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The Price of Oil

The following excerpt is from the Annual Energy Outlook for 2004 published by the Energy Information Administration (EIA) of the United States Department of Energy (DOE).

Excerpt: EIA/DOE Annual Energy Outlook 2004 with Projections to 2025.

Oil Prices Are Expected To Remain Near Recent Historical Levels

Crude oil prices are determined largely in an international marketplace by the balance between production in OPEC and non-OPEC nations and demand. In the reference case, the average lower 48 crude oil price is projected to be $23.61 per barrel in 2010 and $26.72 per barrel in 2025 (Figure 93). In the high world oil price case, the lower 48 crude oil price increases to $32.80 per barrel in 2010 and $34.90 per barrel in 2025. In the low world oil price case, the lower 48 price generally declines to $16.36 per barrel in 2010, then rises to $16.49 per barrel in 2025.

The projections for U.S. petroleum consumption vary with changes in assumptions about economic growth; however, larger variations result from changes in assumptions about world oil prices. Total petroleum consumption in 2025, projected at 28.3 million barrels per day in the reference case, ranges from 25.6 to 31.1 million barrels per day in the high and low world oil price cases (Figure 94). ( See www.eia.doe.gov/oiaf/aeo/ for more information ).

Commentary: How Oil Prices are Calculated

We have to remember that crude oil price per barrel quotations in reports like the EIA/DOE Annual Energy Outlook are based on the average annual price American refiners pay for imported oil. Called the Imported Refiners Acquisition Cost (IRAC), the EIA report averages the anticipated price for both light sweet crude (the reference price usually quoted by the press) and lower grades of crude oil (crude oil with a high sulfur content, oil derived from tar sands, etc.). For any given year, the IRAC price projection will be lower than the comparable price for light sweet crude by more than $3.00 per barrel and this spread is likely to increase as depletion forces us to use lower grades of crude oil for petroleum products. Furthermore, when the EIA projects its average price for crude oil into the future, it does its projection based on Real dollars (in other words, future price estimates have been discounted for inflation). If the EIA did its projections based on nominal dollars, then the administration's future price estimates would be higher. The EIA's average price must also account for the fact that in 2010 some 35 - 40 percent of the oil refined in the United States will also have been produced in the United States.

So. What does all this mean? The EIA projects that in 2010, the average annual IRAC for oil in the lower 48 states will be no more than $32.80. That means that during the year, the IRAC will sometimes be less than $32.80 and sometimes more than $32.80 per barrel. By comparison, the Production Crisis Scenario in my book "Oil, Jihad and Destiny" assumes that in 2010 the average price of oil on the world market will be $38.00 per barrel. In the Political Crisis scenario, the average annual price for a barrel of oil jumps to $73.00. Price disparities like this are not uncommon in books about oil depletion.

So. What's happened? Why the big difference in the projected price of oil?

The easy explanation is that most of the books and reports on oil depletion use the world price for light sweet crude in their pricing assumptions. Furthermore, projected prices are usually (but not always) based on the nominal price of oil. In other words, the quoted price has not been adjusted for inflation. The net effect is to overstate the average price refiners pay for crude oil. By 2010, the difference between the DOE/EIA estimated IRAC price and an unadjusted light sweet crude price will be on the order of $6.00 per barrel. The $38.00 number used in the Production Crisis scenario of Oil, Jihad and Destiny (which was independently derived from a rather lengthy study of oil price action) matches the high price assumptions calculated by the EIA for 2010.

Ok. But what about the $73.00 price per barrel used in Oil, Jihad and Destiny's Political Crisis Scenario?

This explanation is a bit more complex. World economic activity promises to be volatile through 2010 (and beyond). At best, oil shortages will put mild to moderate downward pressure on economic activity. At worst, shortages will drive the world economy into a depression. Declining economic activity will bring down the demand for oil, forcing producers to reduce the price as they compete for market share. There will be a temporary surplus of oil to support renewed economic activity. As the world's economy picks up, excess production capacity is quickly absorbed and shortages again make their unwelcome appearance. The world economy will subsequently go into another decline and the economic cycle will be repeated.

During these cycles, the price of oil will fluctuate in response to sizeable changes in consumer demand, hence the wide variation in projected prices. If there is a political crisis like the one described in Oil, Jihad and Destiny, then there will be "wild" swings in the price of oil. Oil consumption, on the other hand, will be limited by available production and the impact of a chronically recessive economy. Hence the $73.00 crude oil price used in Oil, Jihad and Destiny for 2010 (which also was derived from the same lengthy study of world oil price action) simply reflects the interaction of demand versus supply in a world where economic activity has been constrained by crude oil shortages. It also should be mentioned that one can use either the IRAC or the nominal price of oil in calculating price action, and its impact on the economy, so long as one consistently uses the same measurement of value for every calculation. The discounted IRAC value, however, is more useful when comparing oil price increases with other measures of economic value - such as the average price of housing, food, or autos for an extended period of years.

