & Whitney reports that it is now having much better success selling its jet engine washer, which, if regularly used, will reduce engine fuel consumption by a percent or so. Take a percent here and a percent there and a percent somewhere else, and pretty soon the cumulative effect becomes very significant.

    But.

    In the U.S. and in much of Europe, rational reactions to oil prices–and other energy issues–have been substantially inhibited by political factors. Not only has much oil and gas drilling been prohibited–nuclear power has been brought to a standstill, wind programs have been stopped by concerns about aesthetics, and grid connections for solar projects are also being delayed. A very powerful culture of protest has developed, with the ability to use the courts and the regulatory system to severely delay any large infrastructure project whatsoever. And politically-driven energy solutions, as in the domestic corn-ethanol incentives coupled with the tariffs on imported sugarcane ethanol, have been very poorly thought out.

    So, it is not at all clear whether or not the West will be allowed to use its creativity, knowledge, and flexibility to deal with the energy situation that now faces us–or whether solutions will be stopped by the dominant political classes, leaving us to deal with a new age in which ownership of oil-bearing land is the world’s most important source of wealth.

     

    4 Responses to “A Scary Ratio”

    1. vanderleun Says:

      Well, if that’s the case then — after we allow the rest of the planet to pump itself dry — we should be sittin’ purty.

    2. vanderleun Says:

      …. assuming we’re still around.

    3. Shannon Love Says:

      To paraphrase Richard Feynman: Value is a subtle concept.

      Value is not a fixed property. I learned this the hard way back in the oil boom and bust back in the 80’s. I inherited some mineral rights from a great-great aunt. At one point circa late 1982 the rights had an esitmated value of ~$12,000-$20,000. However, the price of oil burst in ’83 and in ’86 I sold my rights to another family member for $2,000

      Oil in the ground has no value save that we consume it while we create more wealth. The oil itself has no value unless the rest of the world has a booming vibrant economy. The value of the oil will rise and fall in sync with the prosperity of those who have no oil. It’s something of a golden handcuff. As long as oil consumer prosper, oil producers prosper. When the prosperity of oil consumers falls, say do to high oil prices, the oil producers will suffer as well.

      .

    4. ElamBend Says:

      To paraphrase Shannon: The value of the one is dependent on the value of the other. They are equal in value only nominally; plus one is a decreasing asset, the other builds upon itself.

      I’ll take the human capital any day.