Don't Believe Long-Term Oil Forecasts: Part II

There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don't know. But there are also unknown unknowns. These are things we do not know we don't know.

Former US Defense Secretary Donald Rumsfeld, 12 February 2002

My recent article Do Not Believe Long Term Oil Forecasts caused some good discussion over at Seeking Alpha.

My prior article drew attention to a Wall Street Journal article that commented on the long term oil demand growth with price implications. In my article, I commented that it is difficult projecting West Texas Intermediate supply and demand as well as oil prices beyond five years. I discussed why these variables are hard to predict without referencing much numerical data by requesting that readers begin thinking of different scenarios. I wanted readers to think about possibilities rather than be anchored to numerical data. I also provided reference to Professor Bartlett's lecture that is recorded on YouTube. If Professor Bartlett's lecture is good enough for Jeremy Grantham, well known institutional investor and co-founder of GMO LLC, then it's good enough for me.

After investors thought of different scenarios, I further asked readers that, as investors, how might their views change toward various national oil companies such as: Gazprom OAO (OGZPY.PK), Petróleos de Venezuela, S.A., Petróleo Brasileiro S.A. - Petrobras (PBR); and oil sands companies such as: Suncor Energy, Inc. (SU) and Canadian Oil Sands Trust (COSWF.PK); and large multinationals such as ConocoPhillips Company (COP), Chevron Corporation (CVX), and Exxon Mobil Corporation (XOM).

Please click through on the above charts to see larger versions

As we can see from the historical WTI Prices chart, WTI began breaking free from its historical price range of $20-$30 per barrel near the year 2000. What about the future? Well, we can look at the CME Group's Light Sweet Crude Oil (WTI) Future's prices. And using the futures prices as a guide, I don't expect a return to a sustained price range of $20-$30 anytime soon.

Do professional consultants or forecasters have a different view? While I don't know all forecasts, I looked at oil price forecasts from GLJ Petroleum Consultants, a prominent and well respected oil and gas consulting company located in Calgary, Alberta. If you are interested, you can register at Sproule Associate Limited, another prominent and well respected oil and gas consulting company located in Calgary, to receive its forecasts. GLJ's forecast, dated 30 September 2009, has WTI nominal (as opposed to real) prices at $74.00 per barrel in 2010 and rising to $101.59 in 2018 and rising by $2% per year thereafter.

The challenge for creating long term supply, demand and price forecasts is that nobody knows the future. Setting aside the two Calgary consulting companies, if a consultant or forecaster provides you with a long term forecast, ask the following questions or requests:

• Is your price forecast substantially different from the WTI futures? Often the forecast is materially different. Ask the consultant to explain why. They will often tell you that the futures curves are a) wrong, b) change with time, and c) are heavily influenced by Wall Street types who are not using fundamental analysis to arrive their futures prices.
• If the consultant has strong conviction that its price forecast is correct and that the futures curves are wrong, then is it putting its money at risk? This is a rhetorical question meant to emphasize that few have strong conviction. In reality, this is an unfair question because the consultant would lose its credibility if it were playing the markets while providing price advice. It might, however, make the consultant work harder when it has some skin in the game.
• Has the consultant's price forecast changed or is it expected to change? The answer is yes.
• Request to see the last two years' worth of price forecasts. Note that the forecasts do change, often materially so.
• Request to see its price forecast from the year 2000. Did it even allow for the possibility that oil prices would be sustained at or above $70 per barrel by 2010? Most likely not.
• Ask the consultant to provide its methodology to arrive at its price forecast. This is just a general interest question. The reality is, it doesn't matter.

As we have seen from historical prices, futures curves, and one oil and gas consultant forecast, the prior range of $20-$30 per barrel for WTI does not look imminent. If prices are known to fluctuate wildly, which would then change the future curves and consultants' forecasts, then why am I confident that prices won't return to their prior range?

