Petrocapita Update

May 2010
Summary

Perception and Reality

It has been said that good investment requires the skill to capture
the arbitrage available between perception and reality and therefore
it is critical to know both.

Consider the perception and reality reflected in the following quotes:

“In some ways it’s a battle of the politicians against the

markets. That’s how I do see it. But I’m determined to win
this battle.” Angela Merkel, German Chancellor

“How did you go bankrupt? Two ways. Gradually, then

suddenly.” Ernest Hemingway
Contents
I think that there is something emblematic of our current financial
predicament in these two snippets of text. With constant fiscal 4 The Inflation Lag
deficits the governments of the developed world have so far been 4 Die Leerverkäufer Sind Kaputt
gradually bankrupting themselves. Now by stepping in to transfer 4 Developed World Has the Debt
private sector debt problems onto already precarious public sector Problem, Can You Believe Less
balance sheets I believe they may be moving on to the sudden stage So For the Emerging Markets
of bankruptcy – if not de jure then de facto. What Chancellor Merkel 5 ‘Some horrendous Keynesian/
is really saying is that she is unhappy that the market is starting monetarist nightmare’
to see through the false assumption of sovereign solvency and is 5 A Glimpse Into the Financial Hell
acting accordingly. of Stagflation
6 QE Update – When is the
Here are a few more observations in the category of reality/ Sterlisation Going to Happen?
perception arbitrage: 7 The Market Goes “No Bid”
7 Who is in worse Shape – US in
– Perception: Bailouts stabilize the system and reduce volatility 2009 or Argentina in 2001?
Reality: Bailouts increase long-term volatility/risk by creating 7 A comparison of public debt to
moral hazard and subsidizing failure – whatever activities you revenue ratios during past crises
subsidize and de-risk you will ultimately get increased production with some of those today.
of, not less. 7 In the Category of You Know You
Have Problem When…
8 In the Category of You Know You
Have an Even Worse Problem
When…

1
Summary (continued)

– Perception: Government intervention will help maintain growth

Reality: Increasing the size of government is reducing not
improving our ability to create real growth. The idea that we
must keep credit available to the state at any cost because only
state spending can maintain growth while the private sector
recovers borders on lunacy. Government spending is purely
a transfer mechanism and typically destroys capital. Therefore
increasing government spending at this time destroys capital
exactly when it is needed the most to rebuild balance sheets
thereby ensuring lower real growth rates in the future.

– Perception: Private sector debt reduction/defaults make deflation

our biggest risk – CPI shows that there is no inflation
Reality: The absence of general price inflation being used as
proof of the lack of inflation misses the much more subtle nature Contents Continued
of inflation - inflation does not happen in the aggregate and
newly created money and credit flows into certain assets/goods 9 Greece versus US
first then only over time is spread throughout the economy. 9 China May Surpass US GDP by
Monetary inflation has for many years been focused on risk 2027
assets rather than consumption items (it is consumptions items 10 More on Sovereign Defaults…
that overwhelmingly drive the typical inflation measure such as 11 Bondholders Beware?
CPI). 11 Unsustainable Public Sector
Fiscal Path
You can have an economy that is experiencing strongly 12 Cheerleaders Get Paid Better
increasing and decreasing nominal prices at the same time as Than You Thought
newly created money and credit rotates from sector to sector in 12 Fiscal Analysis – Reductions
search of returns. Required in Virtually Every
Country
Of course, the heavily geared asset classes that were the 13 US Farmland Returns
beneficiaries of the monetary expansion of the last decade – 13 IEA 2010 Energy Demand
the financial sector, sovereigns, residential and commercial real Report
estate come immediately to mind - should continue to suffer 14 World Energy Markets by Fuel
ongoing solvency issues and pronounced nominal price declines Type 
as credit is re-allocated within the system but this is not the 15 Energy Factoids
same as generalized deflation through-out the economy.

2
Summary (continued)

Given this, it would seem a good assumption that much of the recently created money/credit will
ultimately flow into a new part of the economy – likely those sectors whose fundamentals remain the most
unimpaired and where gearing levels are lower.

