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Quarterly Letter to Clients

July, 2008

Indices at quarter-end (June 30, 2008):

Dow Jones Industrials: 11,350.01 2Q'08 -7.44% YTD -14.43%

Standard & Poor's 500: 1,280.00 2Q'08 -3.23% YTD -12.83%

I keep having this conversation on a personal level, so I thought it might be timely to review it in this forum. The topic is energy; electricity and oil.

2006 is the latest year that my source, the U. S. Government Energy Information Administration, has published figures. In that year, electricity in the United States was generated by the following fuels: 49% coal; 20% natural gas; 19% nuclear; 7% hydro (meaning dams); 2.4% other renewables (including wood, municipal solid waste, landfill gas, tires, agricultural byproducts, geothermal, solar and wind); and, finally, only 1.6% of our electricity is generated by petroleum.

Thus you can see that we are not dependent upon oil for our electricity.

Where we are dependent on oil is on the road. Our automobiles make up the bulk of our petroleum consumption. From the same source we find that Americans use, on average, 20 million barrels of oil per day, or roughly three gallons of unrefined crude per person.

Of this, 12 million barrels are imported from more than 25 countries. Fully 46% of that 20 million barrels is refined into gasoline for our automobiles; the next big uses are home heating oil, at 20%; and jet fuel, 7%. (Other uses are plastics, lubricants, etc.)

Which leads me to the Strategic Petroleum Reserve. The government has recently decided to halt the filling of this reserve, which now stands at 702 million barrels, out of a maximum capacity of 727 million barrels. Until recently we had been pumping 76,000 barrels a day into salt domes in Texas and Louisiana.

Much of the oil that we have been pulling up out of the ground (in order to pump it back into the ground) comes from domestic drilling in the Gulf of Mexico, and is taken by the government in lieu of royalties from the drillers. That accounts for about 60%. The balance of the supply has come from all over the world.

Now, you can look at the 76,000 barrels a day and in comparison to our usage of 20 million barrels, you could say it appears to be minor. And you would not be wrong. Our total reserve only comes to less than two months of consumption (of our imports).

But you could also look at the constant drain on supply, and reflect on the effect it has on prices. At a recent high price of something north of $136 a barrel, our Strategic Petroleum Reserve is approaching a value of one hundred billion dollars. And it is hard to say that a hundred billion dollars of product removed from the supply has not affected the price.

Those, remember, are your tax dollars being pumped into the ground.

At this point you can understand why I believe that the future of automobiles in America is ultimately electric.

It is interesting to note that while we are importing more oil than ever, Americans are actually using a smaller percentage of the world production now than in 2000. U.S. imports have shrunk to 14% of the world total, down from the peak of nearly 19% in 2000. Over the last seven years our imports have risen by over 60%, but imports by the rest of the world have gone up more than 170%. Today, developing nations use over 41% of the global oil supply, up from 33% just seven years ago.

So global production is up, but usage worldwide is also much higher. It is simple supply and demand: until the world reduces its hunger for petroleum, you can expect prices to remain elevated.

I would be remiss if I did not remind you that the falling dollar is also part of the price increase in the U.S. Thus, Europe, for example, has seen prices rise, but by a smaller percentage than here.

I have said in the past that all markets have a psychological aspect, and that applies to the oil market as well. It is certainly possible that we may look back on this period, marked by the cessation of the filling of the SPR, as the beginning of a psychological turning point in the market.

But I’m not holding my breath hoping that prices will abate anytime soon. Demand is simply too strong. I personally would not be surprised to see $200 oil. I would also not be surprised to see it later tumbling back to earth as we develop alternate sources of fuel.

In the end there are no easy answers to this problem. But my guess is that we won’t see substantive change in terms of alternate energy until gasoline is in the area of $10 a gallon. At that point, you, too, may find an electric car appealing.

Jim Pappas