It takes water to produce energy and energy to produce clean water. That nexus creates a number of profit possibilities. Sometimes, they are not so obvious. But often, a company that possesses expertise in water treatment will possess a related expertise in the energy field. The connection between water and energy is at least as old as the process of pumping water into old oil fields to boost production.

But the connection between these two precious fluids is changing quite a bit.

Let's take a look at one of the less-obvious connections...

You may not realize this, but two-thirds of oil discovered stays in the ground. The average recovery rate is only about 35%. What if we could recover more of the oil we've already discovered?

If the recovery rate improved to 50%, the world's recoverable oil would increase by 1.2 trillion barrels. It would double today's proven reserves, says the IEA. That much oil makes even a cynical old oilman catch a gleam in his eye and starts his heart aflutter. Indeed, lots of big brains churn away at this problem day and night.

"It's the prize for the next half century," says Howard Mayson, vice president for technology at British oil giant BP, quoted in this morning's Wall Street Journal. BP relies heavily on enhanced-recovery methods. These methods aim to improve that oil recovery rate.

As The Wall Street Journal reports:

"Enhanced recovery is a lifeline for the biggest oil companies, such as Exxon Mobil Corp. and BP, which are under intense pressure from shareholders to keep ramping up production and gaining access to fresh reserves. But that's hard to do when the companies are shut out of the oil-rich Middle East and places like Russia. So they rely more and more on existing fields, some of which have been producing oil already for decades."

It is like squeezing a sponge ever tighter to extract the most of what you can get. The old method is to simply flood the reservoir with water. The idea is to create enough pressure to make it easier to pump the oil out. It is not very efficient, but it works for a time. It is also becoming a bigger problem to secure the water supply. That's why we see oil companies buying water rights out West. Currently, the shale oil plays consume a lot of water.

Instead of using water, some companies will pump the reservoir with carbon dioxide. Companies used to store carbon dioxide in old unused reservoirs. Using this method of enhanced oil recovery, they put that carbon dioxide to work. BP uses this method out in its Prudhoe Bay reservoir, to great effect. Recovery rates there are 60%. Now Prudhoe Bay, which people in the 1980s once thought would cease pumping oil in 30 years, looks to be good for another 50 years.

The WSJ describes another method BP uses: "flooding reservoirs with polymers that expand like popcorn when they come into contact with hot rocks, thus flushing more oil out of difficult-to-reach nooks."

The name of that polymer is BrightWater. One company has a patent on this material and makes it for a profit. That company is Nalco Holding (NLC:NYSE), a company I recommended several months ago to the subscribers of Capital & Crisis. BP uses BrightWater in Argentina and Pakistan. "BP says the additional oil the new technology will produce over the next 20 years is roughly equivalent to finding a major new field," reports the WSJ.

"Nalco," you say, "but isn't Nalco is one of the world's largest water purification companies for industrial companies?" This is what we mean by energy-water nexus. The two are related. And Nalco sits right in the middle of that nexus.

Last year, Nalco's energy services segment was a bright spot. Sales grew 17% organically for the year. In the fourth quarter, sales were up 23% despite the steep oil price decline. In that segment is Nalco's enhanced oil recovery (EOR) business.

CEO Erik Fyrwald commented on this business in a quarterly conference call. "We are in with a lot of oil companies explaining and talking to them about it," he says. "We believe as oil prices come back up, [EOR will be a] really big growth opportunity, just delayed for a period of time."

The delay stems from the fact that many oil companies slashed their exploration and production budgets last year, when oil and gas prices were falling. But it seems inevitable that as the big oil reservoirs dwindle, the EOR business will be big down the road. Of course, EOR is only one of the many valuable things Nalco does in the energy-water nexus. It is no wonder why Warren Buffett's Berkshire Hathaway is the biggest shareholder.

Nalco is a long-term buy.

Regards,

Chris Mayer
for The Daily Reckoning Australia

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According to the US Department of Energy, liquid fuel demand in the developed nations peaked in August 2005 at 41.89 million barrels per day. Since then, it has plunged by 3.6 million barrels per day to 38.27 million barrels per day. However, you may want to note that despite these tough economic conditions, consumption has been extremely resilient in the emerging world. For instance, demand in the developing countries peaked in October 2008 at 46.33 million barrels per day and it is down by only 0.36 million barrels per day! I am amazed that the worst global recession in decades has barely managed to shrink energy demand in the developing world. Whilst this is wonderful news for the energy investor, it is a terrible sign for society.