– Perception: Governments are not monetizing their debt

Reality: Money is fungible so by buying bank assets and encouraging the risk free trade of investing
in sovereign debt with excess bank reserves, central banks have used the captive and/or nationalized
banking system as a vehicle to monetize government debt:
– The Bank of England printed £200bn = 2009 UK government deficit.
– The US Federal Reserve printed $1.25 trillion = 2009 US government deficit
– ECB printing Euro 750 billion for Greek bailout = 2009 EU 27 government deficit

In any event, I believe there will come a point when central banks will monetize government deficits much
more openly. Logically the vast amounts of government debt rolling over the next years combined with
already large and growing fiscal deficits will be the catalyst. In just one example, how can the US borrow
an additional $10 trillion and rollover another $13 trillion in debt over next decade when the current money
supply is only around $15 trillion? Even assuming that budget estimates are accurate – and many
observers expect the total to be more like $20 trillion than $10 trillion – then is a failed US debt auction a
possibility in the future?

In the near term volatility will remain the order of the day as the economies of the west experience the clash of
strong inflationary forces against the liquidation of decades of mal-investments playing out across many asset
classes.

Therefore, I continue to believe that capital preservation should be given the highest priority with an allocation
to investments with returns linked to markets with generally favorable demographics, low national debt levels,
high savings, and trade surpluses that can be expected to continue going forward (e.g. emerging economies
and Asia in particular).

Regards

Stephen Johnston - Partner

3
Petrocapita Update (continued)

The Inflation Lag

In his book, “The Dying of Money” Jens Parssons to shore up the Euro and shift the blame for its
discussed the concept of the “inflation lag”. The weakness to the financial markets rather than the
idea is simple; the money supply often can increase profligate bailout of Greece.
significantly over an extended period of time before
inflation becomes apparent. We have experienced Developed World Has the Debt Problem,
almost 30 years of benign general price inflation Can You Believe Less So For the
coupled with massive monetary base expansion Emerging Markets
such that a large inflation gap has accumulated.
When inflation begins to accelerate it may be Chart 2 shows an IMF forecast for government debt
commensurately massive and lengthy as the gap is levels of developed and developing countries. The
closed – see chart 1. emerging sovereigns’ debt levels are much lower
and stable while their more “developed” brethrens’
Die Leerverkäufer Sind Kaputt levels are much higher and accelerating – years of
unrestrained government spending coming home
The German breed of short-seller (“Leerverkäufer”) is to roost? As Paul Kedrosky recently quipped are
set to become extinct. In the spirit of the “battle of the developed economies called that “because they
the politicians against the markets” Germany has have developed a fully metastasized case of societally
banned naked short-selling. The message is clear, terminal debt?”.
naked derivatives trades where the underlying is
the Euro will not be tolerated - a desperate attempt
Chart 2: General Government
Gross Debt Ratios
Chart 1: MZM Stock, PPI, CPI (% GDP, 2009 PPP-GDP weighted average)
MZMN5, 1960-04=100 120
Index PPIACO, 1960-04=100 G-20 Advanced
CPIAUCNS, 1960-04=100
3,600 100
All Advanced
3,200
Low Income
2,800 80
2,400
2,000
“Inflation Lag”
60
1,600 G-20 Emerging
1,200 40 Emerging
800 (broad sample)
400
20
0
1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: St Louis Federal Reserve
Source: DB Global Markets Research, IMF