Last year, many oil companies had internal long term price forecasts of $70-$75 per barrel in real terms. Some might have been lower and others higher. And last year, I read that new greenfield oil sands development projects required $70-$110 per barrel to achieve an economic return. While construction and operating costs have been reduced over the past year, they haven't been reduced much. Yet, many oil sands development projects by large and sophisticated companies are moving forward. Furthermore, look at the rate of returns most oil companies are enjoying at today's prices (they are not extreme), and then ask yourself what their returns would look like at sustained prices near $25 per barrel. Hint: it wouldn't be pretty.

It's interesting to watch the dynamics of senior executives of oil sands companies. As they plan and prepare for a new project, they all acknowledge that oil prices are volatile and that between now and the end of the project, there are likely going to be several stomach churning price drops. At this point, they are undaunted. Yet, when the prices drop, these same executives begin to reassess if they can scale back, postpone, or phase in projects over time. It's amazing how much influence short term prices have toward a long term outlook.

If you ran an oil company and believed that $20 per barrel prices were imminent and didn't want to play the futures market, then you would likely stop investing in new projects and wind down or sell existing production, fire all but essential staff, and just bide your time. When oil prices hit $20 per barrel, there will be many distressed assets available at fire sale prices. Moreover, many oil and gas companies will be shutting down, throwing their talented workers on the street. At that point, you could relaunch the company with better (lower costs) and greater (more production and reserves) assets than you had previously. I am unaware of any company embarking on this strategy.

As you do your own research and analysis, remember that the treadmill gets steeper as world production increases. What do I mean by that? Most oil fields (oil sands being an exception) experience a natural decline rate. For argument's sake, let's assume that at some time in the future we have the following conditions: a) annual oil production at 100 million barrels per day; b) annual supply and demand growth rate of 1%; and c) a natural decline rate of 7% annually. Then, just to maintain production for the following year, an additional 7 million barrels per day of production must be found. And, another million barrels per day must be added as part of the supply growth. As annual production increases with the same decline rate, more reserves and production must be found.

I am neither in the bearish camp that says the sky is falling nor in the bullish camp that says we have plenty of oil at affordable prices. I believe we do have challenges in front of us. Furthermore, I believe we will have significant changes. It's best to keep an open mind and watch for signs that indicate abrupt changes are about to take place.

One last closing comment: I am glad that I do not provide long term oil and gas price forecasts—there are too many known unknowns and too many unknown unknowns.

Disclosure: I am long shares in Canadian Oil Sands Trust, Suncor Energy, and Exxon Mobil as well as long and short puts in Exxon Mobil.

Comments

[perceptions...:]

Key oil figures were distorted by US pressure, says whistleblower
Exclusive: Watchdog's estimates of reserves inflated says top official


The world is much closer to running out of oil than official estimates admit, according to a whistleblower at the International Energy Agency who claims it has been deliberately underplaying a looming shortage for fear of triggering panic buying.

The senior official claims the US has played an influential role in encouraging the watchdog to underplay the rate of decline from existing oil fields while overplaying the chances of finding new reserves.

In particular they question the prediction in the last World Economic Outlook, believed to be repeated again this year, that oil production can be raised from its current level of 83m barrels a day to 105m barrels. External critics have frequently argued that this cannot be substantiated by firm evidence and say the world has already passed its peak in oil production.
Link -
www.guardian.co.uk/env.../ peak-oil-international...
==========
One more nail in the status quo coffin!

Whilst miracles can still happen, I am of the opinion that the status quo will not go down without a fight!!

You can expect "smoke & mirrors" all the way, those with self interest in the status quo, including politicians will fight every inch of the way, with everything at their disposal!!!

Nov 10 05:30 AM

[Davewmart:]

perceptions:
The article you link to is spot on.
All the pressures on the IEA have been to exaggerate reserves, from the US and also from the oil producers, as they get a bigger say in OPEC according to reserve estimates.
So according to their own unaudited figures Saudi has acheived the remarkable fear of exporting many billions of gallons of oil, whilst it's reserves remain constant!
In addition to the politics of OPEC, they also do not want to forecast shortages as serious efforts might then be made to reduce oil dependence.
Governments like the UK have hidden behind IEA forecasts, as they did not want to take the painful measures that would be required by oil shortages.
The situation is actually far worse than simply going into a gradual decline, as you have a whipsaw effect, with high oil prices killing the economy, and the reduced demand for oil then killing oil prices so it is uneconomic to develop expensive new oil fields.
In addition the demand for oil from the producers is rapidly rising, leaving ever less for export.
This is crash territory, not decline.
The IEA has lied to us, and lied again and again.