At present, our world is using up roughly 84 million barrels of liquid fuels per day and for the moment at least, there is sufficient supply to meet demand (Figure 1). However, when economic activity picks up, it won't take much for demand to zip right past supply. Remember, it is much easier to increase usage, but it takes a long time to ramp up production. So, unless this is a permanent global recession (which I doubt), it is inevitable that the price of oil will go up significantly over the medium to long-term.

On the supply side of the equation, let me be clear. If I was asked to pick the biggest threat to a sustainable economic recovery, Peak Oil would top that list. Remember, Peak Oil doesn't mean that we are running out of oil reserves, crude will be around for decades. However, 'Peak Oil' does imply that we are dangerously close to peak global oil production. 'Peak Oil' also means that rather than experiencing a burst in oil supplies as many expect, from here onwards, we will witness sharp declines in global flow rates. In a nutshell, the era of cheap energy is over and the price of crude oil will rocket higher over the
coming decade.

Now, many skeptics will argue that if Peak Oil was real, the price of oil wouldn't have dropped to roughly US$30 per barrel in last autumn's stunning crash. Valid point; but let us not forget that the spectacular plunge occurred at a time when global economic activity virtually came to a standstill. Let us also keep in mind that last autumn's crash in asset prices was caused by a total freeze in credit and the associated asset liquidation. Whilst I agree that the final action in crude oil's parabolic blow-off last July smacked of speculation, I can assure you that speculation alone couldn't have created a multi-year boom whereby the price of crude oil went up by almost 1500%! As you can see from Figure 1 above, supply clearly fell short of demand between 2005 and 2008, and this is why we had a magnificent bull-market in crude oil.

Make no mistake, global demand for liquid fuels will rise again - and if my homework is correct, supply won't be able to keep up. If you ignore the noise and review hard data, you will observe that the vast majority of the world's most prolific oil provinces are now past peak production and in a state of permanent depletion. According to the BP Statistical Review of World Energy, out of the 54 oil producing nations and regions in the world, only 14 are still increasing production. Alarmingly, 30 oil producing nations and regions are definitely past their peak output and the remaining 10 appear to have modestly declining production rates. Put another way, when weighted by production, Peak Oil is already a grim reality in 61% of the oil producing world!

Still not convinced about Peak Oil? Then review Figure 2, which charts the expected combined flow rates for crude oil, lease condensates and Canadian Oil Sands. As you can see from the grey shaded area, production is about to decline by roughly 5 million barrels per day by 2012.

Ironically, Figure 2 also plots the optimistic (almost laughable) forecast made by the International Energy Agency (IEA) in its "World Energy Outlook 2008". Interestingly, in last year's "World Energy Outlook", the IEA stated that in order to fulfill its optimistic projections, the world had to install 64 million barrels per day of new supply by 2030 or the equivalent of six times the Saudi Arabian output! Furthermore, the IEA declared that the energy industry had to invest hundreds of billions of dollars every year to achieve this favorable outcome.

Now, I can understand that the IEA is a government-funded agency so it has to paint a rosy picture, but it is ominous that the energy watchdog failed to mention where this surplus oil would come from!

Well, I guess you get the idea. Global crude oil production has probably peaked, new discoveries have dried up and there is a shortage of capital for investment purposes. Apart from these factors, if you believe the energy optimists, all is well in the energy industry and the price of oil is about to drop to zero!

After years of extensive research, I have no doubt in my mind that unless global demand stays weak forever, we will see supply shortages in the not too distant future. And before that occurs, the price of crude oil will stage an explosive rally. Accordingly, I suggest that all my readers allocate a large proportion of their investment portfolio to upstream energy companies and to businesses in the energy services sector.

Finally, in the energy complex, the price of natural gas is still scraping along its recent crash low and this is a fantastic long-term investment opportunity. As we approach winter in the Northern Hemisphere and heating demand picks up, we are likely to see a big rally in the price of natural gas. So, investors may want to allocate capital to this unbelievably inexpensive commodity.

Regards,

Puru Saxena
for The Daily Reckoning Australia

• Supply of Conventional Crude Oil is Very Close to its Peak
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Meanwhile, the U.S. dollar index is showing all sorts of weakness. The chart below tells you a couple of things. First, you can see that when the short-term moving averages cross the longer-term moving averages, it usually signals a move. We're not making this up, by the way. We asked technician Gabriel Andre why the crossing of the 50-day MA over the 200-day MA was significant. His answer below.

"Is it sort of like Ghostbusters, where you're not supposed to cross the stream," we asked?

