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No pleasant
surprises in the new oil order
By Marshall Auerback
"The Saudis are out of capacity. That's my
opinion ... They have no infrastructure or extra pipes
or gas, oil, and water separators [very expensive large
globes used to separate what comes out of a water
injection well]. They have very heavy oil which, through
a conventional refinery, produces asphalt. We don't need
asphalt. We need gasoline. It takes a complex refinery
to make gasoline and it only takes seven to 10 years to
build one."
- Matt Simmons, Simmons & Co, a
leading independent oil analyst (from Michael C
Ruppert, Peak Oil Revisited)
As July
began, Saudi officials announced that they were
satisfied with the current level of world oil prices,
around US$35 a barrel - the clearest indication yet that
the kingdom has abandoned support for the old
Organization of Petroleum Exporting Countries (OPEC)
price range of $22-$28 per barrel. Saudi Arabia's oil
minister, Ali al-Naimi, indicated that, at current
levels, oil prices were "fair". Two implications flow
from this.
The Saudis have now lined up with the
rest of the OPEC cartel in implicitly suggesting
that the old reference benchmark of $22-$28 was less
than fair. From this flows a simple but dramatic
conclusion: It is highly unlikely that we shall see
an "October surprise" in which the Saudis flood the crude-oil market
to bring prices down sharply and thereby help ensure
re-election for President George W Bush. Faced with
rising welfare costs and escalating political tensions,
the kingdom has a corresponding need for additional
capital expenditure for increased oil capacity. Goldman
Sachs estimates that the Saudis require an average price
of at least $30 a barrel over the next five years just
to maintain real per capita expenditure.
Perhaps more significant, the
Saudi statement speaks volumes about the true state of
supply/demand in the oil market. The kingdom's actions
may in fact constitute an implicit fait accompli, an acceptance of their
inability to increase production substantially beyond
current levels, bringing the days of peak oil production
ominously closer.
The latter point is especially
germane to those who continue to harbor thoughts of a
return to cheap oil. It remains the consensus among
investors on Wall Street and among a number of
policymakers in the West that current high prices are a
temporary aberration. Such misplaced optimism mirrors
the stated (inflated) production targets of oil
companies and oil-producing nations. Oil companies
themselves appear to be consistently overly optimistic
because of their desire to convey to investors that they
still have attractive growth prospects. This was
certainly the case with Shell, which only recently
sacked its chief executive officer and director of
exploration for persistently overstating the company's
reserves.
The oil-producing nations of OPEC also
continue to set forth ambitious production targets in an
attempt to negotiate more favorable OPEC quotas. So far,
careful analysis of these optimistic forecasts has
revealed that they are based on questionable assumptions
regarding investment and technology, as well as
unrealistic timetables. They all assume quite low
depletion rates on existing output. Last, the
historical record shows that this sort of optimistic
bias has prevailed for some time, while actual
production growth has consistently fallen short of
optimistic forecasts.
It is striking
that the vast majority of Wall Street oil analysts,
indeed, the oil companies themselves, have continued to
base their forecasts on the old OPEC targeted price
range of $22-$28 per barrel in spite of increasing
evidence of looming supply shortages. But the comments
by Saudi Arabia last week, coupled with concerns
raised by Nigeria, Iran and Venezuela, suggest that OPEC
may finally be acknowledging the new reality:
depletion dynamics - a technical term that simply refers to
declines in production of existing fields regardless of
demand or increased capital expenditure to improve them
- have now come to the fore. Investment aimed at newer,
smaller reservoirs and improving existing fields will
not be enough to overcome these depletion dynamics.
Therefore, even with higher prices and higher levels of
investment, growth in global oil output will slow.
Which does call into question the efficacy of
the planned production increase OPEC announced with some
fanfare last month in Beirut. OPEC officials assured the
world that the organization would increase production by
2 million barrels per day to 25.3 million barrels per
day in an attempt to cool down global oil prices. There
is some question, however, about the sustainability of
such production hikes, given that the cartel has not
pumped out such volumes of crude since the second oil
shock produced by the Iranian revolution over a
quarter-century ago.
"After the Oil Runs Out",
an article by James Jordan and James R Powell in the
Washington Post last month, addressed just this point:
If you're wondering about the direction
of gasoline prices over the long term, forget for a
moment about OPEC quotas and drilling in the Arctic
National Wildlife Refuge and consider instead the
matter of Hubbert's Peak. That's not a place, it's a
concept developed a half-century ago by a geologist
named M King Hubbert, and it explains a lot about
what's going on today at the gas pump. Hubbert argued
that at a certain point oil production peaks, and
thereafter it steadily declines regardless of demand.
In 1956 he predicted that US oil production would peak
about 1970 and decline thereafter. Skeptics scoffed,
but he was right.
It now appears that world
oil production, about 80 million barrels a day, will
soon peak. In fact, conventional oil production has
already peaked and is declining. For every 10 barrels
of conventional oil consumed, only four new barrels
are discovered. Without the unconventional oil from
tar sands, liquefied natural gas and other deposits,
world production would have peaked several years ago.
Lost in the debate are three much bigger
issues: the impact of declining oil production on
society, the ways to minimize its effects and when we
should act. Unfortunately, politicians and
policymakers have ignored Hubbert's Peak and have no
plans to deal with it: If it's beyond the next
election, forget it. The reference to
"Hubbert's peak" - after the geologist who first made
the case for depletion dynamics in the oil patch - omits
to note that the prediction was highly controversial
inside and outside of the oil business until the 1980s,
when it was proved correct. The basic reasons for a bell
curve in any plot of production over time are that
exploration is not a random process and that oil and gas
are depleting assets. When exploration of an area
begins, the largest reservoirs are the easiest to find.