4
Petrocapita Update (continued)
‘Some horrendous Keynesian/monetarist
nightmare’
Royal Bank of Scotland strategist Bob Janjuah’s
recent research note has a somewhat dark mood
to say the least: “I had assumed, after doing
what it took in late 08 and early 09 to avoid global
depression and systemic financial system collapse,
that policymakers & their buddies would see the light
and realise that the only path to long term success
for the problem economies (US, UK, most of Europe,
Japan, etc) would be a period of Austerity, Balance
Sheet repair, Deflation, Real Structural Economic
reform and Serious Financial System/Accounting
regulation/reform. This path is NOT the easy path
near term, but it is the ONLY path for ensuring
the long term health and success of the problem
economies, as well as ultimately the ONLY path which
will both successfully iron out the grotesque global
imbalances and help ensure the long term success
of the global economy. SADLY, during my period
of reflection, I have come round to the view that we
have missed this golden opportunity. What instead I
am seeing is a desperate attempt to re-write history
(‘there was no bubble’, ‘rates too low for too long
had nothing to do with it’, ‘it’s all just the fault of a
bunch of greedy traders’, etc etc) AND at the same
time it is clear global policymakers and their buddies,
whilst jaw-boning us about ‘exit’ and ‘austerity/
fiscal repair’, simply do NOT mean what they are
saying – in other worlds, they are talking ‘responsibly’
but are acting IMHO in a reckless and irresponsible
manner. And in my book actions ALWAYS speaker
far more clearly and far louder than (cheap) talk. The
Greece bail-out, the goings on at the IMF involving
the huge build-up of ‘new bail-out’ reserves, and
all the talk in the UK about fiscal repair based on
fantasyland ‘efficiency gains’ are the latest evidence
that policymakers EVERYWHERE have no appetite
to be brave, to be strong and to do the right thing. It
seems that it is clearly too painful to do anything else.
Instead, policymakers EVERYWHERE seem to have
decided that the only way out of the hole is MORE
DEBT, MORE DEBASEMENT, MORE BAILOUTS,
ugly INFLATION and/or even uglier STAGFLATION,
FAKE AUSTERITY, ZERO STRUCTURAL ECONOMIC
REFORM, & MINIMAL REGULATORY REFORM.
We are trapped in some horrendous Keynesian/
monetarist nightmare, where policymakers, aided/
abetted/advised by their buddies in the media, in
the lobbyist cabal and in financial system, have YET
AGAIN decided to go down the route which merely
delays the problem/pushes it down the road, but
which virtually guarantees that when the NEXT bubble
collapses (I assume it will be the Global Government
Debt/Bond Bubble and/or the Global Fiat Money/
Paper Money/FX Bubble), there is NO pleasant way
back.”
A Glimpse Into the Financial Hell of
Stagflation
Royal Bank of Scotland strategist Alan Ruskin
recently conducted a thought experiment on a US
sovereign debt crisis. According to Rushkin, only
food commodities would be worth owning. “Now a
US Treasury crisis should also never have to extend
to default, as long as the Fed is willing to buy US
Treasury debt, and deliver the haircuts to investors
through inflation rather than direct restructuring –
which may be preferable for reputational interests.
Unfortunately the inflation route is still desperately
5
Petrocapita Update (continued)
painful, not least because it drives up nominal
yields and delivers the pain incrementally through
bond and currency losses, rather than all upfront
as a restructuring. Such bond losses are indicative
of how a fiscal funding crisis quickly ends up as a
monetary policy crisis, and a collapse in central bank
control across the curve. Although this all feels like
jumping deep into the land of the hypothetical, the
above scenario is not too far removed from the late
1970s period of stagflation. I have gone back a good
deal further, to the start of the 20th century to see
how assets coped with stagflation (a relatively rare
phenomenon) which would be the likely backdrop to
(or outcrop of) a US sovereign crisis. The conclusions
are not pretty. As feared there have been very few
places to hide outside commodities when US growth
is very soft and inflation is above a 5% threshold.
Sell, equities, be a big seller of BAA then AAA bonds
and yes buy FOOD commodities. Food commodities
have been up as much as 30% y/y in years since
1900 when US per capita income was negative
and inflation is above 5%, perhaps because these
conditions are also accompanied by energy shocks
or war, that are among the other darkest channels to
financial blight.’
QE Update – When is the Sterlisation
Going to Happen?
According the SocGen anlalyst Dylan Grice “In 2009,
the BoE printed £200bn, thus completely financing
the UK government deficit. It can’t have felt good
about doing it but since the alternative scenario
was so scary– financial meltdown and possibly
IMF support– it held its nose and did it anyway. It
said it was going to sterilise the intervention, but
on discovering that such was the financial system
distress it was unable to, it just carried on regardless.
In the US, the Fed printed $1.25 trillion to monetise
the problematic mortgage market. It also said it was
going to sterilise the intervention, but like the BoE it
soon found it couldn’t, and like the BoE continued
anyway because the alternative financial meltdown
scenario was too scary to contemplate. Today,
the ECB is buying insolvent Eurozone government
debt which it is promising to sterilise. Yet they face
the same stark calculus faced by their Anglo-Saxon
cousins in 2008. You can only worry about the
economy’s ‘price stability’ if the economy hasn’t
already melted down! So here’s my prediction: they
won’t sterilise, and the program will expand.
Most economists seem to think that QE puts us
in uncharted waters. It doesn’t. Printing money to
finance government expenditure is a very well trodden
path which is as old as money itself: persistent
monetisation causes inflation. Of course the current
monetisation need not be persistent. Central banks
can theoretically just stop it at any time.
But with government balance sheets in such a mess
across the developed world (even with yields at
historically unprecedentedly low levels), government
funding crises are likely to be a recurring theme in
the future. Since banks hold so much “risk free”
government debt, those funding crises point towards
more banking crises which point towards more
money printing. When do they stop? When can they
stop? But what does it all mean? The question to
my mind isn’t whether or not inflation will accelerate
from here. If government balance sheets are in as big
a mess as I think they are, inflation is inevitable.”
6
Petrocapita Update (continued)