"No."

"Okay, please explain."

"Yes. The shorter-term price action has more weight. When the 50-day crosses the 200-day on the upside, it's bullish, as your chart shows. Conversely, when it crosses the 200-day in a negative direction, as your chart also shows."

"What happens when the longer-term moving average moves down too?"

"When it rolls over?"

"Is that what it's doing?"

"Perhaps. You would have to look at a longer-term chart. But this one indicates dollar weakness, which is showing up in Aussie dollar strength and a rise across the commodity sector. The prices are all relative to the weaker dollar."

Ah yes, the world of relative pricing. We admit we approach the technical explanations of market movements with a great deal of trepidation. The belief among the chartists and the technicians is that all the relevant information about an asset - it's past, present, and future - show up in the chart. You just have to learn how to read the chart, which is admittedly more of an art than a science (in our opinion).

Nonetheless, the chart of the dollar index is consistent with our own fundamental diagnosis of the dollar's weakness. Big fiscal deficits, massive unfunded social liabilities, low interest rate, a labour market facing lower structural wages and more service sector jobs, an increasingly reliance on government transfer payments, and higher taxes in the offing to pay for government-sponsored health insurance ...these are all bad signs for America's economy and its currency.

And by contrast, Australia looks downright bullish. So bullish, in fact, it appears to have cheered up Dr. Doom himself. Nouriel Roubini was in Kalgoorlie yesterday at the Diggers and Dealers conference signing Australia's resource praises. "As the global economy goes toward growth as opposed to recession, you are going to see further increases in commodity prices especially next year," he said.

Those commodity price increases - and the earnings that Aussie firms will generate from them - are what investors are queuing up for right now. It's what's sending stocks higher. But is it real growth or phantom growth?

We know that China is the world's biggest metals consumer. And we know that China's GDP grew in the second quarter at 7.9% and we know that China is spending hundreds of billions of dollars to keep its economy ticking over, employment full, and metals fully stock piled.

But what we don't know is if the world's economy has really reached the bottom of this debt-deflation cycle, where the bad investments and underperforming assets of the credit boom are written down, or off altogether. Is the balance sheet recession - the reduction of debt and the write down in assets bought with debt - really over?

That's the question. We'd suggest the answer is no. But then, it doesn't pay to argue with markets does it? The wretched performance of the U.S. dollar and dollar-denominated bonds leaves investors with a simple choice: speculate on other, riskier assets, or watch the value of your dollar-based savings erode.

So we have the era of forced speculation. It's a kind of dollar exodus. And anything that is not the dollar is a potential promised land. The upside - if you own oil, base metal, and commodity shares - is that there's a strong tailwind behind your investments.

The downside is that the speculation may not be based on real sustainable growth. It's just another lending bubble in China piled on the rubble of the real estate lending bubble in America. Bubbles built on rubble aren't stable. That means you may be better of trading the shares, rather than buying and holding and getting whipsawed by volatility. It's worth thinking about.

Not that we're complaining that shares are rising. But it's important to distinguish between a genuine bottom in the cycle and an epi-cycle, a mini asset boom in the middle of a broader bust (which is what we think this phase is). If it's one and not the other, your investment strategy and trading tactics would change.

The only real reason to whinge about it, from a value investor's perspective, is that it makes it harder to find under-bought bargains. Dirt cheap valuations and laggards are harder to find when a liquidity boom drives up all stocks. With so much cash coming in from the sidelines, it sure looks like a liquidity driven rally.

One asset that's especially confusing is oil. It's benefitting from its "not-the-dollar" status. But there are also, we believe, some fundamental reasons to like oil and energy stocks.

According to a recent article in Britain's Independent, "The world is heading for a catastrophic energy crunch that could cripple a global economic recovery because most of the major oil fields in the world have passed their peak production."

The report quotes Dr. Faith Birol, the chief economist at the International Energy Agency (IEA). Dr. Birol told the Independent that, "global production is likely to peak in about 10 years-at least a decade earlier than most governments had expected."

The IEA provided a detailed assessment of 800 major world oil fields. Those fields account for more than 75% of the world's proven oil reserves. The IEA concludes that that production at most of the biggest fields has already peaked and that, "the rate of decline in oil production is not running at nearly twice the pace as calculated just two years ago."

"On top of this," the Independent reports, "there is the problem of chronic underinvestment by oil producing countries, a feature that is set to result in an 'oil crunch' within the next five years."

