When I was in Calgary last year visiting several oil and gas companies, the CEO of one of Canada’s best run junior oil and gas companies looked across the conference table and said something that stuck in my mind: “Get ready for $50 oil!” Such a bold prediction, made when nearly every Wall Street and Bay Street analyst was lowering his 2004 oil price prediction, underscores the massive divide in opinion on the future price of oil. Many geologists believe we are in for a period of significantly higher oil prices, while nearly all economists and the analyst community predict oil prices will fall. Who do you believe?

In this issue we will review both sides of the oil price debate in an attempt to separate fact from fiction.

What the analysts are saying…

Throughout most of 2003, many analysts believed that once the War in Iraq was resolved, oil prices would head into the low twenties as Iraq unleashed a torrent of oil onto world markets. While I was surprised to see to see Iraq’s oil production reach 1.8 million barrels a day (mmbl/d) by the end of 2003 (note: the pre-war level was 2.5 mmbl/d), I believe future production gains will be far more difficult for a number of reasons.

Iraq’s large oil endowment will largely remain unexploited until a stable political environment is established in the country. Political risk is something that major oil companies (as well as their insurance carriers) do their best to quantify before sinking billions of dollars into a county. At this time, Iraq’s political risk is unknowable. It will likely be at least a year before we see any foreign oil company make a major commitment to help Iraq further develop its oil fields.

Before we see any major production growth from Iraq, the country’s dilapidated oil infrastructure must be updated. This includes pipelines that have been blown up in recent months as well as production facilities that are in desperate need of repair. The below passage was excerpted from an article that appeared in the December 22nd edition of the Oil and Gas Journal. It was written by Tariq Ehscan Shafiq, founder and director of the Iraq National Oil Company. Mr. Shafiq is recognized as one of the world’s leading experts on Iraq’s oil industry:

“The replacement of wells and repairing or replacing of damaged equipment and other production facilities in the old and new producing fields may not take more than 2 years in order to restore production to its prewar level of 2.5 million b/d and to rehabilitate to pre-sanctions levels of 3 to 3.5 million b/d, law and order permitting.” (emphasis added).

Another commonly held belief among members of the analyst community is that high oil prices will choke off economic growth. While I believe this thesis to be true at oil price levels two to threetimes today’s levels (near $100US), current oil prices do not pose a threat to economic growth.History supports this statement. In a wonderfully researched white paper entitled “Price Signals or Cheap Oil Noise?” published in 2003 by economist Andrew McKillop, we find the following:

“The US economy attained its highest-ever postwar growth of real GDP, achieving what today would be the unthinkable and impossible growth rate of 7.5%, in the Reagan re-election year of 1984. At the time, in dollars of 2003 corrected for inflation and purchasing power parity, the oil price range for daily traded volume crudes was $57-65/barrel. Despite this simple fact of economic history, Cheap Oil is still regarded by uninformed, sectarian opinion as a passport to economic growth.”

Recent history has provided us with further proof that high oil prices and economic growth are not mutually exclusive. Third quarter economic growth (albeit hedonically adjusted) in the United States was estimated to be 8.2% at a time when oil prices averaged approximately $27US. Clearly, very acceptable GDP growth rates can be achieved in the US with substantially higher oil prices.

Many members of the analyst community are also of the opinion that today’s high oil prices (above OPEC’s stated price band) will trigger OPEC production increases. Others are convinced that high oil prices will induce several OPEC members to exceed their stated production quotas and flood the world with oil. Both of these scenarios are unlikely. In early January 2004, oil traded above OPEC’s price band for 20 consecutive days and OPEC gave no indication that it intended to increase production. With no spare production capacity available anywhere in OPEC (including Saudi Arabia), there is little OPEC can do to raise daily production even if it wanted to. With respect to prices, OPEC recently hinted for the first time that it is likely to raise its offering prices, not lower prices due to a falling US dollar.