The Market Goes “No Bid” Who is in worse Shape – US in 2009 or

Argentina in 2001?
Various high frequency trading systems or fat
finger explanations notwithstanding here are two A comparison of public debt to revenue ratios during
experienced market commentators with much simpler past crises with some of those today.
ideas about how markets can fall unexpectedly and
rapidly – simply put an absence of buyers.
Chart 3
John Kenneth Galbraith described the crash of
1929 as follows: “Of all the mysteries of the stock Historical public debt/revenue ratios during selected defaults Selected ratios today
18
exchange there is none so impenetrable as why there 16
should be a buyer for everyone who seeks to sell. 14
12
October 24, 1929 showed that what is mysterious is 10
not inevitable. Often there were no buyers, and only 8
after wide vertical declines could anyone be induced 6
4
to bid ... Repeatedly and in many issues there was 2
a plethora of selling orders and no buyers at all. The 0
Mexico, 1827

Spain, 1877

Argentina, 1890

Germany, 1932

China, 1939

Turkey, 1978

Mexico, 1962

Brazil, 1963

Philippines, 1983

South Africa, 1985

Russia, 1998

Pakistan, 1998

Argentina, 2001

Greece, 2009

Spain, 2009

Japan, 2009

US, 2009
stock of White Sewing Machine Company, which
had reached a high of 48 in the months preceding,
had closed at 11 on the night before. During the day
someone had the happy idea of entering a bid for a
block of stock at a dollar a share. In the absence of
Source: SG Cross Asset Research, Reinhart and Rogoff 2009
any other bid he got it.” John Kenneth Galbraith,
1955, The Great Crash

Richard Russell described the 1973-74 crash as
follows: “I started accumulating stocks in December
of ‘74 and January of ‘75. One stock that I wanted to
buy was General Cinema, which was selling at a low
of 10. On a whim I told my broker to put in an order
for 500 GCN at 5. My broker said, ‘Look, Dick, the
price is 10, you’re putting in a crazy bid.’ I said ‘Try
it.’ Evidently, some frightened investor put in an order
to ‘sell GCN at the market’ and my bid was the only
bid. I got the stock at 5.” Richard Russell, 1999, Dow
Theory Letters
In the Category of You Know You Have
Problem When…
Even the US military thinks the US budget deficit is
too big. To quote a recent research paper by the
Army “Although these fiscal imbalances have been
severely aggravated by the recent financial crisis and
attendant global economic downturn, the financial
picture has long term components which indicate
that even a return to relatively high levels of economic
growth will not be enough to right the financial

