Monday, March 5, 2007

The Issue of Oil

A March 2005 OPEC meeting in Esfahan, Iran shocked the oil markets when ministers made comments claiming that for the first time in OPEC's 45 year history the cartel had lost the ability to govern the price of crude oil. "There is not much we can do, Algerian Oil Minister Chakib Khelil told reporters. OPEC has done all it can. Qatar Oil Minister Abdullah al-Attiyah said."

While this news may shock some it should come as no surprise. The topic of oil and its depletion has generated significant media coverage over the last couple of years and for obvious reasons. From its low of $10 a barrel in 1998 to its record close of $78 in June of 2006, oil as a commodity has made substantial gains. As with all commodities the underlining governance of price is the interaction between supply and demand. Critics will argue that oil is falsely overpriced due to extrinsic issues such as escalating political tensions with Venezuela or the possibility of conflict with Iran. While these issues have relevance, one must realize that the price of oil is not controlled by greedy corporations like Exxon Mobil or corrupt despot governments like Saudi Arabia. It is ultimately controlled by you and me, the consumer.

From British Petroleum’s 1999 surprise name change and its investment in solar energy, to Goldman Sach's profound warning that oil is reaching the initial stages of a "super spike"; Multinational corporations are telegraphing very distinctive messages. Chevron's Chairman and CEO David J. O'Reilly succinctly put it, “One thing is clear: the age of easy oil is over.”

I could continue with additional examples of corporate maneuvering such as DuPont’s investment in biofuels or GM's ethanol push but I believe it would be redundant due to the media's current feeding frenzy. Given the context of this blog; I believe it far more important to discuss why oil will never again see $40 a barrel and what this means for you and I as investors.

The Future of Oil

Some will insist that we have seen this before, that the exact same situation occurred with the 1970s oil crisis. From 1970 to 1982 the price of oil moved from a low of $1.35 to a high of nearly $35 a barrel, or a twenty-six-fold increase. For oil to make similar gains today, the price would have to move above $250 a barrel(adjusted for inflation)! Fortunately the price of oil has quite a ways to go before we feel the pain endured during the 1970s. So why then are we seeing similar investments by corporations and governments to squelch our dependency on oil?

Unlike the oil crisis of the 1970s, which was predominantly a politically derived problem, our current energy conundrum stems from the inherent geological constrains of the Earth. Due to petroleum’s finite nature, there is a predetermined limit to the amount we can produce. In June 1996, in an Issues in Science and Technology article, James J. MacKenzie discussed how oil naturally occurs in very large pockets such as the Mexican Cantarell and Saudi Ghawar fields. Due to their massive size these pockets are discovered in the very early stages of oil exploration. MacKenzie states: "The largest 1 percent of oil fields contains 75 percent of all the discovered oil, and the largest 3 percent contain 94 percent of the oil." As exploration continues the average size of discovered fields will decrease. In the later stages of oil discovery companies must drill more and search even more obscure locations to find the remaining oil reserves,which ultimately leads to a higher exploration costs per barrel. According to the U.S Geological Survey, global discovery of large new fields peaked in 1962...

New Frontiers

Areas such as the deep waters in the Gulf of Mexico provide relatively uncharted potential for oil discoveries such as the massive discovery in September of 2006, by Chevron. Cambridge Energy forecasts that this discovery will produce 800,000 barrels of oil a day within seven years and account for 11 percent of US oil production. However, for Chevron and its partners to bring this oil online, years of development and billions of investment dollars will be required. Simply put, it is technically difficult to extract oil from fields located 5 miles below the surface of the ocean.

As the price of oil has moved higher with demand, the exploitation and development of previously uneconomical energy sources such as deep water drilling and oil sand mining will see rapid growth. Suncor Energy Inc, the oldest and second largest refiner of oil sands expects to double it’s currently production capacity to 500,000 barrel a day by 2012. The company estimates that this endeavor will cost them $2 billion dollars in 2007 alone. While this move and the recent discovery by Chevron are both significant strides toward securing our energy needs, they fail miserably when compared to the world’s insatiable demand.

According to the 2006 Energy Information Administration's annual report; world demand for oil is expected to reach 118 million barrels a day by 2030 up from the current 86 million, with the US leading consumption at over 27 million barrels. For the world to meet these lofty goals, production rates must increase drastically from their current levels. In the energy crisis of the 1970-80s we were able to avoid economic shock by significantly increasing oil production and bring online new energy streams such as nuclear. From 1980 to the end of the decade OPEC was able to increase petroleum production by 35 percent and between 1980 and 1990 nuclear power generation doubled. These measures greatly increased the total energy capacity and thus eased prices. Today the situation is much different. There are no major petroleum streams waiting to come online and there is no economically viable energy replacement like nuclear which can accommodate our energy needs. Even more disconcerting is our increasing reliance on OPEC. With US oil production in decline since 1970, we are now importing >50 percent of our daily petroleum needs.

Global Peak Production?

Often a topic of tense controversy, the idea of global peak production is staunchly divided into two groups. "Peakers", such as energy banker Matthew Simmons believe that Saudi Arabia and the world are very near or past peak global production. Which if manifested, will result in price hikes as the supply demand equation becomes skewed. Skeptics like Morry Adelman, an MIT economics professor, believe that there is plenty of oil remaining as long as consumers are willing to pay the price. I agree with Professor Adelman's view that as the price of oil increases with demand, previously ignored prospects will be developed due to improved economics. However, I find it ironic that the most technologically advanced nation in the world has been in an irreversible decline for over 30 years. If all it takes is more technology and strong consumer demand, then why has the United States oil production been in critical decline since the 1970s?

One fact is clear. The global economy needs oil for continued growth. Even more important, as China with its 1.5 billion inhabitants emerge as a major economic player, the demand for petroleum will escalate. If we can accommodate this demand with a combination of new petroleum streams and a shear cornucopia of alternatives, then the world’s economy can continue to grow. If we are unable to meet this demand and the worlds petroleum supply is in fact at or near its peak then we could be looking at a far worse scenario involving possible stasis, recession or perhaps Armageddon.

Being an optimist and a firm believer in a market economy, I feel that we can meet this challenge and move into a post petroleum era relatively unscathed. If as a society we can overcome this obstacle and avoid an all out economic collapse, then the savvy investors who capitalize on this trend will be greatly rewarded. Due to this emerging trend, I will focus my next post on a discussion of possible investing strategies for the impending energy crunch.

No comments: