Oil: It’s Supply And Demand, Stupid!
“There is lots of oil out there. But it’s a finite resource; we can’t get around that. Eventually, you’re going to get to the point where there’s not any more to find.”
– Karl Kurz, vice president of marketing and minerals for Anadarko Petroleum.
"There is ample historical precedent for the willingness of leaders to threaten or resort to violence in the face of significant risk of catastrophe. But the stakes are far higher today. The choice between hegemony and survival has rarely, if ever, been so starkly posed."
– Noam Chomsky, (Hegemony or Survival; America’s Quest for Global Dominance, Hamish Hamilton, Nov. 2003)
At its conference last week in Vienna, OPEC announced that it had increased its oil production quotas by 1m barrels, in effect ratifying what has already taken place in the real world. Ostensibly, the announcement was designed to “send a signal” that the oil cartel was “uncomfortable” with prices above $40 a barrel. OPEC may indeed be uncomfortable with $40 oil. But it is unclear whether the markets, which remain remarkably range-bound, share the cartel’s discomfort despite WTI crude prices again surging past $45 in response to an unexpectedly large fall in weekly inventories of 7.1m barrels in the US.
Today’s relative calm is a far cry from the howls of anguish heard last month when oil almost hit $50 a barrel, and global recession was said to be right around the corner. Perhaps this reflects continued optimism about global economic growth in spite of the continued strength of crude, but more likely reflects a stubborn belief that today’s high oil prices are as ephemeral as a desert mirage. Such reasoning is still very widespread in the markets and reflects a complete lack of understanding of the underlying supply/demand fundamentals which continue to best explain crude’s persistent strength. OPEC just doesn’t have a lot of spare capacity to produce. In the words of The Economist:
“Cartels exist to place artificial constraints on supply. But the constraints on today’s oil supply are all too real. OPEC’s members, excluding Iraq, produced 27.5m bpd in August, according to the International Energy Agency (IEA), which advises oil-consuming nations. The most they could sustain with their current capacity is just 27.8m bpd, the IEA says. Only Saudi Arabia is said to have much spare oil ready to pump, but no one knows exactly how much, how quickly it could be brought to market, or indeed how marketable this sulphur-heavy variety of crude would be.
With supplies stretched this tight, any disruption or disturbance can move the oil price: the insurrectionist sabotage of pipelines in Iraq, the court-ordered sabotage of the Yukos oil company in Russia, or the meteorological sabotage wreaked by Hurricane Ivan in the Mexican Gulf. News of another fall in America’s stocks of crude added almost a dollar to the oil price during trading on Wednesday, leaving OPEC rather upstaged.”
This year’s sustained rise in oil prices has occasioned little analysis in the way of supply and demand, but much discussion of “irrational political risk premiums”, temporary hurricane related damage, or critical comments about nefarious speculators “hijacking the oil market” through manipulation of the futures’ market. Last week’s London Sunday Times, for example, breathlessly spoke of Morgan Stanley’s accumulation of vast warehouse space in the Netherlands to store its hottest new property – oil – as if this alone explained the recent price surge.
To be sure, such speculative positions of the sort taken on by the likes of Morgan may influence the level of oil prices by several dollars a barrel in each direction, at least over the short run. But it is noteworthy that, when oil was $17 to $20 a barrel a few years ago, no analysts were arguing that speculative short selling was significantly depressing the oil price. In fact, despite a near-record speculator short position at that time, most oil analysts were forecasting the oil price to go even lower. Thinking symmetrically, the recent build-up of a near record long position in the futures market probably did elevate the oil price by several dollars, pushing it close to the $50 mark, just as a near record short position some two years ago no doubt unduly depressed it. As this position was unwound last month, prices inevitably fell, but the underlying resilience of crude in spite of this significant spec liquidation suggests something else at work.
A near doubling of crude prices over the past 18 months amidst record OPEC production can no longer simply be ascribed to the work of idle investment bankers, simply turning their speculative attentions away from dotcoms and telecoms to “the black gold rush”. The reality is that dramatic changes in underlying fundamentals have gone unnoticed for years by the majority of investors. The world is now losing more than a million barrels of oil a day to depletion - twice the rate of two years ago - according to a new analysis published this month in Petroleum Review, the oil and gas magazine of the Energy Institute in London.
The analysis shows that output from 18 significant oil-producing countries, accounting for almost 29 percent of total world production, declined by 1.14 million barrels a day (mb/d) in 2003. The annual rate of decline also appears to be accelerating, contrary to the widely held view that depletion progresses slowly.
Based on data in the latest BP Statistical Review of World Energy, production from this group of 18 countries peaked in 1997 at 24.7 mb/d and by 2003 it had fallen to 22.1 mb/d. In 1998 their total production dropped by less than one percent, whereas last year it declined by nearly five percent.
