Peak Oil, National Debt, and the Military
BLAIR WATSON
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Nov 15, 2009

For nearly two centuries, militaries have used fossil-fuel-powered craft to fulfill their missions. The first warship propelled by a steam engine was the Demologos, an American floating battery built to defend New York Harbor from the Royal Navy during the War of 1812. Since that conflict, fossil fuels have been increasingly important to navies, armies and air forces – in war and during peacetime. The wars of the early 20th-century proved that ­militaries cannot operate effectively without vehicles that burn fuel and use lubricants derived from petroleum. In the past 100 years, global demand for oil and fossil fuels has increased more than 24,000% – from approximately 350,000 barrels per day to 85 million.

Two years ago, the Wall Street Journal reported: “A growing number of oil-industry chieftains are endorsing an idea long deemed fringe: The world is approaching a practical limit to the number of barrels of crude oil that can be pumped every day. Some predict that, despite the world’s fast-growing thirst for oil, producers could hit that ceiling as soon as 2012. This rough limit – which two senior industry officials recently pegged at about 100 million barrels a day – is well short of global demand projections over the next few decades.”

A report published in October 2007 by the Energy Watch Group concluded that data from the U.S. Energy Information Administration showed that petroleum production reached its zenith – “peak oil” – in the third quarter of 2006.

On June 17, 2008, in his testimony before the U.S. Senate Energy and Natural Resources Committee, Texas oilman and billionaire T. Boone Pickens said, “I do believe you have peaked out at 85 million barrels a day globally.”

At a petroleum conference in October 2007, Sadad I. Al Husseini, former vice-president of Aramco, the national oil company of Saudi Arabia, said, “World [oil] reserves are confused and in fact inflated. Many of the so-called reserves are, in fact, resources. They’re not delineated, they’re not accessible, they’re not available for ­production.”

In December 2005, an Exxon-Mobil company spokesman told the Boston Globe, “All the easy oil and gas in the world has pretty much been found. Now comes the harder work in finding and producing oil from more challenging environments and work areas.”

Unprecedented Demand for Oil and Fuels
One year ago, Canadian certified financial analyst, oil sands investor, multi-millionaire, and philanthropist Seymour Schulich said, in an interview with the Financial Post, “When the demand [for oil and other commodities] does pick up, there will be enormous shortages [due to exploration and development projects being shelved because of falling commodity prices during the recession], and the price levels on the next cycle will make past levels pale by comparison. You’ll get US$300 oil, US$50 nickel and US$10 copper.” As of November 2009, light crude oil has been trading around US$80 per barrel – up 100% in just nine months.

Over the next 12 years, China’s middle class is forecast to increase by more than the existing population of the United States (308 million). By 2025, India’s middle class is expected to reach 660 million people, 20 times the population of Canada. In China, annual sales of passenger and commercial vehicles are increasing annually at 40% and 15% respectively. Nearly 10 million new cars and trucks are appearing on China’s roads each year. Annual growth of new vehicle sales in India is also double-digit.

In September, the Boeing Company, maker of the Globemaster III strategic airlifter operated by the Canadian Forces (CF) and other militaries, forecasted that “air travel and air cargo market growth will cause China’s fleet to more than triple to 4,610 airplanes by 2028, to about as many airplanes as are operating in Europe today.” Boeing has estimated that the Asia Pacific region, which includes India, will rank as the world’s largest aviation market over the next 20 years – requiring as many as 8,960 new commercial jets.

Global demand for fuel is expected to double by 2030. Because of supply and demand fundamentals, it is conceivable that the annual Department of National Defence (DND) fuel bill could reach $1 billion within 10 years.

In Fiscal Year (FY) 2008/9, $336,252,287 of the CF’s budget was used to pay for fuels consumed by military equipment. According to DND data, the amount of fuel used by Canada’s military from FY2003/4 to FY2008/9 increased 10% while the amount of money spent on fuel rose 103%.
The extra $376,921,065 spent during these five years is equivalent to the acquisition cost of 55 Leopard 2 A6M tanks and spares, and more than twice the expense of upgrading CFB Shearwater in Nova Scotia.
 