7
Petrocapita Update (continued)
picture. The near collapse of financial markets
and slow or negative economic activity has seen
U.S. Government outlays grow in order to support
troubled banks and financial institutions, and to
cushion the wider population from the worst effects
of the slowdown. These unfunded liabilities are a
reflection of an aging U.S. Baby-Boom population
increasing the number of those receiving social
program benefits, primarily Social Security, Medicare,
and Medicaid, versus the underlying working
population that pays to support these programs.
Rising debt and deficit financing of government
operations will require ever-larger portions of
government outlays for interest payments to service
the debt. Indeed, if current trends continue, the U.S.
will be transferring approximately seven percent of
its total economic output abroad simply to service its
foreign debt. Interest payments are projected to grow
dramatically, further exacerbated by recent efforts to
stabilize and stimulate the economy, far outstripping
the current tax base shown by the black line. Interest
payments, when combined with the growth of Social
Security and health care, will crowd out spending
for everything else the government does, including
National Defense. The foregoing issues of trade
imbalance and government debt have historic
precedents that bode ill for future force planners.
Habsburg Spain defaulted on its debt some 14 times
in 150 years and was staggered by high inflation
until its overseas empire collapsed. Bourbon France
became so beset by debt due to its many wars and
extravagances that by 1788 the contributing social
stresses resulted in its overthrow by revolution.
Interest ate up 44% of the British Government budget
during the interwar years 1919-1939, inhibiting its
ability to rearm against a resurgent Germany. Unless
current trends are reversed, the U.S. will face similar
challenges, anticipating an ever-growing percentage
of the U.S. government budget going to pay interest
on the money borrowed to finance our deficit
spending.”
In the Category of You Know You Have an
Even Worse Problem When…
According to the US Army “A severe energy crunch
is inevitable”. In a recent report Army analysts
wrote “To meet even the conservative growth rates
global energy production would need to rise by 1.3%
per year going forward. By the 2030s, demand
is estimated to be nearly 50% greater than today
and even assuming more effective conservation
measures, the world would need to add roughly
the equivalent of Saudi Arabia’s current energy
production every seven years (1.4 MBD per year).
The discovery rate for new petroleum and gas
fields over the past two decades (with the possible
exception of Brazil) provides little reason for optimism
that future efforts will find major new fields.
At present, investment in oil production is only
beginning to pick up, with the result that production
could reach a prolonged plateau. By 2030, the
world will require production of 118 MBD, but energy
producers may only be producing 100 MBD unless
there are major changes in current investment and
drilling capacity.
8
Petrocapita Update (continued)

By 2012, surplus oil production capacity could Greece versus US

entirely disappear, and as early as 2015, the shortfall
in output could reach nearly 10 MBD.
A severe energy crunch is inevitable without a
massive expansion of production and refining
capacity. While it is difficult to predict precisely
what economic, political, and strategic effects such
a shortfall might produce, it surely would reduce the
prospects for growth in both the developing and
developed worlds. Such an economic slowdown
would exacerbate other unresolved tensions, push
fragile and failing states further down the path toward
collapse, and perhaps have serious economic impact
on both China and India. At best, it would lead to
periods of harsh economic adjustment.” Emphasis
mine
In the last 42 years the US Federal Government has
run a deficit 88% of the time and deficits of 9%, 7%
and 6% are expected over the next 3 years. Greece,
the current poster boy for profligate government
spending, has had average deficits of 7% of GDP
over the last 5 years.
China May Surpass US GDP by 2027
Goldman Sachs is predicting that the GDP of China
will surpass the US in 17 years, 13 years earlier than
their previous prediction.