Back in March we reckoned this underinvestment was going to lead to a spike in oil prices. There was the little matter of the super-contango in the oil futures market, where the futures price for oil was, briefly, nearly four times the spot price. This indicated that speculators and traders were betting on much higher oil prices later this year.

Since then, the futures price has declined a bit as the global economy proved more resistant to fiscal stimulus than first expected. But the spot price has soared. The contango has narrowed. But the net result is that oil is much higher. So what now?

The trouble with forced speculation is that it makes all asset prices more volatile. They are less driven by supply and demand and more driven by relative movements in other asset prices (currencies and bonds). But with oil, we prefer to keep our eye on the long-term supply picture. Why?

Barring a total collapse in industrial civilisation, it's safe to assume demand growth for oil will resume. You may not know when. But you know it will happen eventually.

Supply growth is a whole different mammal. Not only does the IEA report show that production at the world's major fields is declining faster than expected, it shows that traditional oil exporters are exporting less and consuming more of their own exports. When you combine those two factors with a resumption in demand growth - it leaves countries like Australia on the outside looking in.

Exporters are producing less and exporting less (at least that's the trend). And Australia must compete with large consumers like the U.S., India, China and Japan. Not a pretty position to be in. But for investors, it's not a nightmare either. The junior oil patch is heating up.

What about the rest of the market? Chart Partners Group Ltd. tells Bloomberg that the S&P/ASX 200 could plunge by as much as 19% in the next three months. It reckons the index will peak at 4,300 (about 1% up from here) and then hit 3,500 by October.

Keep in mind the whole thing is up 35% from a five-year low in March. A correction would be in order. But as reading the chart is not our game, we're going to get Swarm Trader Gabriel Andre on the case and report back to you tomorrow on what he says. Until then...

Dan Denning
for The Daily Reckoning Australia

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Just over the horizon, things are about to become dicey. This week, the International Energy Agency (IEA) will release a new report on the future of world energy. In its World Energy Outlook, the IEA will state categorically that "Current global trends in energy supply and consumption are patently unsustainable."

There's not much wiggle room in that statement. According to the IEA, despite the recent fall in oil prices, the medium- and long-term outlooks for energy supply are grim. Conventional oil output is destined to decline. Demand will still grow, however, especially in the developing world. And the twain shall only meet by prices rising to clear the market. "It is," as our Arab friends like to say, "written."

The IEA performed a comprehensive study of 800 of the world's largest oil fields. And it concluded that depletion in conventional oil fields is occurring at a rate in excess of 9% per year. (That's an average. We see depletion rates in excess of 15% in Mexico's Cantarell field, for example.) This means that absent large amounts of new drilling, new investment in enhanced recovery and new discoveries, the current worldwide oil output will decline by over 9% per year. And if it keeps going along this trend (there's no reason why it won't), the base of world oil output could conceivably dry up within seven-10 years.

Don't get me wrong. The world won't run out of oil in seven-10 years. That's not how it works. It's just that volumes of conventional oil are declining. The takeaway point is that the energy markets will tighten up, like a hangman's noose around the collective neck of the oil-consuming world. We might not quite realize it, but when it comes to oil, we are all walking that long green mile.

The investment angle for OI is that the companies that own oil reserves in the ground, and the oil service companies that extract oil and natural gas, should profit in the future. Yes, the portfolio is down. It has been a hard hit to everyone (me too) who bought into the market up until midsummer. We've all lived through a midsummer's nightmare on this one.

So how long will we have to wait for this "future" to show up? Well, how long will the current worldwide recession last? I don't know. But I do know that many energy companies in the OI portfolio are at long-term lows in share price. If you can afford to be patient with your funds, these firms should eventually stage a comeback as oil prices rise again. As I said above, "It is written."

Says who, you ask? Written by whom? Well, how about the IEA? According to the IEA, even with massive levels of investment in the oil patch, the best estimate is that the global oil industry can reduce the rate of depletion to perhaps the 6% range. So the world energy industry will have to run faster just to keep from falling too far behind the demand curves.

Again, you need to keep in mind that current energy prices are just too low to support the level of energy investment that the world needs going forward. (Meanwhile, the U.S. government is spending trillions of dollars forward just to bail out the banks and bankers, not one of whom runs pump jacks.)

The IEA estimates that the oil industry will have to invest over $350 billion per year to counter the steep rates of decline in output. And even that will not be sufficient to maintain levels of output for traditional forms of crude oil. Thus, much of the future investment will have to go toward extracting other kinds of hydrocarbon substances.