How has the DND addressed rising fuel prices since 2003? According to a request for information for this article, “DND/CF principally coped with high fuel prices during this period by reallocating funds to focus on priorities, such as operations and training (which can include fuel). The reallocation of funds is a normal practice within DND/CF, as it is in any other Government department. Additional funds to reallocate were secured through budget surpluses in other areas or projects deemed a lower priority being either deferred or cancelled.”
 
Thinking Outside the Box
In the latter 1990s, the vice president of finance at Dallas-based Southwest Airlines, Gary Kelly, realized that with China’s and India’s huge populations and growing economies, and a finite amount of global oil, the price of jet fuel would increase significantly in the new century. He also realized that for Southwest to continue its business model as a low-cost air carrier, the company would need to greatly increase the amount of jet fuel it hedged. The board of directors agreed with Kelly’s assessment and strategic vision and authorized the finance department to hedge as much as 90% of the fuel consumed by the airline’s 300-plus Boeing 737s.

How much money has fuel hedging saved Southwest Airlines during the past decade? US$3.3 billion. Enough to buy 60 new B737 airliners. In April, Southwest’s chief financial officer, Laura Wright, told The Wall Street Journal, “We need hedges for the same reason we’ve always needed them, so that we have a range where fuel costs will be that we can use for overall business planning.” Southwest Airlines co-founder and former chief executive officer and chairman Herb Kelleher said in an interview with Success Magazine after his retirement in 2008, “Hedging has been our salvation.” Air carriers that did not hedge, or hedged less than half of their jet fuel, lost US$42 billion from 2003 to 2008 as the price of oil soared 635%.

Most of the world’s oil comes from the Middle East; Iran is the third largest exporter in the region. The country’s nuclear enrichment program worries the Obama Administration significantly and Israel even more so. A National Post report in early February said, “Israel has a year or so in which to attack Iran’s nuclear facilities pre-emptively, an Israeli legislator and weapons expert said on Wednesday [Feb. 4].” Eight months later, ABC News in the United States reported that the Pentagon had received government authorization to accelerate the Massive Ordnance Penetrator (MOP) project. These are 30,000-pound “bunker-buster” bombs that can penetrate 200 feet of reinforced concrete. American B-2 stealth bombers are reportedly being modified to carry MOPs. Air strikes against nuclear facilities in Iran, the world’s fourth largest crude oil exporter, would send the price of fuel skyrocketing. Hedged fleet operators will be very grateful for the financial protection afforded by fuel hedging if Iran is attacked.
 
What is fuel hedging?
It is the practice of using financial instruments – futures, options, or swap contracts – in the commodities markets to lock in or limit the price paid for anticipated fuel purchases via offsetting financial transactions. The effect is similar to buying insurance in that fuel hedging provides fleet operators with protection against rising and volatile fuel prices.

Is fuel hedging financially risky? Not if done by someone with the requisite education, training, and experience, and in accordance with the organization’s hedging policy. Not hedging, on the other hand, can be very risky because it leaves an organization financially exposed to the effects of political decisions, wars, acts of terrorism, natural disasters, etc.

The Canadian Securities Institute provides comprehensive training and testing of individuals who seek authorization to deal with regulated exchange hedge contracts. Seasoned risk management specialists have significant experience with the energy markets, types of contracts used in hedging, technical and fundamental analysis, and more. They intimately understand the markets and employ sophisticated hedge strategies, when necessary, to achieve an organization’s financial objectives.

Savings
What kind of savings can be realized? If 1.1% of the FY2002/3 DND budget ($130 million) had been set aside for fuel hedging, all of the fleet fuel bills over the next six years ($1.37 billion) would have been paid for by the financial gains. The savings could have been used to buy new equipment, upgrade aging DND facilities, and more.