"It appears that depletion is now becoming a much more significant, though largely unrecognised, consideration in the supply-demand equation, and may be contributing to the rise in oil prices," said Chris Skrebowski, Editor of Petroleum Review and a Board member of The Oil Depletion Analysis Centre (ODAC), who prepared the new analysis.
A very different situation pertained a mere twenty years ago: In 1986, the worldwide surplus of crude oil production capacity totaled 13 million barrels per day or roughly 25 percent of global consumption. This excess supply was distributed among 11 different oil exporting countries. At the same time, North American natural gas markets were plagued with 15 billion cubic feet per day of idle deliverability. Like oil, this represented 25 percent of demand.
The contrast between 1986 and today is striking. Consumption growth and lackluster exploration results have recast the supply-demand equations. Today, the supply cushion of crude oil has fallen to an alarmingly low level. With surplus capacity at less than 10 percent of consumption, the world is one strategically placed natural disaster or political upheaval away from a crisis. Meanwhile, North American natural gas deliveries are near a hand to mouth configuration relative to demand.
These are facts, not speculation. Here are some other key findings in the Petroleum Review report:
* Gabon, where output peaked in 1996, tops the list of countries in sustained decline with production there falling over 18 percent in 2003, more than double its average decline rate for the last three years.
* Australia saw its production drop more than 14 percent in 2003, almost twice the average decline rate since it peaked in 2000.
* UK production from the North Sea, which peaked in 1999, posted the world's fourth largest decline in 2003 at nearly 9 percent.
* Indonesia, an OPEC member, has been in decline for 12 years, averaging 2.6 percent a year, but over the past few years this has accelerated to 8.5 percent last year.
* Having confirmed that its two largest producing regions are now in decline, China, with only modest production growth of 1.5 percent last year, looks likely to go into decline soon.
* Venezuela is also an old oil province. Its four oldest fields produced at one time together over 2 million barrels a day, but this has dropped to 850,000 barrels. It is struggling to keep its production up.
However much oil executives bemoan OPEC’s reluctance to open their doors further to international oil companies to ensure that supply meets growing demand, as Thierry Desmarest and Lee Raymond, chairman and CEO of Total and CEO of ExxonMobil respectively did at last week’s OPEC meeting, the reality is that no amount of investment dollars can reverse the impact of depletion dynamics, just as no alchemist has yet found a means of reversing the ageing process. To be fair to M. Desmarest, he did concede in a recent Financial Times interview that exploration alone, even in existing OPEC oil fields currently off-limits to the international oil companies, would not solve the current capacity crunch. But he does not belong to the camp which believes that world oil reserves are running out. The chairman of Total argues that much new production can come from the so-called heavier crudes, which until recently were too heavy to extract at prevailing lower prices.
This is a comforting story if true. It certain conforms to the happy nostrums of the economist’s world of supply and demand in which there is plenty of marginal oil around so long consumers are willing to pay the price to produce it.
But does this reflect a real understanding of oil’s underlying supply/demand dynamics? A lot depends not only on reserves left underground, but also production capacity. As Princeton University geologist Kenneth Deffeyes notes, “I can’t drive into the filling station and say fill her up with reserves.” Deffeyes argues that production capacity has grown more slowly than demand – based on production figures that are a lot more reliable than reserve data. This is also consistent with the views of Groppe, Long & Littell, who have probably had the most conspicuously successful track record in forecasting the oil and natural gas markets over the past several years, based on their rigorous analysis of global supply and demand (and a concomitant skepticism at the numbers produced by the IEA).
Even those, such as BP’s CEO, Lord Browne, who deny the existence of a supply crunch, conceded that recent volatility was because “we’ve reached a point where the difference between potential supply and demand is very small and that delta is small than the absolute production in Iraq. It’s the classic example of energy security.”
New discoveries, or positive developments in projects such as the Canadian tar sands, (one the areas targeted as a huge new source of reserves by Desmarest), are invariably trumpeted by Wall Street analysts as proof that there is any given amount of crude for any given price. The reality is somewhat different: Roughly 70 percent of the world’s oil supply comes from oilfields that were discovered prior to 1970. Output from many of these old fields is now on an accelerating decline curve. New discoveries, and technological advances in extraction techniques, have in reality done no more than offset the existing declines in older, more mature fields and in many cases simply accelerated the depletion of existing reserves, according to leading independent oil analyst, Matt Simmons: “Modern technology has created super straws that do not extend the amount of oil by any significant degree, but actually suck out the amount you were ultimately going to get a lot faster.”