Nov 10 07:44 AM

[Tim Miles:]

Thanks, Kevin, for your analysis. Once, again---the United States needs to wean itself off of its reliance on foreign oil!!!!!!!!!!! We are not going to be able to extract domestic oil resorces (whatever there really is left in our nation) cheaply in the future so we have to move to alternative renewable energy and engage in a crash energy-efficiency effort.

Tim

Nov 10 08:20 AM

[perceptions...:]

Sorry, that link in the previous post didn't seem to be working, let's try this?

www.guardian.co.uk/env...


On Nov 10 05:30 AM perceptions_now wrote:

> Key oil figures were distorted by US pressure, says whistleblower
>
> Exclusive: Watchdog's estimates of reserves inflated says top official
>
>
>
> The world is much closer to running out of oil than official estimates
> admit, according to a whistleblower at the International Energy Agency
> who claims it has been deliberately underplaying a looming shortage
> for fear of triggering panic buying.
>
> The senior official claims the US has played an influential role
> in encouraging the watchdog to underplay the rate of decline from
> existing oil fields while overplaying the chances of finding new
> reserves.
>
> In particular they question the prediction in the last World Economic
> Outlook, believed to be repeated again this year, that oil production
> can be raised from its current level of 83m barrels a day to 105m
> barrels. External critics have frequently argued that this cannot
> be substantiated by firm evidence and say the world has already passed
> its peak in oil production.
> Link -
> www.guardian.co.uk/env.../ peak-oil-international...
>
> ==========
> One more nail in the status quo coffin!
>
> Whilst miracles can still happen, I am of the opinion that the status
> quo will not go down without a fight!!
>
> You can expect "smoke & mirrors" all the way, those with self
> interest in the status quo, including politicians will fight every
> inch of the way, with everything at their disposal!!!

Nov 10 09:01 AM

[koolsool:]

Any economic oil shock can be avoided here in the USA by switching to North American natural gas for transportation & electricity generation. New drilling technology has made American NG abundant & cheap. This would accomplish a number of positives. Reduce imported oil, reduced demand will keep the price stable. We would be using a cleaner fuel for vehicles & electricity generation (verses coal). New jobs & revitalization of the auto industry making new NG or multi-fuel cars & trucks. The build out of new NG infrastructure would be a huge boost for American business. NG would also be used in partnership with solar & wind electricity generation to keep the turbines running consistently when solar & wind are not present.

Nov 10 10:37 AM

[Jimbo:]

I AM VERY INCLINED TO AGREE WITH THE AUTHOR'S POSITION. Assuming the people in charge of things in Washington are rational, why are they not seeking to develop domestic energy resources in the U.S.? Yes, we should also undertake to develop alternative energy sources as well. Washington seems to have a death wish.

Nov 10 11:14 AM

[ryanclarke:]

Sir, it's too late. The crash energy program should have started twenty years ago. Don't forget Bush's idea of an energy program was to get it from Iraq by use of the military. The fact Iraq hasn't increased production by much in the past four years indicates to me the reason for a lack of Iraq oil production increases ... is not because of armed conflict or malfuctions in the oil producing infrastructure ... but because Iraq doesn't have the oil reserves as claimed to boost production to 6-8 million barrels per day as advertised.


On Nov 10 08:20 AM Tim Miles wrote:

> Thanks, Kevin, for your analysis. Once, again---the United States
> needs to wean itself off of its reliance on foreign oil!!!!!!!!!!!
> We are not going to be able to extract domestic oil resorces (whatever
> there really is left in our nation) cheaply in the future so we have
> to move to alternative renewable energy and engage in a crash energy-efficiency
> effort.
>
> Tim

Nov 10 11:45 AM

[chris coonan:]

Black Gold was just discovered UNDERNEATH Goldman Sach's office in New York....who would have guessed....time to convert that building to a better use.