How much fuel do CF aircraft, land vehicles, ships and other marine craft consume? Nearly 300 million litres per year. What percentage of the current DND budget would be required to hedge all of the fuel consumed by the fleets for one year? One-tenth of one per cent, or $19.5 million.
 
Federal Debt and Budgets
For the first time in six and a half years, on November 22 Canada’s federal debt rose above $500,000,000,000 (at a rate of nearly $6.38 million per hour). In September, Finance Minister Jim Flaherty revealed that the federal debt will reach $628 billion by FY2014/15 when the government expects Canada to return to a balanced budget (the national debt reached a previous high of $563 billion in FY1996/97).

Flaherty’s projections are based on sustained improvement in Canada’s economy, which is substantially dependent on a strengthening U.S. economy over the next 5+ years (70% of Canadian exports go to the United States). However, economic growth south of the border is based on the Obama Administration’s plan to pay for $3.6+ trillion of federal expenses annually and subsidize current tax levels (which are relatively low) by adding $8 trillion of debt over the next decade to the current debt load of $12 trillion. Total indebtedness in the United States – government, corporate, and household debt – is forecast to reach $42 trillion by 2020. In that year, the U.S. federal debt will reach 150% of the nation’s Gross Domestic Product, up from 80% at the end of 2009.

The Obama Administration’s plan is dependent on foreign creditors such as China and Japan continuing to loan the U.S. government an average of $730 billion each year between now and 2020. China currently holds more than $800 billion in U.S. Treasury securities, and Japan, which has the fastest growing portion of a population over 65 years of any country, holds about $725 billion.

Foreign creditors – China in particular – have expressed serious concerns over the colossal amount of debt that the U.S. government has taken on since 2002 and plans to add to its books. It is very likely that within a decade the Chinese and other creditors will inform the Americans that they are unable to loan the United States the hundreds of billions of dollars it needs each year to maintain the status quo, and start closing the credit spigot. When that happens, all levels of U.S. government will be forced to slash spending, sell off assets, and reduce workforces.

The deficit-spending-propped-up American economy will plateau, at best, and Canada’s economy will feel the effects of U.S. belt-tightening in the form of decreased trade and tourism. Also, the weakening U.S. dollar will continue to be a significant problem for Canadian exporters.

The International Monetary Fund (IMF) recently warned, “sweeping spending cuts and tax increases will be required across the industrialised world over the next decade to bring public finances under control following the economic crisis.” The IMF also cautioned against assuming that low borrowing rates would prevail and released research showing that interest rates will rise considerably. For a deeply indebted country like the USA, the only way to persuade foreign investors to buy federal bonds is to offer an elevated interest rate. But higher interest rates result in decreased house and vehicle buying, fewer businesses willing to take on loans, dampened economic activity, and lower tax revenues.

On this side of the border, the Harper government plans to add at least $130 billion to Canada’s national debt over the next five years (at current tax levels). If the warnings of economists such as Dr. Nouriel Roubini in 2005 and 2006 of a looming American subprime credit implosion and global economic mauling had been heeded, and hedging introduced to protect against the inevitable downturn in the Canadian economy, the financial gains on a $25-billion investment by Ottawa from October 2007 to March 2009 would have paid for the $130-billion debt increase. Such is the power of hedging to safeguard financial health and budgets. As in war, in financial matters, not knowing, or knowing but not implementing, the best strategy can be very costly.

Looking forward, if the federal government freezes or cuts defence spending – a real possibility given rising national debts for Canada and the United States – and the price of fuel increases (as predicted, due to the strong Asian demand), the Canadian Forces will need to save every dollar possible. Will DND take advantage of fuel hedging, a proven way to control costs and save millions of dollars? Time will tell.

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Blair Watson has been an advocate of fuel hedging as an invaluable financial tool over the past five years. He is the president of Kelowna, BC-based Concord Hedge Solutions Ltd.
© FrontLine Defence 2009

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