Fundamentals Suggest Oil's Headed Much Higher

A lot of observers are looking for lower oil prices in the short term. They cite:

• a looming recession
• 2003 - 2007 higher prices resulting in demand reductions and supply increases
• the end of dollar weakness
• the end of Chinese preparations for the 2008 Olympics
• reduced geopolitical tensions, especially regarding Iran

All this looks right on paper and it may well happen, but I wouldn’t bet on it. I would bet that if prices do fall sometime soon, maybe after the peak winter demand season, exporters will cut back fairly quickly to try to keep the price above $80 or so. Further, when prices eventually begin to rise again, perhaps in the Spring or Fall of 2008, exporters will then be slow to raise production, having just experienced lower prices. So I think a possible reduction in the oil price next year would be shallow and would likely be followed by a counter trend leg up that will probably bring the price well above $100.

My thesis is based in part on the hoarding mindset that now dominates the oil market and is hardly ever discussed. Exporters (read OPEC, particularly KSA, UAE, Kuwait, and Venezuela) are now addicted to high and rising oil prices. Their ever increasing cash flows from oil have led to their making huge future capital commitments; they are not willing to see falling oil prices endanger those commitments. They also know that due to tight global supplies relatively minor production cuts are sufficient to raise prices. Finally they now believe that oil in the out years will only get more expensive. Thus near term production cuts will also be rewarded because the oil not sold now can be sold later for more money. In summary, exporters today have their hands on a hair-trigger for raising the oil price and they will not hesitate to pull it if the price falls much below $85. I summarize this series of attitudes on the part of oil exporters as the “hoarding mindset.”

Meanwhile global oil production is now at an historically high level but still does not seem to be able to satisfy demand. The Saudis and the Iraqis have both managed to increase production by roughly 500,000 b/d helping to cause the 85 mb/d global production plateau that has existed for nearly two years to be eclipsed during the past few months; production now seems to be running in excess of 87 mb/d as shown in this chart:

Figure 1 - World Liquids Fuel Production January 2002 - November 2007

Yet the price of oil refuses to sink. Each time oil goes into the high $80s it seems to bounce right back in the face of tight inventories. U.S. crude oil inventories keep sinking – they are now the lowest in nearly three years. This is a chart that indicates the tightness of U.S. oil supplies measured in days of inventory:

The only way that global supply can be rising and still be tight is that demand must be rising even faster. Recent front page articles in the Times and the Journal have highlighted rapid demand growth among oil producing countries like Mexico and Saudi Arabia. Those articles describe only a part of the total picture. In fact all countries that are exporting either oil or goods in great quantity, such as China and India, are ramping up their rate of oil consumption by 5% - 7% a year. If such countries consume 30% of all oil globally, and assuming consumption in all other countries is flat, their consumption growth rate translates to a global growth rate of about 1.5 - 2%, which, in fact, is about what the rate of increase in oil consumption has been running.

The International Energy Agency recently increased their projection for new oil demand in 2008 from 1.9 mb/d to 2.1 mb/d, a global growth rate of about 2.5%. The IEA tends to be pessimistic about the adequacy of oil supply. OPEC, on the other hand, predicts demand growth of just 1.3 mb/d, which seems designed to justify their producing less oil than the IEA would like. See discussion above re: hoarding.

What About the Energy Bill?

The new Energy Bill is a bit mysterious in some respects. For example, it is not clear yet – at least to me – how the biofuel mandates will work. The bill calls for enormous increases in biofuel production and use. What if a target is not hit? Does someone go to jail? Infrastructure and feedstock bottlenecks on ethanol may limit supply in the near term. Ultimately biofuel use will depend on the emergence of new technologies to produce ethanol cost effectively and to scale. I continue to believe that biodiesel has a better chance to be the big winner, as discussed here. In sum, the real impact of the Energy Bill’s bio-fuel mandates remains to be seen.

New CAFÉ standard will probably have a more predictable outcome. Individual car companies would probably pay fines if their CAFÉ standard is not met. I suspect the standards will be taken seriously and will give further impetus to the current efforts by car makers to offer far more efficient vehicles to the public. Whether they buy them or not is a different matter. We’ll need consistently higher oil prices to spur demand. Even with that, the new standards do not hit until 2011, limiting the impact of this bill during the next five years, which is the relevant investment time frame. All that said, though, over the long term the new standards will tend to make the U.S./Canadian fleet much more efficient; it is certainly a good thing.