Chart 4: US Deficit/Surplus Chart 5: GDP Projections BRICs v West

as Percent GDP ($billions)
70,000
4%
60,000
2%
50,000
0%

-2% 40,000
“Il Sorpasso”:
2027 (previously 2040)
-4% 30,000

-6% 20,000

-8% 10,000

-10%
2006 2011 2016 2021 2026 2031 2036 2041 2046
-12%
1975 1985 1995 2005
Brazil Russia United Kingdom
China Germany United States
Source: Bloomberg
India Japan
Source: Goldman Sachs

9
Petrocapita Update (continued)

More on Sovereign Defaults…

Chart 6: Periods of Banking Crises,
The lessons of financial history, inflation and outright Default and Inflation by Country
sovereign defaults as distilled by Niall Ferguson
author of “The Ascent of Money”:
Since independence or 1800 Since 1800*

Share of Share of Total Share Share Number of

What do governments not do with world war size years in a years in number of of years of years hyperinfla-
debt burdens? banking default or defaults in which in which tion years
– Slash expenditure on entitlements crisis reschedul- and inflation inflation
ing reschedul- exceeded exceeded
– Reduce marginal tax rates on income and ings 20% 40%
corporate profits to stimulate growth Austria 2 17 7 21 12 2
– Raise taxes on consumption to reduce deficits
Belgium 7 10 7
– Grow their way out without defaulting or
depreciating their currencies Denmark 7 2 1

Finland 9 6 3
What do governments usually do with world war size Germany 6 13 8 10 4 2
debt burdens?
Greece 4 51 5 13 5 4
– Oblige central bank and commercial banks to
Hungary 7 31 7 16 4 2
hold government debt
– Restrict overseas investment by firms and citizens Italy 9 3 1 11 6
– Default on commitments to politically weak Netherlands 2 6 1 1
groups and foreign creditors Norway 16 5 2
– Condemn bond investors to negative real interest
Poland 6 33 3 28 17 2
rates
Portugal 2 11 6 10 4
What are the geopolitical consequences of crises of Spain 8 24 13 4 1
public finance? Source: Reinhart and Rogoff (2009)
Sweden 5 2
– In fiscal stabilizations, discretionary military United 9 2
spending is usually the first casualty Kingdom
– In cases of default on external debt, conflicts with
Source: Reinhart and Rogoff (2009)
creditors can arise
– In cases of currency depreciation, reserve
currency status can be lost to a rising rival

10
Petrocapita Update (continued)

Bondholders Beware? and reduce their adverse consequences for long-

term growth and monetary stability... It follows that
Chart 7 represents the real annual returns on UK and the fiscal problems currently faced by industrial
US bonds, 1900-1995. Are we heading into another countries need to be tackled relatively soon and
period of negative real returns to bonds?

Unsustainable Public Sector Fiscal Path

Chart 8: Debt/GDP Projections
“Our projections of public debt ratios lead us to
conclude that the path pursued by fiscal authorities Portugal Ireland
300 400
in a number of industrial countries is unsustainable. 250
Drastic measures are necessary...” That is a 200
300

direct quote from a recent study by the Bank of 150 200

International Settlements (“BIS”). The study looks at 100
100
public sector fiscal policy and public debt in a number 50

of developed countries (see chart 8) and concludes: 80 90 00 10 20 30 40

0
80 90 00 10 20 30 40
0

“Our projections of public debt ratios lead us to

conclude that the path pursued by fiscal authorities Greece Spain
500 400
in a number of industrial countries is unsustainable.
400
Drastic measures are necessary to check the rapid 300
growth of current and future liabilities of governments 300
200
200

100 100

0 0
Chart 7 80 90 00 10 20 30 40 80 90 00 10 20 30 40

12 United Kingdom United States

600 500
10
500 400
8
400
6 300
300
4 200
200
2 100
100
0 0
1900-1909 1910-1919 1920-1929 1930-1939 1940-1949 1950-1959 1960-1969 1970-1979 1980-1989 1990-1999 0
-2 80 90 00 10 20 30 40 80 90 00 10 20 30 40

-4
-6 Baseline scenario
-8 Small gradual adjustment
-10 Small gradual adjustment with age related spending held constant
UK US
Source: GFD Source: BIS

11
Petrocapita Update (continued)

resolutely. Failure to do so will raise the chance of demonstrate a marked inability (unwillingness?) to
an unexpected and abrupt rise in government bond forecast downturns. Not an unsurprising institutional
yields at medium and long maturities, which would bias in a sector that is dependent on selling securities
put the nascent economic recovery at risk. It will also to the unsuspecting public regardless of the quality or
complicate the task of central banks in controlling economic conditions.
inflation in the immediate future and might ultimately
threaten the credibility of present monetary policy Fiscal Analysis – Reductions Required in
arrangements.” Virtually Every Country

