Tuesday, February 17, 2009

Eric Fry, offering a wild guess about the oil market…

As the price of crude oil continues its death spiral, forward-looking investors have every reason to scratch their heads in amazement. The oil market seems to be pricing in a global economic condition that would be even more dire than a second Great Depression. $35 oil seems to imply that mankind will resume its reliance on ancient energy sources like whale oil, tallow and cow dung.

Maybe so…but we doubt it.

Late last year, the International Energy Agency (IEA) released its World Energy Outlook 2008, which presents a thorough field-by-field analysis of production trends at the world's 800 largest oil fields. This comprehensive study suggests that the oil price is much more likely to rise than fall over the next few years.

The IEA stops short of promoting that "Peak Oil" theory that the planet is running out of hydrocarbons. But the Agency does point out that output from the world's major oil fields is declining much faster than previously believed.

As our learned colleague, Chris Mayer, observes, "The IEA's findings state that without additional investment to raise production, output will decline 9.1% annually. Everyone knows that oil production is on a treadmill, on which aging fields produce less oil over time. But that decline rate was faster than previously thought. Even with investment, the annual decline rate is 6.4% per year. These are big annual declines in a market that already wobbles along a knife's edge of supply and demand.

"Demand probably will continue to taper off as we get into this recession/depression," says Chris. "But supply is falling also, and it's not as if there is a lot of unsold oil lying around. The Economist reports 'Official oil stocks [or inventories] are well below their average of the past five years.' And let's not forget that most of the world's oil reserves are in the hands of capricious or unstable governments."

These various factors inspire your Rude Awakening editors to offer up a prediction (or what we like to call "a wild guess"): $100 crude before $20 crude.

Oil's spectacular collapse from $147 a barrel to $35 may say a lot about what is happening in the global economy at the moment. But today's depressed oil price says absolutely nothing about what will happen next. Specifically, today's oil price doesn't know squat about what will happen to global demand for crude, nor what will happen to global supplies.

Your editors don't know squat about future supply/demand trends either. But we would argue, nevertheless, that an utterly clueless investor is better off on the long side of the oil market than on the short side of it.

The Oil Glut of 2009…and Why it Won't Last
By Byron King

The current oil price contains absolutely no risk premium. $35 crude price simply does not reflect how rapidly the oil market could tighten in 2009…or how rapidly prices could rise.

Western nations are now experiencing the bow wave of a profound change in the current and future availability of oil. Oil output from all major Western oil companies is on an ominous decline trend. Exxon Mobil, for example, announced that its average oil output has fallen by 614,000 barrels per day in 2008.

Western oil majors like Exxon are finding it harder than ever to identify new prospects and successfully complete new oil projects. BP's Thunder Horse project in the Gulf of Mexico, for example, is finally coming online in 2008, with an anticipated output of nearly 250,000 barrels per day. But this one project has taken almost 20 years to complete, at a cost in excess of $6 billion.

And Chevron's recent success with its Jack 2 project in the Gulf came at a cost of over $240 million for just one test well. And this prospect is still years away from being a successful oil-producing prospect.

These sorts of developments have implications far beyond the Peak Oil argument, as valid as that thesis may be.

One of the key reasons for the decline in oil output from major Western companies is world politics. In the 1990s, the key strategic development in the wake of the fall of the Berlin Wall and the decline of communism was the trend toward globalization. Much of the world opened up to the West figuratively, as well as literally. And the oil industry was one beneficiary, making significant investments in unexplored or underexplored regions from South America to the Caspian Sea.

But the key strategic development in the first decade of the 2000s has been, arguably, the concept of "resource nationalism." That is, in the many nations that were formerly friendly toward Western companies, the attitudes toward foreign investment have fundamentally changed. Western oil companies have found themselves squeezed out of resource-rich areas.

Assertive host governments are gaming the rules to favor their state-owned national oil companies (NOCs). Some Western companies have experienced outright nationalizations, such as what occurred with Exxon Mobil and ConocoPhillips in Venezuela. Other Western companies have been shown the door through intimidation and bullying legal tactics under the guise of "tax laws" or "environmental enforcement," such as what happened with Shell Oil Co. at its Sakhalin project in Russia.

Even Brazil has flashed its nationalistic teeth to foreign investment. Recently, Brazil withdrew numerous areas from prospective lease sales after it became apparent that the odds of finding oil were quite good. Why not just save it for Petrobras?

The traditional model of resource development, in which Western companies obtain legal title and control over oil and gas deposits in the ground, is becoming increasingly NON-traditional.

As recently as the late 1970s, Western oil companies controlled well over half of the world's oil production. But now the NOCs - such as Saudi Aramco, National Iranian Oil Co., Kuwait Oil Co., Petroleos de Venezuela, Petroleos Mexicanos (Pemex), etc. - control over 85% of the world's oil resources. Western majors control only about 7% of the world's oil resource base.

Meanwhile, oil output from mature regions is in decline. From the North Sea to the Alaska North Slope, the Western oil companies are faced with lower production volumes from their existing oil fields. And there is a much thinner book of potential business elsewhere in the world. According to Amy Myers Jaffe, who studies the oil business from her chair at Rice University, "This is an industry in crisis."

This sense of crisis also helps explain why Western oil companies are fighting to expand their options for offshore drilling in the U.S., as well as to expand access to areas like northern Alaska. The U.S. offshore, and other frontier areas such as the Arctic National Wildlife Refuge (ANWR) are among the few options remaining for Western oil companies.

So one key point that the Western oil industry makes is that its resource base and reserves are in decline. And over the medium to long term, this means that the economic importance of the Western companies will erode. Despite any plans or efforts at conservation and efficiency, as well as a large-scale shift to alternative energy sources, the Western world will become increasingly dependent on NOCs for oil.

In other words, when you combine the oil market's geological condition with the oil market's geopolitical condition, the odds tilt toward much higher oil prices.

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