Nov 10 01:12 PM

[chris coonan:]

If America could get off the Oil narcotic, we would all be a lot better off.

Nov 10 01:14 PM

[slam stocks:]

Good article and honestly don't believe the world is running out of oil. We do have a crisis whereby access to cheap or safe oil. The available oil is difficult to reach due to the political risks since they are controlled by dictators, Arab fundamentalists, communists or war torn countries. I read somewhere in Fortune that 90% fall in this category.

With 3rd world countries such as China, India, Indonesia, Brazil exploding into the 21st century with their population and economies, their infrastructure is still based on fossil fuels. The western countries need to do more to lower the use of oil, look for alternatives or newer places for exploration such as the oceans. The sooner we get off oil, the better so we can let the 3rd world countries fight amongst themselves and end sacrificing westerners in remote and dangerous areas to quench our appetite for oil.

Nov 11 01:18 AM

[LilBob:]

I agree with all here regarding energy efficiency and alternative energy sources. As with all things, market prices will eventually dictate when Americans begin conserving energy and looking for alternative energy sources. In the summer of 2008 we observed that the Threshold of Elasticity for 87 octane unleaded was around $3.85 USD/gallon. National oil consumption dropped by around 4% and pump prices fell by almost a dollar a gallon before they started inching back up again. With the economy being so weak there appears to be a "Burnt Finger Effect" which is a lingering consumer resentment that results in a decline in the Threshold of Elasticity price point at the pump. As pump prices and the monthly utility bill begin going higher we'll see increased sales of small and hybrid vehicles, more car-pooling and bus-riding, and greater interest in renewable energy sources. Unfortunately, as we all know, American consumers have to get burned pretty badly, then work through the five stages of grief with Media encouragement and support before they'll actually do anything.

Nov 11 07:51 AM

[mbkelly75:]

Both articles made the point very well and I agree with the writer. Thank you for putting it so clearly and making it understandable.

Nov 11 08:39 AM

[User 391256:]

Slam,

In 2005 a clear and strong report was produced for the DoE (en.wikipedia.org/wiki/...) making it clear that there is a significant lead time, over a decade, necessary to bring any new energy solution to market. Since 2005 nothing along the lines of a major push toward alternatives has been done. No major effort has been made to educate the public about the decline of the primary resource. Nothing. Wishful thinking and hypothetical transitions will not get us anywhere.

The new drilling technology for NG production, particularly in tight shales, is going to run into trouble (already has in NY) because there are toxic chemicals used in the "hydrofracking" process which can get into potable water aquifers, which generally causes adverse reactions in the people who depend on that water.

Business As Usual is confronting fundamental limits to growth due to the fact that despite theories that seem to indicate the contrary the Human Economy is not separate from or free of the larger Natural Economy. We are embedded in that larger economy and every time we harm that larger economy or ignore some limiting factor we set ourselves up for a very great fall. We can't keep ignoring the alarm bells coming from our life-support system just because economic theory tells us that there are no such bells.


On Nov 11 01:18 AM slam stocks wrote:

> Good article and honestly don't believe the world is running out
> of oil. We do have a crisis whereby access to cheap or safe oil.
> The available oil is difficult to reach due to the political risks
> since they are controlled by dictators, Arab fundamentalists, communists
> or war torn countries. I read somewhere in Fortune that 90% fall
> in this category.
>
> With 3rd world countries such as China, India, Indonesia, Brazil
> exploding into the 21st century with their population and economies,
> their infrastructure is still based on fossil fuels. The western
> countries need to do more to lower the use of oil, look for alternatives
> or newer places for exploration such as the oceans. The sooner we
> get off oil, the better so we can let the 3rd world countries fight
> amongst themselves and end sacrificing westerners in remote and dangerous
> areas to quench our appetite for oil.

Nov 11 12:38 PM