What do I mean by "other kinds" of hydrocarbon substances? Fortunately, there are many different kinds of hydrocarbon molecules out there. The total worldwide carbon base actually adds up to a very big number, and that is NOT including the carbon that is part of the current living biology of the planet. For now I'm just discussing the fossilized carbon like oil, natural gas, bitumen in tar sands, oil shale and coal.

The big problem for the nonoil forms of carbon is affordability. That is, are people willing to pay? It takes a lot of steel and technology to transform some kinds of carbon into something we want to use. We see that, for example, in the Canadian tar sands projects. Lots of steel, concrete, labor, machinery, water and energy input - all to extract this thick, gunky crud that has to be upgraded to something that looks like diesel fuel. And the whole thing emits lots of carbon dioxide (CO2) in the process, as well.

The other big problem is whether or not there is the political will to "do carbon." Will the governments of the world allow - let alone promote - industry to invest in the industrial base that will be required to transform the varying kinds of carbon into something that the world can use? Because the other side of this coin is ever-increasing CO2 emissions, global warming and climate change. The more carbon that gets burned, the more CO2 that goes up the flue and into the atmosphere. In essence, within about two centuries, mankind is undoing the geological work of tens of millions of years.

This is not a "global warming" article. But most nations of the developed world have governments that are more and buying into the global warming thesis more. The political gun sights are on carbon. But if we collectively decarbonize the economy, the energy supply will dry up and we'll wish for the "good old days" when we had to worry only about Wall Street crashing. And besides, try telling the developing world not to develop. People have fought wars over lesser issues.

Do you want some numbers on hydrocarbon resources? Here are estimates of the total hydrocarbon resources in the world and the relative costs to convert them. This is my summary, based on several different government and academic compilations:

These are big numbers, right? And they can supply a lot of energy over a long time, but only if the world collectively decides to utilize the resources. If not? Well, you had better own some gold too.

The stark assessment from the IEA described above comes just as much of the world's banking and finance system lies in ruins. Many forms of lending have dried up, and much of the former system of world commerce is just not functioning.

So the politicians, bankers and investors of the world - including us - have their work cut out.

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"With oil prices hitting 140 U.S. dollars," said IEA Executive Director Nobuo Tanaka, "we are clearly in the third oil shock, with prices affecting economic growth, truck drivers are going on strike. Airlines are closing down."

The IEA said high prices would discourage demand for oil in the short-term, but in the medium-term, "demand growth in developing countries and ongoing supply constraints continue to paint a tight market picture."

The IEA remains in a remarkable state of delusion about the world's ability to increase oil supply. It projects that global demand will grow from 86.8 million barrels per day this year (with supply of around 88mbpd) to 94.14mpbd in 2013. That's an increase in global production of 8.5%.

Let's see. Where will that come from? Well, assuming there is no decline in current production, you could double Iraq's production, throw in 2mpbd from the Saudis and their spare capacity and new fields, chuck out Chavez and get Venezuela humming again, and bring on-stream a lot of the deep-water projects...and maybe, just maybe you'd get there.

Crhistophe de Margerie, the CEO of French oil company Total, says 94mpd is an optimistic forecast in ten years, and probably the peak anyway. "We will have to fight against the natural decline of (present) oil fields," he said "It will not go smoothly."

You can fight against some things...love handles, injustice, heavy traffic. But if you pick a fight with something like gravity, you're going to lose every time, and probably injure yourself. The natural decline in the production on an oil field can be "fought" with some methods to enhance recovery. But depletion is depletion. They don't make Botox for oil fields.

In any event, the IEA announcement did not create a super spike in oil. This leads us to believe oil may be running out of gas, at least in the short-term. Event-driven price increases are almost all played out, barring an Israeli attack on Iran. If that happens, all bets are off. Keep in mind, though, that oil prices actually fell when the first Gulf War began. They did the same in 2003. We're not saying the same would happen this time, especially if the Iranians tried to clog up the Strait of Hormuz.

But the real reason prices may have topped out is that the world is having a hard time coping with $140 oil. Could it live with $200 oil? Who could afford it? At its current price, oil is killing the airlines and destroying truck drivers. Also, gold seems to be catching up with oil as the most attractive anti-inflation investment alternative.

Dan Denning
The Daily Reckoning Australia

• Higher Oil Prices, the New Normal
• Peak Oil – The Rewards
• Buying Oil on Sale as U.S. Dollar Gets Weaker
• Oil Price Chart Shows Slight “Correction” in Near Future
• Dollar’s Demise Has Started a Chain Reaction in Currency and Commodity Markets