In January of this year, I put together an article that appeared in the February issue that laid out the case for and against $50 oil. While the arguments against $50 oil have been thoroughly discredited, most market observers still do not understand that the price of oil will continue to head much higher. In this issue, I will examine several of the reasons why the price of oil will not significantly pull back from today’s levels and is likely to reach the $80 mark within the next 24 months.

At the foundation of many oil analysts’ argument for lower oil prices is the belief that OPEC can control the price of oil and use its spare capacity to keep the price within acceptable limits. There is one main reason this line of thinking is not valid — OPEC has no spare capacity whatsoever. OPEC, or more specifically Saudi Arabia, has given several indications over the past two years that it will increase production to keep oil prices at palatable levels, yet we continue to see oil prices reach new highs.

I believe OPEC’s ability to increase prices is a geological impossibility since Saudi Arabia’s Ghawar field is dying. Ghawar, the world’s largest oil field, produces approximately 4.5 million barrels of oil per day and has been on production since 1951. Due to the outstanding work of Matt Simmons, the world has become increasingly aware of the high water cuts at Ghawar and several other large fields in Saudi Arabia. According to Mr. Simmons, the use extensive of water injection wells has provided an illusion of stable production at Ghawar and elsewhere. Water injection wells are designed to push the oil column to the producing well bores and keep reservoir pressure high. However, as the amount of water produced along with oil increases, production often heads into a steep decline. High water cuts at Ghawar (7 million barrels of water a day according to Simmons) are a clear indication that the world’s largest field is about to head into a steep and irreversible decline.

Without spare capacity and with several members experiencing steep production declines, OPEC is no longer a cartel. It has morphed into an extremely exclusive social club. Many market observers are about to wake up to the reality that making pronouncements of more supply coming online at some future date will no longer push oil prices down, even temporarily.

In past years, when there was excess production capacity both inside and outside of OPEC, high prices always brought additional supply onto the market. Times have changed and many analysts have failed to recognize it. Now that the world has reached the apex of Hubbert’s Peak (the thesis that once half of a petroleum producing region’s reserves have been extracted, that region’s oil production will peak and decline along a bell shaped curve), the world’s supply of oil will go down irrespective of price. This is an extremely bullish situation for the price of oil.

The reaching of Hubbert’s Peak is not an economic event but rather a geological event. Oil, unlike many other commodities such corn and wheat, was not created during a growing season but rather over millions of years. For all intents and purposes, the world contains a finite amount of oil and there is strong evidence to suggest that there is a limit to what can be produced at any given time.

Some of the industry’s most informed participants believe there is little that can be done to increase worldwide oil production. Earlier this year, British Petroleum announced that it will be returning to shareholders all cash flow it receives in excess of $25US per barrel. For every dollar the company receives in excess of $25US per barrel, BP will adjust its dividend or increase its share buyback program to return the cash flow to shareholders. BP has essentially given up its efforts to increase production or even keep production flat. Instead, the company has chosen to give shareholders back their capital with interest.

The analyst community and many economists could not have been more wrong about oil production in Iraq. It was only 18 months ago that many market observers were calling for the price of oil to fall precipitously once the US took control of the country. I have always been skeptical of this scenario for a number of reasons that are now quite obvious. The political situation in Iraq has gone from bad to worse and the country’s oil industry continues to spiral downward. While there is little doubt that Iraq has one of the world’s largest endowments of oil, it will take years and tens of billions of dollars to restore Iraqi production to 2.5 million barrels of oil per day.

Another reason the price of oil is headed higher is that OPEC’s reserve base is vastly overstated. One of the world’s leading experts on petroleum supply, Dr. Colin Campbell, contends that OPEC has been vastly overstating its reserves for years. Campbell offers substantial evidence 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 following the implementation of an OPEC production quota system that set country production levels based on country reserves. Kuwait was not alone in increasing its reserves 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 followed suit and reported a massive increase in reserves in 1990.

OPEC is not alone in its overstatement of reserves. In January 2004, Royal Dutch/Shell announced a huge write down of reserves. The company wrote off 20% of its reserves or 2.4 billion barrels of equivalent (boe). To be fair, most oil and gas companies do not overstate reserves but rather understate them. Due to the strict regulations set forth by the SEC about reserve estimates, a company that makes a new discovery may grossly underestimate the recoverable oil that is likely to be produced. As a result, conservative reserve reporting has created a distorted view of how much oil is being discovered each year.

While OPEC members have grossly overstated reserves and, on balance, most Western oil companies have understated their reserves, where does that leave us? Since OPEC member countries own 62.3% of world oil reserves (See the following URL for more information: www.eia.doe.gov/pub/international/iea2002/table81.xls), OPEC reserve numbers more than offset any underreporting by Western oil companies. Therefore I believe world oil reserves are grossly overstated.

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Bill Powers is Editor of Canadian Energy Viewpoint