In sum, the impacts of the new Energy Bill will occur over a long time and they will phase in very slowly. How will it impact oil prices? Well, if the U.S. can reduce oil consumption by 1% a year while still increasing the fleet size that would save about 200,000 barrels per day per year. Given that demand from developing economies is growing at 1.5 – 2.0 mb/d per year, such a North American reduction would be helpful. But in no way would it be a game changer in terms of the global oil price, particularly during the next five years.

On the other hand, some commentators will interpret the biodiesel and ethanol “mandates” as accomplished fact and argue that they will thus reduce U.S. gasoline consumption by significant amounts. So the bill could help manage public expectations in the direction of reducing their perception of the urgency of the Peak Oil problem. Keeping expectations low could dampen oil price speculation, perhaps tending to reduce futures prices. Of course, that might then have an impact on OPEC production, which takes us right back to the earlier discussion of hoarding.

Old Field Decline: A New Data Point

Then there is the never-reported and always-critical matter of the decline in production from old fields. An interesting nugget of news was contained in the Wall St. Journal story referenced above. Buried in the middle is a report that the rate of decline in Saudi oil production from existing fields is 6.6% a year. That is a large number. Chris Skrebowski estimates that global decline is running 3.3% per year. A 6.6% KSA decline rate would mean that the Saudi’s need to add abut 600,000 barrels a year in new production just to produce at the same rate as the prior year. That does not bode well for the basic assumption embodied in the projections of all Wall Street analysts that KSA is the global swing producer that can (and, they believe, will) save the world from higher prices.

What Fundamental Trends Are Saying About Future Oil Prices

While anything can happen in the short term, we should be able to make reasonable predictions of long term oil prices because, by definition, trends tend to last a long time. Here are the trends in oil that I believe to be sustainable:

1. The natural rate of decline in old fields will grow slowly every year.

2. Enhanced Oil Recovery [EOR] methods for improving the recovery of oil from old fields will continue to improve, thus tending to reduce the actual rate of declining production from the old fields to which EOR is applied. But the impact of EOR is already part of the existing 3.3% global decline rate. Improved EOR technologies will not reduce the global decline rate but will keep the rate from rising faster than it would otherwise.

3. Once a given field to which EOR has been applied begins to decline, its rate of decline will be much faster than that of a field to which EOR was not applied since EOR leaves less oil in the ground to be recovered during the extended final life of the field. Cantarell’s 15% decline rate is a paradigm example. At any point in time, this phenomenon could have a substantial impact on global oil supply. If Ghawar were to start to resemble Cantarell, for example, one could see a doubling of the oil price in short order.

4. Rapid growth in oil demand from countries that have high exports of oil or other goods will continue for decades to come. Therefore, global demand growth of roughly 1.5 – 2 mb/d from developing economies will continue for the foreseeable future.

5. Most future new production will come from either deep offshore or from alternative sources such as oil sands. Such resources require long time frames to develop and very high costs to recover. Therefore, new source oil is inherently limited in the rate at which it can be brought on stream and will require increasing marginal oil prices to be feasible.

The logical conclusion from these trends, I think, is that oil production beyond 2009 is likely to fall well short of the sum of growing demand and increasing declines in old fields. They lend credibility to the statistical analysis done by Chris Skrebowski that indicates we will see the benefits of numerous new, primarily land-based projects scheduled to come on stream in 2008 and 2009, after which supplies will become significantly tighter, falling off a cliff by 2014.

This is not to say that there are not potential bright spots such as Libya, Iraq, Nigeria, and Angola. It is possible that oil supply could surprise on the upside. But what I think is distinctly not a bright spot during the next five years are hopes for significant production increases from Canadian oil sands, Venezuelan oil sands, Colorado oil shale, the Gulf of Mexico Jack discovery, or the recent Brazilian find. The latter two are potentially gigantic finds, but the time needed to recover the oil and the costs for recovering it are similarly gigantic.

Fearless Prediction

Considering all of the above, my five year forecast for the oil price range is:

2008: $80 - $140

2009: $105 - $195

2010: $150 - $250

2011: $175 - $325

2012: $275 - $500

Comments

[jet]

irrational exuberance

tulips, oil, dot com, housing, -- energy will be next.

Capitalism has always worked.

www.portfolio.com/view...
this guy says $30 / bbl long term

Nanosolar is shooting for $1/watt solar panels - cheaper than coal.

Oil sands and shale cost about $30 - take time and money to get going.

Capitalism + technology = lower prices for everything --- everything

lower prices = higher living standard - simple.

