What was the biggest oil story in 2004? I posed this question to all the Simmons & Company oil experts this year. The suggested list of topics varied enormously, which spoke to how many key oil events occurred last year. Oil prices in 2004 were on almost everyone’s list. The “scandal of proven reserves” also got many votes. Dwindling spare productive capacity, sky-rocketing tanker rates, historically unprecedented spreads between light/ sweet crude oil and heavy/ sour oil, soaring oil demand and simply “China” and “Yukos” all got votes, along with flattening non-OPEC oil supply and even “Peak Oil”- a topic that received more media attention, during 2004, by a substantial margin than ever before.
What this myriad of stories actually represents is part of a far bigger mosaic for what is emerging in global oil markets as 2005 gets underway. It appears that we are entering a new oil era that could bear little resemblance to the behavior of past oil markets.
But many scoff at this suggestion. Scores of oil experts still are sure that 2004 was an aberration and believe, some with passion, that 2005 will finally see a return to normality in oil markets. This belief presumes that growth in oil demand will slow in conjunction with a significant supply response. Obviously, this combination of events could occur, but it is hard to find any factual data to support how demand could stall while supply soars. Unless one or the other (or both) happen, the oil markets should remain tight or tighten further than in 2004.
I began writing World Oil’s Outlook for Crude Oil story 11 years ago. At the time, crude had collapsed from $21 per bbl six months earlier, to about $13. Conventional wisdom assumed it would stay at these low levels for years to come, but a rebound to over $20 per bbl took a mere six months. Over the course of the next 11 years, I have watched conventional wisdom turn out to be wrong at almost every turn. Throughout the past decade, many oil market observers have continuously predicted that growth in oil demand would be low. Most also believed that a surge in new supplies was just around the corner and that the cost to find and develop oil would steadily fall, making a further weakening in oil prices likely.
Over this 11-year period, oil prices did occasionally collapse. Twice the collapse was quite violent. Each time oil prices collapsed, a choir of oil pundits would proclaim that this was a normal economic adjustment. After every collapse, which became increasingly brief, the subsequent rise got steadily higher.
In 2004, oil markets finally began to shatter conventional beliefs. The widely held belief that $30 oil would cause a recession failed to pan out. The idea that high prices would soon induce a surge in new oil supplies never materialized. The theory that sustained growth in global oil demand was unlikely suddenly shifted to a more ominous question: Is oil demand growth now becoming a runaway train?
The notion that finding and development (F&D) costs would steadily fall also now seems illusionary. While F&D costs stayed in a $5 to $7 per bbl range throughout the past decade, the total exploration and production capital expenditures rose from a steady $55 billion to $60 billion in the first half of the 1990s to over $124 billion in 2000. The sole reason that F&D costs per bbl stayed low was the rise in reported proven reserves.
Until Shell Oil’s stunning reserve reclassification in 2004, few industry observers ever questioned the accuracy of the industry-wide reserve additions that always seemed to exceed current production.
In hindsight, few companies actually enjoyed any significant production growth commensurate with their reported proven reserve gains. This anomaly suggests that lower F&D costs might have come primarily through abnormally low drilling and servicing costs, a reduction in the number of appraisal wells drilled, and a substantial decrease in conducting coring analysis and other expensive well testing. These factors reduced F&D expenses and led to an overstating of proven reserves. With less drilling data, it was easy to assume reserve additions were higher.
A key issue the industry needs to address in 2005 is how proven reserves are booked. We also must decide whether enough testing is being done to justify an aggressive booking of reserve additions by many companies relative to what they end up producing.
Were 2004 oil prices abnormally high, or did this price change signal a new era in oil markets? Were these high oil prices due to fear factors that encouraged many speculative hedge funds and commodity traders to bet on rising oil prices because of supply and demand factors? Or, were prices high because oil inventories tended to be quite low? Is the industry running out of spare capacity? If so, how quickly can capacity additions be created? If a fear factor was one of the culprits, how much of this fear was justified?
There are a variety of data points which shed some light on these seemingly rhetorical questions.