Many analysts have long been conditioned to believe that world oil production grows every year. Much of this belief is rooted in misplaced faith in technological advancements that will further enhance oil discovery and recovery. While there have been significant breakthroughs that have increased oil recovery in recent years, there exists little on the horizon that will significantly alter current recovery factors. More importantly, many of the advancements in technology have focused on more rapidly producing reservoirs which have led to faster depletion of known reserves.

Lastly, let’s turn our attention to the demand side of the equation. Demand for oil is far stronger than many analysts believe. Even at today’s oil price of nearly $35US, I see few efforts at conservation. In fact, many countries (China being the best example) are experiencing record demand. High demand for crude oil is often reflected in low inventory levels as producers/importers are unable to increase supplies quickly. On January 14th, the US Energy Information agency released its weekly crude inventory report indicating that U.S. crude oil inventories decreased by 5 million barrels to 265 million barrels in the week ended January 9th.

Crude inventories now stand 33.7 million barrels below the five-year average and are at their lowest level since 1975. It is difficult to determine how high oil prices would have to go before demand is stifled.

What the geologists are saying…

There is a growing belief among the geologists who study world oil supply that world oil production is soon headed into an irreversible decline. The geologist who has most eloquently laid out the argument for higher oil prices is Dr. Colin J. Campbell. Dr. Campbell, author of the book “The Coming Oil Crisis,” holds a doctorate from Oxford University and spent decades working as an international exploration geologist for major oil companies. After a long career in the oil industry, Dr. Campbell worked for Petroconsultants, based in Geneva, Switzerland.

At Petroconsultants, he was instrumental in assembling what has become widely recognized as the world’s leading hydrocarbon database. Dr. Campbell is now a Trustee of the Oil Depletion Analysis Centre (“ODAC”), a charitable organization in London that is dedicated to researching the date and impact of the peak and decline of world oil production due to resource constraints, and raising awareness of the serious consequences.

I found Dr. Campbell’s thesis on the future of world oil production in a speech he gave to a German university in 2000 entitled “Peak Oil: A Turning Point for Mankind”. (To watch a replay of this speech go to the following URL: www.globalpublicmedia.com/SECTIONS/ENERGY/oil.depletion.php and click on the RealVideo presentation. The beginning of the lecture might be a little blurry.) Below is a summary of his findings.

Dr. Campbell believes worldwide production of conventional oil will head into permanent and irreversible decline in the 2005 to 2010 timeframe. The term “conventional oil” is used to refer to oil that is produced from conventional reservoirs and does not include oil from tar sands, polar areas,deepwater areas or oil from coal or shale.

Conventional oil accounts for 95% of all oil produced today and will remain the determining factor in world production for the foreseeable future. According to Dr. Campbell, world oil discovery peaked in the 1960’s and has declined steadily since. We are now to a point where we produce four barrels for every one we discover. Clearly, this is an unsustainable situation since long-term discovery and production must mirror each other to some degree.

Dr. Campbell is also far from sanguine about the current state of world oil reserves. He provides significant evidence that oil reserves are being grossly overstated by OPEC. Dr. Campbell notes that the two most used estimates of world oil reserves, which are prepared by the Oil and Gas Journal and the BP Statistical Review, are flawed.

Both publications rely on reserve estimates provided to them by governments and industry and make no effort to verify accuracy. The below table (data from the Oil and Gas Journal) supports Campbell’s view that OPEC’s reserve figures are not based on any reliable estimate of total recoverable reserves. Notice how several countries report the same reserve figures for several consecutive years. Constant reserves OPEC Reserves (In Billion Barrels)