Cheerleaders Get Paid Better Than You Assuming governments want merely to stabilize
Thought debt levels as a percentage of GDP the numbers in
chart 10 represent the contraction in fiscal spending
According to a study by McKinsey, Wall Street equity necessary between 2010 and 2030 as a percentage
analysts have on average, overestimated S&P 500 of GDP. Not a promising picture given the virtual
earnings by two times for almost 30 years and inability of governments to undertake sustained
reductions in outlays in the face of political pressure
from the voters and the current low interest rate
environment.
Chart 9: Reality versus
Wall Street “Analysis”
Long-term Forecast1
average % Actual2 Chart 10
18
16
14
14
12 12
10
10
8
6 8
4
6
2
0 4
-2
2
1985-90 1987-92 1989-94 1991-96 1993-98 1995-00 1997-02 1999-04 2001-06 2003-08 2004-09

0
1
Analyst’s 5-year forecast for long-term consensus earnings-per-share
Korea
Switzerland
Norway
Iceland
New Zealand
Sweden
Israel
Hong Kong SAR
Czech Republic
Germany Slovenia
Italy
Slovak Republic
Denmark
Canada
Finland
Austria
Belgium
Singapore
Austria
Netherlands
Portugal
France
United Kingdom
Greece
Spain
Ireland
United States
Japan

-2
(EPS) growth rate. Our conclusions are same for growth based on year-
over-year earnings estimates for 3 years. -4
2
Actual compound annual growth rate (CAGR) of EPS; 2009 data are not
yet available, figures represent consensus estimate as of Nov 2009. -6

Source: HBR/McKinsey Source: IMF

12
Petrocapita Update (continued)

US Farmland Returns economic growth paths that were anticipated before

Institutions that have invested in US farmland have
earned a return of 11.2% since 1992, with no down
years.
IEA 2010 Energy Demand Report
“The global economic recession that began in 2007
and continued into 2009 has had a profound impact
on world energy demand in the near term. Total world
marketed energy consumption contracted by 1.2
percent in 2008 and by an estimated 2.2 percent in
2009, as manufacturing and consumer demand for
goods and services declined. Although the recession
appears to have ended, the pace of recovery has
been uneven so far, with China and India leading and
Japan and the European Union member countries
lagging. In the Reference case, as the economic
situation improves, most nations return to the
Chart 11
35%
Yearly Returns, NCREIF Farmland Index
30%
25%
20%
15%
10% 6.3% 6.3% 6.3% 6.3%
6.3%
6.3% 6.3% 6.3%
6.3%
5%
6.3%
the recession began. 
The most rapid growth in energy demand from 2007
to 2035 occurs in nations outside the Organization
for Economic Cooperation and Development (non-
OECD nations). Total non-OECD energy consumption
increases by 84 percent in the Reference case,
compared with a 14-percent increase in energy use
among the OECD countries. Strong long-term growth
in gross domestic product (GDP) in the emerging
economies of non-OECD countries drives the fast-
paced growth in energy demand. In all the non-OECD
regions combined, economic activity—as measured
by GDP in purchasing power parity terms—increases
by 4.4 percent per year on average, compared
with an average of 2.0 percent per year for OECD
countries. 
The IEO2010 Reference case projects increased
world consumption of marketed energy from all fuel
sources over the 2007-2035 projection period (Chart
12) Fossil fuels (liquid fuels and other petroleum,
natural gas, and coal) are expected to continue
6.3% 1992-2009 supplying much of the energy used worldwide.
annualized
returns Although liquid fuels remain the largest source of
energy, the liquids share of world marketed energy
Russell 3,000
consumption falls from 35 percent in 2007 to 30
Lehman percent in 2035, as projected high world oil prices
6.3% Aggregate
6.3%
lead many energy users to switch away from liquid
6.3% 6.3%
Farmland fuels when feasible. In the Reference case, the use
of liquids grows modestly or declines in all end-use
6.3%
sectors except transportation, where in the absence
6.3%
6.3%
6.3% of significant technological advances liquids continue
6.3% 6.3%
to provide much of the energy consumed. 

