Oil Price Shocks and Market Fundamentals

Capital expenditure (capex) in the oil and gas sector has reportedly been declining since the precipitous fall of crude oil prices from the peak of about US$147 per barrel in July 2008. Speculation has inevitably been rife about a price shock occasioned by the inability of supply facilities to meet demand requirements (due to withdrawal of the enabling investment) when the global economy begins to rebound. The International Energy Agency has projected a price crunch by the year 2012, just 3 years away.

Such concerns may be unrealistic and for three reasons:

First, there have been massive additions to the global production capacity far in excess of the projected losses. There are also equally massive capacities rapidly coming on-stream. For example, Saudi Arabia recently announced the introduction of a record 1.2 million barrels per day of light crude from the large Khurais field to the global tally. This value is expected to be exceeded by production from Brazil's recently discovered and even more massive pre-salt Santos Basin, likened to the North Sea in size and importance. The country's industry regulating agency puts reserve estimates for the basin at 80 billion barrels of oil equivalent (boe). Even more recent discoveries have been made in the contiguous Esprito Santo basin. Production from the Tupi, one of the fields in the Santos basin is expected to reach 1 million barrels per day in about 3 years.

Secondly, claims about a large capex decline may have been exaggerated, according to a recent report. The report indicates that while expenditure by National Oil Companies (NOCs) has remained largely unchanged from 2008, that of the International Oil Companies (IOCs) has only declined by US$22 billion, far less than the much-bandied US$100 billion. The report also held that the global economic downturn has favorably affected project economics; to wit, even where these IOCs have reduced their expenditure, such reduction is expected to be offset by substantial reduction in cost of resources (mainly labor and materials) arising from the decline in economic activity. The implication then is that even with capex reductions, effective investment for the current year may equal or exceed that of the previous year. Canada's Tar Sands projects are reportedly set to benefit from such cost reduction. Projects previously mothballed due to low price regimes, having been based on oil prices of US$85-US$90 per barrel, have become viable even at the much lower price of US$60 per barrel.

Finally, the current thrust of global energy and environmental policies inevitably conduces to lower oil demand. The recent framework for automobile efficiency recently introduced in the United States by President Barack Obama for example, is expected to reduce oil demand by 1.8 billion barrels by the year 2016, a mere 7 years away. This is approximately equal to the total U.S. domestic production for the 2008. By all accounts this is massive; even half of it is still a substantial reduction. Then there is the increasing ethanol penetration in liquid fuels transportation. Biodiesel, which is cheaper and a lot more efficient than petrodiesel is gradually becoming more attractive. According to the United Nations Environment Program, renewable energy has become the fastest-growing form of energy. The United States Department of Energy holds that about 40 % of all light vehicles in the U.S. by the year 2030 will be hybrid. These all indicate a reduced demand for oil. While oil will most probably be dominant for some time to come, biofuels and renewables will take increasing proportions of the global energy mix.

The oil price shock of 2008 had no fundamental support. On the contrary, prices were spiraling higher while the market was well-supplied. The recently recorded surges also showed no such support. The surges were in spite of massive supply overhang, weak demand and signs of deepening (or at best, lingering) economic recession. There may well be an oil price shock when the global economy rebounds from the current recession, but save for extenuating circumstances (war or the equivalent, etc), it is unlikely to hold any market fundamental support.

Comments

[basehitz:]

Last year I read a book entitled “Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy” by Matthew R. Simmons (2006). It makes a compelling case that 1) OPEC’s claim of oil reserves is considerably overstated 2) OPEC’s claim for capacity increasing capacity is also overstated. For example, he notes that Saudi oil fields were developed and initially operated by US oilmen. We also determined reserve estimates. After we turned it over to Aramco (Saudi’s company), the claimed reserves were dramatically increased without any new major oil finds. He notes that OPEC quotas are determined by oil reserves, hence the motivation for this action. He also addresses non-OPEC nations, and again we find alarming future capacity estimates, particularly North Sea, Mexico and Iran. It concludes that the generally accepted notions of extensive OPEC reserves and additional capacity is false. This book is not a quick read; but well worth the investment.

I am currently reading Dr Stephen Leeb’s book “Game Over”, who expands this to include many natural resources in addition to oil.

Both authors acknowledge the new finds you discuss. And we assume (and hope) there will be many more. There must be, or we’re in deep trouble. Active oil field production follows a well established cycle peaking after a number of years in service and going into a steady decline. Collectively, the many fields in service around the world exhibit a similar pattern. If we were to find no more oil after today, we could expect a decline in production of 5-7% per year. If we use 85m bpd production, we’d need to add about 5m bpd production just to maintain current supply. But the developing world will not accept status quo. They want living standards like developed worlds. Transportation is the US biggest consumer of oil. It has 800 vehicles per 1K inhabitants. In Brazil it’s 140 per 1K. In China and India it’s 25 per 1K. This enormous disparity is correcting. And oil consumption growth is in the developing world.

You note the Brazil oil discovery. If fits a pattern of increasingly more challenging sources to extract. Review RIG’s fleet specifications. Note how all the new stuff pushes specs above anything currently in their fleet. This reflects a main thesis of both authors. Namely, we keep finding more oil. It is increasingly difficult to extract. That adds cost. That cost you will see in the price of crude.