The EIA does not, and should not, speculate on the impact that a political crisis would have on the price or availability of crude oil. That's not their job. They have to assume a steady state cultural scenario in which the availability and price of oil is governed by geology, technology, depletion and demand. To do otherwise would be much too speculative. By the same reasoning, the EIA must assume a relatively stable state for the American economy (and by inference, the world economy) throughout the forecast period of their report.

On the other hand, that is precisely the value that books like Oil, Jihad and Destiny offer to the reader. By collecting and analyzing relevant information, we can make high probability projections of cultural change (including political trends), and we can use past data to project the interaction of the oil market with the economy. If you agree with the assumptions of the scenario, you buy into the forecast. At this point in time (December, 2004), the Production Crisis scenario in Oil, Jihad and Destiny is right on track and the Political Crisis scenario remains highly likely.

Ouch!

There are, however, two more structural issues that need to be understood.

The EIA bases its non-domestic oil reserve projections on industry data. Much of that data can be found in the reserve calculations published in the Oil and Gas Journal and World Oil. These reserve estimates place proven reserves at around 1 Trillion barrels. The United States Geological Survey (USGS) however, believes world reserves are closer to 3 Trillion barrels.

So who is right?

Both and neither one. Again, we must understand the definitions used in the data presentation. Industry data generally tabulates proved reserves. Proved reserves are generally assumed to be oil that an analysis of geologic and engineering data demonstrates with reasonable certainty are recoverable under existing economic and operating conditions using currently available technology. The USGS data is far more speculative because it assumes that we can recover every drop of oil on the planet. The truth is somewhere in between.

The application of better technology and the opportunity of higher prices will increase industry estimates of proven reserves. That's because with higher oil prices and improved technology, uneconomical wells and fields become profitable, increased exploration is justified, deep water drilling becomes more attractive, and so on. The net impact is to increase the quantity of reserves that the oil industry is willing and able to recover. We thus need to understand that industry proved reserve data masks the fact that if the price of oil goes up, additional production is probable - but at a higher cost. On the other hand, it is unrealistic to believe that it will ever be economical to exploit all of the oil that the USGS believes exists on our planet - even if we somehow manage to find it.

So the truth lies somewhere in between industry estimates of 1 Tbl and USGS estimates of 3 Tbl. Most analysts put practical recovery in the 1.7 to 2.3 Tbl range.

But that's not the whole story.

On October 26, 2004, London based Television Channel 4 quoted Dr. Sadad Al-Husseini, who retired from Saudi Aramco on March 1, 2004 as executive vice president and a member of its board of directors: "I think in total the [International Energy Agency] outlook is much too high for production and it's unrealistic for the world to be expecting such high numbers from all of the producers, including Saudi Arabia. They're not only overestimating the Middle East, but they overestimate non-OPEC, they overestimate Russia, they overestimate the whole global resource base. And I think this is a rather dangerous situation for the US government policy to be based on."

Dr. Colin Campbell, ASPO president, in his testimony to the British House of Commons stated: "We now find one barrel [of oil] for every four we consume. The general situation seems so obvious....How can governments be oblivious of the realities of discovery and their implications... given the critical importance of oil to our entire economy."

Does that mean industry data is overly optimistic?

Even if we agree that it will eventually be practical to recover 2.2 Tbl of oil, we face substantial escalation in the cost of finding, producing and refining it. Oil exploration will be more difficult (costly), production will have a lower return on invested capital (oil will be more expensive to pump out of the ground), and refinery operation costs are sure to escalate (we will be forced to refine poorer grades of crude oil, adding more steps to the refining process). And recent pricing action suggests that conflict based price spikes (fueled in part by speculation) could be substantially larger than anyone would have previously believed. In addition, cultural conflict is reality. Political confrontation is certain to restrict the exploration, production and transportation of crude oil. This will have the effect of reducing the volume of oil we humans will be able to produce - even from known reserves.

So where does that leave us?

The price of oil has nowhere to go but up. Sure, we will experience wild volatility in the price of oil and it will be tempting to believe all is well in the oil patch when prices fall. But the long term trend is up. Not flat or down.

The good news: our oil reserves will probably last far longer than the pessimists would have us believe. The bad news: our reserves will last longer because oil will be much too expensive to use as a vehicle fuel or for heating our homes - long before we humans have depleted our oil resources. Higher prices will drive down demand and that will delay depletion.

In any event, the EIA needs to revisit its oil price projections and available oil production when it issues the 2005 edition of the Annual Energy Outlook. The interaction of growing demand versus a relatively static supply is certain to inflate oil prices and we can no longer assume that oil production will automatically increase to meet demand.


~~~~

Ronald R. Cooke
The Cultural Economist

Author: Oil, Jihad and Destiny

Oil Jihad and Destiny provides an assessment of world oil production, characterizes the economic devastation of oil depletion and suggests solutions to the emerging energy crisis. Available at www.booksurge.com

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