Year Abu Dubai Dubai Iran Iraq Kuwait Neutral Zone Saudi Arabia Venezuela
1980 28.0 1.4 58.0 31.0 65.4 6.1 163.4 17.0
1981 29.0 1.4 57.5 30.0 65.9 6.0 165.0 18.0
1982 30.6 1.3 57.0 29.7 64.5 5.9 164.6 20.3
1983 30.5 1.4 55.3 41.0 64.2 5.7 162.4 21.5
1984 30.4 1.4 51.0 43.0 63.9 5.6 166.0 24.9
1985 30.5 1.4 48.5 44.5 90.0 5.4 169.0 25.0
1986 30.0 1.4 47.9 44.1 89.8 5.4 168.8 25.6
1987 31.0 1.4 48.8 47.1 91.9 5.3 166.6 25.0
1988 92.2 4.0 92.9 100.0 91.9 5.2 167.0 56.3
1989 92.2 4.0 92.9 100.0 91.9 5.2 170.0 58.1
1990 92.2 4.0 92.9 100.0 91.9 5.0 257.5 59.1
1991 92.2 4.0 92.9 100.0 94.5 5.0 257.5 59.1
1992 92.2 4.0 92.9 100.0 94.0 5.0 257.9 62.7
1993 92.2 4.0 92.9 100.0 94.0 5.0 258.7 63.3
1994 92.2 4.0 89.3 100.0 94.0 5.0 258.7 64.5
1995 92.2 4.0 88.2 100.0 94.0 5.0 258.7 64.9
1996 92.2 4.0 93.0 112.0 94.0 5.0 259.0 64.9
1997 92.2 4.0 93.0 112.5 94.0 5.0 259.0 71.7
1998 92.2 4.0 89.7 112.5 94.0 5.0 259.0 72.6
1999 92.2 4.0 89.7 112.5 94.0 5.0 261.0 72.6

figures are very unlikely considering that production and discovery would have to match each other exactly.

Campbell contends that OPEC reserve estimates are politically motivated. Kuwait is an excellent example of what is wrong with the way OPEC countries report reserves. The country reported a gradual decline in its reserve base from 1980 to 1984. This should be expected from a mature producing country. However, in 1985 the country reported a 50% increase in reserves with no corresponding discovery. The Kuwaiti government increased its reserve estimate due to the implementation of an OPEC production quota system that set country production levels based on country reserves. Kuwait was not alone in increasing its reserve estimates for political reasons. In 1988, Abu Dubai, Dubai, Iran and Iraq all significantly increased their reported reserves for political reasons. Even OPEC heavyweight Saudi Arabia reported a massive increase in reserve estimates in 1990 for similar reasons.

While OPEC has consistently overstated their reserves, Campbell contends that industry has understated its reserves. The pressure on companies to understate reserves by the analyst community has created a gross misunderstanding of how much oil is actually being discovered.

Campbell argues that most company estimates create the illusion of growing reserves when in fact; previously discovered oil is merely being reclassified into the proven category for reporting purposes.

[Note: At least one major oil company is not understating reserves. Royal Dutch/Shell (NYSE:RD) reported a whopper of a reserve write down in January. The company reported that its reserves were overstated by an incredible 20%. The company contends that it acted “in good faith” when preparing its reserve estimates. Such a large write down has attracted the attention of SEC Commissioner Roel Campos, who is considering launching an investigation into the matter].

According to Dr. Campbell, we are likely to face a sea change in the world’s oil production capacity. Campbell maintains that peak production comes close to the midpoint of depletion. According to Dr. Campbell’s estimate of the world’s oil endowment, we are right at the halfway mark.

How might this crisis unfold? Dr. Campbell makes it clear that the crisis will not look anything like the oil price shocks of the 1970’s. Instead, Campbell refers to those politically motivated disruptions in supply as merely “tremors” compared to the “earthquake” that is about to hit the oil consuming world. The first phase of the crisis, which has already arrived, will bring about price shocks. In the nearly three years since Dr. Campbell made this prediction, the world has witnessed several rounds of high oil prices.

However, the onset of chronic shortages will begin around 2010 when the Middle East will be required to supply 50% of total worldwide oil production. More importantly, it is at this time the Middle East will have reached its production midpoint and will head into decline also.

Clearly the scenario laid out by Dr. Campbell is not a pretty one. However in every crisis lies opportunity. Astute investors should recognize the implications of declining worldwide oil production and adjust their portfolios accordingly.
Bill Powers 773-271-7574 bill@canadianenergyviewpoint.com