[saifl]

What in the world is wrong with people? Jet are you smoking pot? Nanosolar will reach $1/watt in 2010. Assuming a doubling every 2 years it will not make a dent till 2020 in electricity demand. Oil shale is a joke. Oil prices are 3X higher than the $30 you mentioned and still oil shale has not produced a single barrel.
Go back and check petrocanada's press release about Oil sands new projects being uneconomical at less than $85!
Plus the oil exporting conutries have no incentive to use your Nanosolar.
A single new smelter in SA will consume 55,000 barrels of oil per day. Do you know how much that is? That uses more energy than all installed solar capacity in the world.

[Pythor Sehn]

Capitalism has promoted exponentially increasing consumption in a finite world. It has always been on a direct course with disaster imposed by the reality that the world is not infinite. We cannot continue with the infinite growth ethic on a limited planet. It's ridiculous to assume otherwise, and that wishful thinking and the hubris of our supposed limitless intellect will be all that it takes to deal with any problem.

Good luck with changing $XXX trillion worth of world infrastructure overnight. The market signals won't be coming until the world is already pushed into a depression, when we no longer have the money to make the huge investments in alternative systems that we need, even if they were economically viable, scaleable, had infrastructure already in place and paid for, and could substitute 100% for all the uses of oil.

Solar is not a direct substitute for oil. You can't use economic substitution principles here. Solar has been and is still limited by grid problems and storage issues.

[NormanLepoff, M.D.]

Good article and good comments. It is too bad we are dependent on oil that comes from countries ruled and inhabited by total maniacs. We need to get off this stuff. In the meantime, it is wise to invest in energy,

[Cxar]

About Mr Lepoff statement about manic ruling over oil fields: well, this will eventually matter less and less, and won't matter at all when the last drop of oil will be spilled.
As for Python Sehn's skepticism about solar, I can't see why the grid must be a problem for solar energy exploitation when the grid can actually be what makes solar a great success. The Internet is the example to follow, ubiquitous production of solar energy distributed through the grid instead of huge oil-burning plants. Oh, and, Nanosolar announced that NOW it has broken the .99 cent/Watt barrier with the panels that's shipping for a megawatt plant in East Germany. After all we won't have to wait for 2010 or 2020, for the future is now.

[Kezorm]

1.) Natural gas trails petroleum in its rate of worldwide depletion. Given the development of LNG infrastructure, Methane can pick up some of the burden that petroleum has traditionally carried. (Natural gas also emits less CO2 per BTU of output than heavier molecular weight hydrocarbons... so natural gas is truly sort of a "green" fuel.)

2.) Electric cars and 2nd gen hybrids like the Chevy Volt. Since the USA uses a disproportionate amount of oil to fuel transportation, advanced hybrids will gradually shift demand away from oil and towards natural gas, and eventually toward grid based electricity.

3.) Grid based electricity can be sourced from all economical alternatives including wind (already as cheap as coal), solar, and nuclear. Nuclear reactors can be run on mixtures of Uranium and Thorium. While Uranium can last for 25-50 years against accelerating demand, Thorium can last almost forever - longer than it will take to develop more-or-less permanent solutions.

see:
www.cavendishscience.o...
www.divainternational....

4.) Shifting the automotive fuel sources away from petroleum and towards various combinations of natural gas and electricity will preserve the precious liquid fuels for those markets where replacement is far more difficult: trucking, shipping and air travel. These will likely mostly rely on liquid fuels for the next 1/4 century.

So, what solutions seems likely to reward investors?

Look for the best-of-breed companies (like Transocean) that drill for offshore oil and natural gas. And note that natural gas drilling will remain a growth business long after offshore oil nears its peak 20 years or more from now.

Advanced batteries for hybrid automobiles and light trucks. Note that Exxon Mobil has formed a partnership to manufacture membrane materials for Lithium ion batteries. This indicates they have read the writing on the wall and are preparing for the future.

Ceneral Motors. (Yikes!) Yes. GM. I have owned four GM autos and light trucks that have gone over 200K miles. (One went double that and my present S-10 has an engine as tight and efficient at 220K miles as the day I bought it.) I really do not think that anyone builds a better vehicle for a customer who wants to extract from it the maximum useful life. So what does this have to do with the price of oil? The Chevy Volt. It will offer a choice of engines used only to spin a generator, which charges a battery. If GM builds into the Volt the same quality I have enjoyed for a million low-cost miles, they may once again dominate their industry. Instead of the old expression: "What's good for GM is good for America...", the new saying might be "What's good for America... is good for GM."