OIL DEMAND: THE REAL STORY
Ten years ago there was a widespread belief that oil demand was unlikely to ever resume any significant long-term growth. The biggest contributor to this belief was that global oil demand had stayed in a narrow band of 66 to 68 million bpd for the prior seven years. The first year that global oil demand crossed 70 million bpd was 1995. Over the next nine years, global oil demand grew from 70.0 to 82.4 million bpd, Fig. 1. It is easy to pin this seemingly surprising demand leap on China, which played a key role. But the reason this growth in oil use was so powerful was because it came from everywhere.
OECD oil use from 1995 through 2004 rose almost 5 million bpd. Non-OECD use grew even faster, expanding by 7.7 million bpd. China was a big contributor but represented only 39% of this non-OECD growth. The story of how demand outgrew supply did not originate in 2004 and did not involve only China. This was a problem that had been building for years.
There are several reasons why oil demand in 2004 was particularly strong. The prosperous countries, led by the US, enjoyed solid economic growth in spite of higher oil prices. Winter weather in the northern hemisphere was not as mild as in prior years. And, finally, almost all developing global economies enjoyed growth. Is this growth rate sustainable? Only time will tell, but there were no unusual factors spurring such strong growth. Demand in 2005 could grow as fast.
OIL SUPPLY: THE REAL STORY
The theory that higher oil prices would quickly create a surge in supply was another one of last year’s myths. Over the course of the last decade, global supply of non-OPEC oil grew by 7.6 million bpd. But the Former Soviet Union’s unexpected supply increase accounted for 4 million bpd, or more than 50% of the total estimated demand change. Over the past five years, non-OPEC/ non-FSU oil supply has barely budged.
If a supply spotlight is focused on the 19 non-OPEC countries listed in the International Energy Agency database as key producers, or on the 11 OPEC producers, it is hard to find oil producing countries that can add significant quantities to the global supply in the near-to-medium-term future.
The list of key oil producers that appear to have reached a production plateau or even moved past their peak oil output is becoming quite lengthy. It includes key producers, Table 1. Collectively, these 14 countries produced over 25 million bpd in 2004. A few of these countries, such as Libya, could see a jump in oil output from their current base, but none are likely to return to peak levels.
The list of key oil producers that still may be able to significantly expand capacity, assuming key investments are made, is far shorter. It includes Algeria, the UAE, Qatar, Brazil, Angola, Ecuador, Chad, Sudan, Equatorial Guinea and Malaysia. These countries currently produce less than 10 million bpd.
A third column of producers I would list as questionable. They may have some additional capacity, or they could also be currently approaching peak output. This list includes some powerful oil producers like Saudi Arabia, Russia, Norway, Mexico, China and India. All might still see big production additions, but every country on this list could now be nearing an era of production declines. The countries on this key list currently produce 29 million bpd.
Witnessing how Russian oil markets change and evolve will be a big story throughout 2005. While Russia achieved large production increases over the past five years, it is questionable whether these gains are sustainable. This sustainability question was magnified in 2004 as the breakup of Yukos began dominating oil news. How Russia copes with a dwindling amount of export capacity should be another story to watch in 2005.
There is an impressive list of new oil supply projects that should come onstream in 2005 and 2006. If all are successful, we could see additional production capacity of 4 to 6 million bpd. It is not clear how fast these projects can ramp up to peak production or how soon they will peak and then begin to decline. It also assumes that all new projects work out as planned.
Whether these new supplies will be enough to meet further demand growth is another question. The global supply database can’t provide information about the level of decline we will see in current production. Many new oil projects in key regions of the world will only help offset a growing decline of the existing base. These declines are being accelerated by technology that enables reservoirs to be drained faster than before and from multiple production zones.
Like the story of surging demand, the flattening oil supply story is not unique to 2004. A high percentage of the world’s oil still comes from discoveries that were made decades ago. Many of these great fields are either now in decline or are soon to begin a decline. Most new field additions in recent years are small, peak fast and decline even faster.