0%
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

13
Petrocapita Update (continued)

Average oil prices increased strongly from 2003 to
mid-July 2008, when prices collapsed as a result of
concerns about the deepening recession. In 2009,
oil prices trended upward throughout the year, from
about $42 per barrel in January to $74 per barrel in
December. Oil prices have been especially sensitive
to demand expectations, with producers, consumers,
and traders continually looking for an indication of
possible recovery in world economic growth and a
likely corresponding increase in oil demand. On the
supply side, OPEC’s above-average compliance
to agreed-upon production targets increased the
group’s spare capacity to roughly 5 million barrels per
day in 2009. Further, many of the non-OPEC projects
that were delayed during the price slump in the
second half of 2008 have not yet been revived.  2020, 103.9 million barrels per day in 2030, and
After 2 years of declining demand, world liquids
consumption is expected to increase in 2010 and
Chart 12
History Projections
250
strengthen thereafter as the world economies recover
fully from the effects of the recession. In the IEO2010
Reference case, the price of light sweet crude oil in
the United States (in real 2008 dollars) rises from $79
per barrel in 2010 to $108 per barrel in 2020 and
$133 per barrel in 2035.
World energy markets by fuel type 
Liquids remain the world’s largest energy source
throughout the IEO2010 Reference case projection,
given their importance in the transportation and
industrial end-use sectors. World use of liquids and
other petroleum grows from 86.1 million barrels
per day in 2007 to 92.1 million barrels per day in
110.6 million barrels per day in 2035. On a global
basis, liquids consumption remains flat in the
buildings sector, increases modestly in the industrial
sector, but declines in the electric power sector as
electricity generators react to rising world oil prices
by switching to alternative fuels whenever possible.
In the transportation sector, despite rising prices, use
of liquid fuels increases by an average of 1.3 percent
per year, or 45 percent overall from 2007 to 2035. 

200 To meet the increase in world demand in the

Liquids
Reference case, liquids production (including both
150 conventional and unconventional liquid supplies)
Coal increases by a total of 25.8 million barrels per day
Natural Gas
100 from 2007 to 2035. The Reference case assumes
that OPEC countries will invest in incremental
Renewables
50 production capacity in order to maintain a share
Nuclear of approximately 40 percent of total world liquids
0
production through 2035, consistent with their
1990 2000 2007 2015 2025 2035 share over the past 15 years. Increasing volumes of
Source: IEA 2010
conventional liquids (crude oil and lease condensate,

14
Petrocapita Update (continued)

natural gas plant liquids, and refinery gain) from sands from Canada and biofuels, largely from Brazil
OPEC producers contribute 11.5 million barrels per and the United States, are the largest components
day to the total increase in world liquids production, of future unconventional production in the IEO2010
and conventional supplies from non-OPEC countries Reference case, providing a combined 70 percent of
add another 4.8 million barrels per day (Chart 13).  the increment in total unconventional supply over the
projection period.” 
Unconventional resources (including oil sands, extra-  
heavy oil, biofuels, coal-to-liquids, gas-to-liquids, and Energy Factoids
shale oil) from both OPEC and non-OPEC sources
grow on average by 4.9 percent per year over the According to the IEA:
projection period. Sustained high oil prices allow – China is expected to consume 11% of global
unconventional resources to become economically oil production in 2010
competitive, particularly when geopolitical or – China accounted for 45% of the growth in
other “above ground” constraints limit access to global oil demand over the past decade
prospective conventional resources. World production
of unconventional liquid fuels, which totaled only
3.4 million barrels per day in 2007, increases to
12.9 million barrels per day and accounts for 12
percent of total world liquids supply in 2035. Oil

Chart 13

History Projections
125

100
Total

75

Non-OPEC conventional
50

OPEC conventional
25
Unconventional

0
1990 2000 2007 2015 2025 2035

Source: IEA 2010

15
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