Alternative fuels, like this one in particular: www.ls9.com/
This company might take ethanol one step further - and produce gasoline directly from plant matter. Use a Google alert to constantly scan for news of IPO's of companies like this that may hit technology jackpots.

[Andy Hoefner]

I think although it *may* be very beneficial for change happening faster for prices to skyrocket like predicted in this article, there isn't a chance it will happen this drastically. We are assuming that oil sands, and heavy oil or the Jack in the Gulf of Mexico aren't viable options to sustainably prolounge (not enhance, but prolongue) our oil output to where I think a price floor of $150 esq is realistic in from 2010 onwards is probably a lot better of a bet than $275.

Things like this arent a huge deal yet, but when oil gets real high in prices, it WILL have a severe impact.

www.seekingalpha.com/a...

Secondly, I think we are going to see a drastic reduction in US oil demand in the next couple of years. Truth be told, we all know too well that we are infatuated with WASTING energy, driving trucks and having disastrous public transport, while not really paying attention to energy saving. There is already a trend in this direction, and given how badly sales of low MPG cars are going (thats just one symptom) I think it will continue to vastly improve.

Solar energy: Yes it isn't the solution, its overpriced, nobody knows how available tellerium really is, HOWEVER, it is growing at an exponential rate worldwide, and despite all its weaknesses, - unless we come up with that palladium cold-fusion-miracle (if you follow SWC or PAL you'll probably know what Im talking about) - it will be a big and helpful part of bridging what otherwise will be one hell of a painful peak oil gap.

[mmmparsley]

You are all missing a real opportunity here in alternative energy. I'll tell you when I fill my position.

[ZB]

Here's a link to a current article regarding the possible renaissance of trains as oil prices stay high:

www.economicprincipals...

I don't know the ins and outs of the railroad business, but it seemed interesting and logical to me. Maybe someone who knows this business can write a line or two here about this possibility.

[ZB]

BTW, this is a good article filled with 1) facts 2) informed, plausible speculation. Nice! Thanks JK.

[Curt]

Interesting article, but it seems to only briefly touch upon Peak Oil, though the overall thrust would seem to only be of concern in a Peak or Post Peak world. Humanity has always been able to adapt to changing circumstances. It will be interesting to see how we adapt this time, though I would expect that adaptation process to involve mass starvation, wars, riots, the end of globalisation, the end of annual long distance leisure trips by air, a serious reduction in global trade, and quite possibly the end of technological growth. In short, the end of the standard lifestyles (and supporting economic systems) in the Industrialised world. Such is the nature and pervasiveness of our greatly entrenched enormous dependence upon a growing supply of cheap crude oil.

[ilikeprivacy]

great article!

I think I should buy a bicycle.

[Andy Hoefner]

Curt and ZB; I coulda told ya that the long term solution to a lot of these problems is the rebirth of smart public transportation.

For example, did you know the Americans that use the least resources per capita are New Yorkers? What im trying to say is this, when oil hits 150 bucks a barrell, the majority of the eastern seaboard states will be fine since you can get almost anywhere without using a car and fairly cheaply, however California will face an economic nightmare.

A lot of States, especially should be giving more thought to a halfway viable public transportation network (and I don't mean just buses).

[Stocky]

Buy nat gas drillers and E&P companies with proven reserves. People have to start switching over. $500 bucks is a little too steep though, not to mention the massive recession we hit before we get anywhere close to that number. There is a price where people just don't buy, and all the excess capacity from a termendous amount of new drilling projects and substitutes will start to come on line. 2012-2015 range. People find a job closer to home, buy a scooter, ride a bike, etc. Believe me they will with $20 a gallon gas. I might even ghet rid of my SUV.

[tessant]

check out my social network i just created...a bunch of info on solar/alt energy...happy new year

growthportfolio.ning.c...

[Simon,ShetlandIslands.]

Couple of points that might be of interest. First is that electricity is a very expensive energy form to move around (only hydrogen gas is more expensive) which is why power plants for oil and coal tend to be close to centres of consumption. Renewable sources like wind and solar tend to be miles from anywhere and mean that even if the costs involved in generation drop significantly they are still going to be relatively expensive forms of electricity production. I live in Shetland in the extreme north of Scotland, where there are proposals to create the Worlds largest windfarm. It is a great spot from a wind potential point of view but getting the energy to market is going to be half the capital and running costs of the turbines themselves. The project can only succeed in a UK energy market heavily rigged against fossil fuels, even at current costs. Energy costs are going to get a lot higher, even than today's high level, in the medium to long term.