This appears to be supported by the circumstances of some of the other majors. Consider the case of Chevron/Texaco: For six consecutive years, ChevronTexaco had good news for anyone worried that the world is running out of oil: the company’s reserve growth implied that it was finding more oil and natural gas than it has produced. Over that period, ChevronTexaco's proven oil and gas reserves have risen 14 percent, more than one billion barrels.
But read the footnotes of these financial filings: for each of those years, ChevronTexaco's wells have produced less oil and gas than the year before. Even as reserves have risen, the company's annual output has fallen by almost 15 percent, and the declines have continued recently despite a company promise to increase production in 2002. ChevronTexaco has promised to reverse its production declines before. In 2002 the company said that it expected its output to rise more than 20 percent by 2006, a forecast it has now dropped.
Similarly, Royal Dutch/Shell, the world's third-largest oil company, admitted this year that it overstated its oil and gas reserves by 22 percent, the equivalent of 4.5 billion barrels of oil. Regulators and prosecutors in Europe and the United States are investigating Shell, which in March forced out Sir Philip Watts, its chairman.
These declines in reserves are occurring against a backdrop of hugely rising demand. Mr Raymond of ExxonMobil forecast at last week’s OPEC meeting that world oil demand could double by 2020, rising by 65m-85m barrels a day from the current 82m: “This is about eight times Saudi Arabia’s annual production. Obviously it is no small chore.”
Although the Arabian Gulf countries together comprise roughly 64 percent of the world’s proven oil reserves (and thereby do present the prospect of greater instability given today’s political realities), depletion dynamics ultimately operate independent of political considerations. The basic reasons for a bell curve in any plot of production over time are that exploration is not a random process and that oil and gas are depleting assets. When exploration of an area (basin, state, country, etc.) begins, the largest reservoirs are the easiest to find. Total production rises as they are brought into production and exploration for smaller reservoirs continues. Eventually enough small reservoirs cannot be found to offset the declines in production from the large reservoirs as they are depleted. Prices and technology affect the area under the curve – the total amount of oil and gas recovered over time – but not the shape of the curve. It is a process similar to aging and death in living organisms.
The debate over oil reserve estimates and demand-production trends is not just academic; at stake is nothing less than the economic well-being of the world over the next few decades. The markets remain in denial about this. It may indeed be the case that sometime in the future oil will be exhausted, but that this day is still generations away. But one should hardly take comfort from this fact. The common pronouncement that at present rate of production the discovered reserves will last 40 years may well be technically true, but highly misleading in any case; it implies a scenario in which production is flat for 40 years and then drops to zero after that. The more likely eventuality is that oil production increases until depletion dynamics overwhelm production and then production drops at some specified yearly rate until it is exhausted. When the world enters this phenomenon, half of the original oil endowment will still be there to be extracted, but at much higher prices and attendant potential for conflict, as consuming countries faced with a struggle to get by with diminished supplies each year aggressively compete (militarily or otherwise) to get hold of needed supply.
The United States consumes 19.7 million barrels of oil daily. It imports almost 60 per cent of this, a figure bound to increase as U.S. fields deplete further. This not only has continued adverse consequences for the country’s haemorrhaging current account deficit (and, by extension, the dollar), but geopolitical implications as well. It is true that over half of the imported oil comes from Canada, Saudi Arabia, Venezuela, and Mexico, and that the United States is less directly dependent on Middle Eastern oil today than it was 30 years ago. This is less comforting than appears on the surface. Oil is a fungible commodity, meaning that it is traded globally. Consequently, the country of origin makes no difference, as transportation costs ultimately determine the destination. Oil shortages have implications everywhere, no matter which country is actually pumping out the oil.
When oil becomes scarce, those willing and able to pay, or fight for it, will secure the oil without regard from where it comes, and regardless of how they get it. To that extent it is silly to speak of oil’s “political risk premium” as if it is somehow divorced from the attendant realities of changing supply and demand dynamics. Members of the Bush administration have openly conceded that the need for a substantial American force presence in the Gulf transcends the issue of the regime of Saddam Hussein. As if to make a mockery of claims that the goal is to transform Iraq into a model liberal democracy for the Middle East, the US State Department has just announced it is switching $3.4bn of US funds from water and power projects. Most of the money will be reallocated to boosting security and oil output.
To what end? The dearth of oil and the corresponding need to ensure adequate supply amidst burgeoning demand is viewed as a matter of economic survival. Even former President Clinton asserted America’s right to resort to “unilateral use of military power” to ensure “uninhibited access to key markets, energy supplies, and strategic resources.” Supply/demand dynamics therefore will fuel America’s hegemonistic impulse and heighten the very geopolitical uncertainties which have given rise to this alleged political risk premium in the oil markets. The markets themselves remain in denial about this, much as they have about the real reasons for oil’s continued strength. They will continue to ignore this at their collective peril, as valuations continue to suffer amidst rising political risk premiums.
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