SPARE PRODUCTIVE CAPACITY
Lack of spare capacity exists at every step of the supply chain. From drilling and producing, to transportation, and on to processing, there is little or no spare capacity available to accommodate demand growth similar to that in 2004.
If any spare wellhead capacity still exists, it is for crude that is both heavy and sour. The refineries that are equipped to refine this type of crude are currently operating at 100% capacity. Compounding this problem is the fact that the world’s light sweet crude supply is also in decline. Almost 90% of new oil projects produce oil that is either sour, heavy, or both.
The world’s network of crude oil pipelines also is now operating at virtually 100% capacity. For most of 2004, the world’s tanker system operated at full capacity, too. This sparked an unprecedented rise in tanker rates, which added up to $5 to $6 per barrel to the wellhead price of oil in some key long-haul export routes.
The fleet of high-quality drilling rigs is now close to 100% utilized, even though utilization remains soft in drilling markets like the Gulf of Mexico, Venezuela and the North Sea. A high percentage of the offshore drilling fleet is approaching an age that used to signal obsolescence, yet the global capacity to replace even 10% to 15% of the existing fleet over the next five years is almost non-existent. Many of these capacity bottlenecks can be corrected over time, assuming sufficient investment is made. The industry must begin replacing the aging rig fleet, but fleet expansion is also required to drill more wells and fight the growing decline curve.
A lack of qualified manpower is looming high on the list of capacity problems. In addition to the many layoffs and downsizing events that our industry has endured, we’ve only been hiring a handful of entry level employees each year. As a consequence, we now have an aging workforce at a time when the technical intensity of the industry is increasing each year. This manpower issue is an industry-wide problem and there is little evidence that anyone is creating a plan for resolving the problem.
Meanwhile, oil and gas price volatility grows as the industry operates entirely on a spot market mentality. These increasingly high price swings are eroding price signals as normal guidance for how industry participants should behave.
Oil inventories have also moved so close to “just-in-time” supplies that any sudden interruption can send prices spiraling upward. In the fall of 2004, Hurricane Ivan crossed the Gulf of Mexico with enough power to destroy much of the production infrastructure, but in the end delivered only a glancing blow. However, the small amount of damage incurred by Ivan still required several Gulf Coast refineries to borrow oil from the US Strategic Petroleum Reserve to remain operational.
Whenever a rise in oil inventories occurs (as it needs to do if demand continues to grow), it is usually viewed by oil traders and analysts as a sign of pending supply glut rather than welcomed as a calming influence in an extremely tight oil market. Just-in-time supply in the oil business is a dangerous energy form of Russian roulette.
None of these trends are easy to stop. Few of these trends also reflect signs of a healthy, sustainable and prosperous industry. How all this plays out throughout 2005 will be interesting to observe. If oil demand enjoys a growth year similar to 2004, it is hard to see how supply can keep pace.
There is a chance that extremely mild weather could depress winter demand. Summer weather could become so mild that it hampers air-conditioning usage. The global economies could also weaken so much that oil demand is flat. China could experience a hard landing or endure social chaos. The Asian tsunami could unravel Southeast Asia’s economic growth. A surprise outbreak like SARS or the Asian flu could stall further oil demand.
Any of these scenarios are possible, but unless they occur it is hard to see how supply will outstrip demand in 2005.
|Matthew R. Simmons, Chairman & CEO of Simmons & Company International graduated cum laude from the University of Utah and received an MBA with distinction from Harvard Business School in 1967. He served on the faculty of Harvard Business School as a research associate for two years and was a doctoral candidate. After five years of consulting, he founded Simmons & Company International in 1974. The firm has played a leading role in assisting energy client companies in executing a wide range of financial transactions. He is a trustee of The Museum of Fine Arts, Houston, and The Farnsworth Art Museum in Rockland, Maine. He serves on the boards of several industry and civic groups. He is past chairman of the National Ocean Industry Association, and he serves on the board of the Associates of Harvard Business School and is a past president of the Harvard Business School Alumni Association. Mr. Simmons’ papers and presentations are regularly published in a variety of publications and oil/gas industry journals, including World Oil.|