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The Crude Awakening

"The days of cheap energy are gone." - Michael Hershey, president, Landis Associates LLC

The only shock about the surging price of oil these days is that Wall Street is shocked by it. If professional investors didn't see this one coming, they must have either been locked up in an Iraqi prison or in a coma. We certainly saw it coming.

For as much as we have talked about the impact of growing demand for petroleum from China, India and a cavalcade of SUV drivers in North America, the biggest reason for the bull market in oil is a shortage of supplies. From bottlenecks caused by aging refineries and a supertanker shortage to depleted production from non-OPEC producers, the price of crude is being pushed higher because of one simple fact: There isn't enough of it.

One of the biggest bottlenecks - one that can't be overcome quickly or easily - in the industry, is the lack of refining capacity in Canada and the United States. The U.S. Energy Department reports that refining capacity in the United States has grown by just 2.4% since 1977, while demand for gasoline has risen 27% during the same period.

And the cruel fact is that no major new oil refineries have been built in the United States or Canada since the early 1980s, and many of the ones that used to exist have been shut down. That's left the continent's existing refineries stretched to capacity, just as North American gasoline markets are heading into the heavy demand summer driving season. According to one estimate, U.S. refineries are running at about 97% capacity.

In fact, many of the refineries that disappeared in the past 20 years were closed because it would have been too expensive to upgrade them to meet new environmental rules. It's not a coincidence that no new refineries have been built since the U.S. Environmental Protection Agency brought in its Clean Air regulations, which placed limits on refinery emissions.

How expensive is expensive? Just meeting the various local, state and federal environmental and planning requirements for a new refinery could cost as much as $100 million, according to some estimates - if a site could even be found. And if the permits were acquired, the U.S. Senate Committee on Environment and Public Works estimates the cost to build a new refinery at a whopping $2.5 billion. And, oh yes, it could take seven years to complete.

If you want to understand the world's oil supply problem, simply look at what happens to a single oil field. Whether you are talking about Prudhoe Bay in Alaska or Leduc in Alberta, the life cycle of an oil field is the same. It takes several years after an oil basin is discovered to achieve maximum production as the field continues to be developed with additional step-out wells.

As a good rule of thumb, after half the recoverable reserves have been pumped from a field, there is a rapid decline in the field's oil reservoir. It becomes less and less economical to pump oil from the field, until a break-even point is reached - a point where the expense of operating the oil field equals the revenues produced by the field.

The physics that apply to a single field also apply to a region or an entire country. Consider the continental United States. The rate at which new oil was discovered hit its peak in 1957. By the early 1960s, the nation's total proven reserves reached their all-time high. Less than a decade later, U.S. production peaked. Production was relatively stable until the mid-1980s and then began to fall precipitously.

Year after year the Americans have made up the shortfall in oil production by importing foreign crude. But what happens when the world's output begins to fall? The price impact of dwindling supplies will meet surging demand - a formula for incredible profits in oil and gas stocks.

What is so bullish for oil is that, while world discovery rates peaked in the 1960s, global oil reserves have not increased since 1990. In fact, over the past four decades, exploration efforts have yielded a diminishing return.

In the 1960s the industry discovered 375 billion barrels...in the '80s, 150 billion barrels were discovered. Even fewer barrels were discovered during the 1990s.

Perhaps this year, and certainly by no later than 2005, world production will hit its apex. That means that over the second half of this decade world oil output will begin to decline...just as global oil demand is surging.

And each year, the world pumps and burns 26 billion barrels of oil, this nonrenewable resource. That means that every four years, more than 100 billion barrels of oil - five times the total reserves of the United States - are consumed.

Of course, not all oil-producing nations will experience a reduction in output at the same time. As I mentioned, U.S. production began to fall in the 1970s. Mexico and North Sea productions are now in decline, and few expect a major discovery in those regions.

The only other major non-OPEC oil region is Russia. But new oil discoveries in the former Soviet Union have been in decline since the late 1980s. The expectation of most oil executives is that we are on the verge of declining Russian oil production.

Oil production from non-OPEC countries has kept oil prices in check until just recently. But nowadays, oil supplies outside OPEC don't gush to the surface the way they once did. The really plum oil fields are in the Persian Gulf.

In 1973 - the eve of the first oil crisis - there were 15 giant oil fields in the world producing over 1 million barrels per day. They accounted for almost 30% of the world's daily supply. Moreover, their average age was only 23 years.

Today 13 of these 15 giant fields are still producing, though their average age is now 50 years. Only two of these original fields still produce over 1 million barrels of oil per day, and the 11 remaining fields each have an average production of around 200,000 to 300,000 barrels per day.

Today, only two fields in all non-OPEC countries produce over 1 million barrels per day. Another three produce about 500,000 barrels per day.

As production in these regions enters into decline, more power falls to OPEC, particularly Arab OPEC. Already countries around the Persian Gulf produce one-third of the world's crude oil and control two-thirds of the world's reserves...and make up the only major oil-producing region in the world that is not yet close to its oil reserve half-life.

Turning to our ally in the Middle East - Saudi Arabia - brings up a new question: Just how effective can Saudi Arabia be in easing the supply crunch?

Put aside for a moment the frightening terrorist activities in that country - like the recent killing of 22 people in Khobar. When you look at the issue of supply versus demand, you have to recognize that not even Saudi Arabia has the oil capacity to ease the world's supply problems.

Twenty-five years ago, Saudi Arabia stood ready to pump 14 million barrels per day. Currently, the Saudis say that, if necessary, they can raise oil output over time from 8.35 million barrels per day to 12 million barrels per day.

But a Calgary geologist, who has spent extensive time working in Saudi Arabia over a career that has spanned 25 years, told us that while the Saudis could raise production to 12 million barrels per day for a time, they certainly couldn't keep that output going for long. Oil simply doesn't flow the way it did 20 years ago. Not even for the Saudis.

All this just tells us that oil prices aren't ready to stabilize, let alone retreat...even though much of the world doesn't believe prices will stay at these levels. The conventional thinking is that oil prices will fall, but I'm certain they'll go just the opposite way...higher!

Regards,

John Myers,
The Daily Reckoning

Editor's note: John Myers - son of the great goldbug C.V. Myers - is the editor of Outstanding Investments. Our man on the scene in Calgary, John has his fingers on the pulse of natural resource profits - including oil, gas, energy and gold.

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