Currently, oil speculators are running price around based on . . . whatever. Eventually we’re going to come out of this downturn. (My bet is 2010.) So the current lull in oil demand will revert back to historical trend, with the added pressure of 2 trillion people (China and India) plus others in the developing world wanting to increase their standard of living.

The rubber will meet the road when the slack in the supply side is taken up and producers are again challenged to increase production for an ever increasing demand on this limited resource. That’s why RIG keeps pushing the envelope on specs. And if these authors are both right, we will not have prepared adequately for the day when we realize oil is not infinite.

The market appears to be on the verge of a correction. Barring an event, that should take down oil. If last year’s playbook repeats, traders will run into USD and Treasuries. As the dollar strengthens (temporarily) it will further pound oil. The drillers will also sell off. And that will be my focus. International oil drillers, especially those with deepwater specs. Eventually the commodities oil, gasoline, heating oil and natural gas will all be very attractive. That and other commodities, and those that produce them are my only interest right now. So short term, I agree with you. But only short term.

Jul 05 07:45 AM

[pftittl:]

Excellent analysis basehitz. I concur that the market has overreached on price and a short term correction has already begun, but if it gets back down to $20-$30 a barrell, go back in full bore. That won't last, like it didn't last time. May take till 2012, but absent some breakthrough technology oil is still a commodity that will make you wealthy in the next 10 years.

Jul 05 10:00 AM

[Ferdinand E...:]

Interesting. Recently I put on my 'leading academic energy economist in the world' cap, and wrote a brilliant short note on speculation vs fundamentals. (I seem to have some problems getting it published however, which bothers me not at all.) Among other things I said that when thinking about fundamentals, OPEC policy should be at the top of the list. What that means is that If the OPEC countries allow the price to seriously decline, it means that they have taken leave of their collective senses. Note the expression 'seriously decline'. An oil price of e.g. $60/b should be acceptable to the OPEC directorate at the present time, and may well be the optimal price in the light of our macroeconomic troubles.

I also chose to ignore the talk about an increased oil production from new (or old) oil deposits in Saudi Arabia. A couple of years ago an ignoranus of a professor from Yale university provided me with some information about forthcoming oil production in Saudi Arabia. I ignored his absurd claim because the only thing it signified to me was that he couldn't read English, despite having a Scots-Irish name: the King of Saudi Arabia has clearly stated that the oil in his country has got to last a few more generations, and so motorists in the oil importing countries should get used to that idea. Etc, etc.

.

Jul 05 10:06 AM

[isaac the t...:]

Most of the measures we can take to reduce oil consumption will take a solid decade to enact, and we haven't yet begun in ernest. these measures would include massive- nuclear energy buildout, conversion of the transport sector to electricity and natural gas, replacement of the current fleet of vehicles across the country, massive solar/ wind/geothermal buildout. And it will take a good decade to mobilize much of the Brazilian supply. This supply addition won't offset the further decline in US/Mex/NorthSea production.
The only thing that keep oil prices as low as they are today would be a continual global deep recession with severe demand destruction. That is possible, unfortunately.

Jul 05 11:21 AM

[surgcare:]

Anyone who believes anything the Saudi's say need their brains rebalanced. Besides that most of whats in this article came from Peter Pan .

Jul 05 12:01 PM

[Ekwood:]

The new capacity from Khurais is offsetting production decreases from other big fields I believe ('resting' the giants?).

Also, all these new discoveries are not cheap light oil. Prices (or oil company execs) must be high in order to get that oil.

Jul 06 05:52 PM

[G. L. Turner:]

And....this article was written yesterday, before today's continued slide in Oil and Gasoline. According to my pricing analysis/model, completed last spring, suggested to me that oil this spring should have never gone above $60....which is profitable and will encourage new production, except in the most extreme places. Secondly, gasoline, which I had contended and faxed the WH and Congress numerous times, alleging market manipulation, has been at least 30 cents ahead of where the spring's oil price should have dictated, based on previous cycles/years of pricing...

All, of which were a fiction and myth purported most by the twin pariahs - US Big Oil and Gov. Sachs....both who were best positioned to gain... (and steal the cream off the recovery, which I told the WH in April/early May - as is now evident...)

Which leads us to simply ask the question form this article...WHO SAID SO....the current bursting of the 2009 Oil/Gasoline Bubble has onve again shown who the real culprit is. When we will put a stop to these two forces who were made even more powerful under the Bush/Cheney regime? Time to dismantle these groups...like in ANTI-TRUST, remember that law...it was thrown out the window the last 8 years....

Jul 06 07:01 PM

[Dennis U. A...:]

Just a note or two on the comments so far:

1. Production from the Brazilian fields were based on an oil price bench mark range of between US$35 and US$40 per barrel, which makes it very profitable at current prices. This however is not the same for many other prospective fields around the world where the economics are prohibitively higher.

2. Production has already commenced in some of the Brazilian fields, the Tupi for example.

3. The arguments about production capacities and reserve estimates are double-edged: many IOCs often underquote production purely for the benefit of their balance sheets (pulling the wool over the heads of their less-technical hosts), while some NOCs overquote capacities to bolster their quotas (in the case of cartels).

4. True, the transportation industry is oil intensive. But the bulk of developing nations may not necessarily pick up much slack in demand in the developed nations. China for example has one of the most intensive biofuels and renewable enegy development programs. Brazil has an ethanol penetration of 50% of all vehicles ranging from E24 to E100.

Jul 07 02:31 PM