Total production rises as they are brought into
production, while exploration for smaller reservoirs
continues. Eventually enough smaller reservoirs cannot
be found to offset the declines in production from the
depleting large reservoirs. Prices and technology affect
the area under the curve - the total amount of oil and
gas recovered over time - but not the shape of the
curve. Think of it as a process similar to aging and
death in living organisms, as Hubbert himself rightly
surmised.
Indeed, since 1970, the three largest non-OPEC
oil discoveries have all been in offshore areas and
are expected to achieve peak production of only one-and-a-quarter
million barrels a day - far less than the
peak production of the major discoveries of the past in
the United States, Russia, the Middle East, Mexico, Venezuela
and Nigeria. However much one trumpets these new
discoveries, it is important to note that they will only
offset declines in production on existing fields, and
not increase the overall aggregate supply of global
crude oil. Indeed, the disappointing exploration
"successes" of the past 30 years have occurred despite
huge investments engendered by dramatically higher oil
prices in the 1970s and much of the 1980s. The record of
the last two decades suggests that no more mega-fields
may be discovered to replace the depletion of today's
largest oil reserves and provide the growth in oil
output that most market participants today take for
granted.
Unfortunately, the Washington Post
story relied on generalities about peak and decline to
the exclusion of the hard data that have surfaced over
the past two years, all of which points to an imminent
acceleration in global depletion dynamics, notably in
Saudi Arabia. There, Ghawar, the largest field in the
world, and all of Saudi Arabia's other large fields are
old and tired. In recent years, the Saudis have resorted
to both water injection and so-called "bottle-brush"
drilling to maintain production - techniques that tend
to accelerate decline and damage reservoirs.
For a country with an allegedly huge marginal surplus of
oil production, turning to such extraction techniques
is likely to prove an unwise move. With
bottle-brush drilling, a shaft is drilled horizontally over
long distances with a number of brush-like openings. Water
is then forced under pressure into the reservoir,
forcing the oil up toward the wellheads. Extraction is
thereby increased. However, when the water table hits
the horizontal shaft, often without warning, the whole
field may go virtually dead and production will
immediately drop off to virtually nothing.
Examples of what has happened in other
oil-producing countries when "bottle-brush" drilling was
employed abound. Syria's oil production is now in
terminal decline. Yemen is following, according to Ali
Samsam Bakhtiari, vice president of the National Iranian
Oil Co, who has long suggested that Saudi oil
production might have peaked in the spring of 2003. Adds
analyst William Kennedy, "For the record, Ghawar's
ultimate recoverable reserves in 1975 were estimated at
60 billion barrels - by Exxon, Mobil, Texaco and
Chevron. It had produced 55 billion barrels up to the
end of 2003 and is still producing at 1.8 billion per
annum. That shows you how close it might be to the end.
When Ghawar dies, the world is officially in decline."
In the short term, speculation in futures
markets has contributed significantly to the fall in the
oil price over the past month, although even with oil
traders liquidating these futures positions on
commodities exchanges, prices have stubbornly remained
above $35 a barrel, well in excess of the old reference
benchmarks. And while such speculative positions may
influence the level of oil prices by several dollars a
barrel over the short run, in the medium to longer term,
supply/demand considerations will trump all else. Strong
growth in global energy demand, a loss of capacity in
some OPEC states, and rising depletion rates will all
continue to contribute to a much tighter market.
Moreover, as the Financial Times notes, "A buildup of
inventories is now needed ahead of peak seasonal demand
in the fourth quarter. But higher crude inventories do
not address the problem of insufficient refining
capacity in the US."
It is
beside the point to maintain that current prevailing high
oil prices are the result of a "political
instability" premium, when the Saudis have set themselves
up for additional terrorist attacks on their
oil installations through repeated pledges to boost oil production
and drive down prices. Saudi Arabia was the only OPEC member to come
out of the Amsterdam meeting three weeks
ago with planned production hikes. This isolated
position has likely earned it the ire of terrorists and given it
a further vested interest in disrupting oil production,
as has already been occurring with increasing frequency
in Iraq over the past 12 months. Some security
experts believe that key Saudi installations such as Ras Tanoura
and Abqaiq, the world's largest oil-processing complex,
are vulnerable to attack. Questions about the competence
and loyalty of elements within the Saudi security forces
remain, as their ranks are said to be infiltrated by
Islamic extremists. Recent attacks on foreign oil
personnel in the kingdom seem to have revealed intricate
personal and tribal links between the security forces
and the alleged al-Qaeda operatives in the country.
Then there is the worst-case scenario
- a complete collapse of the House of Saud. Were
a collapse of the Saudi regime to remove the country's
oil supply from world markets, even temporarily, the
impact on prices would be far greater than those
sustained during the two OPEC oil shocks of the 1970s. This would
up the tab for a debt-ridden, cheap-oil-driven US economy
currently importing almost 60% of its crude from abroad.
"Whither oil prices?" is not simply an academic
question. Future US economic growth is largely
dependent on reliable, accessible and affordable
supplies of energy. Hints of an impending oil-production
peak are already beginning to impact seriously on
economic growth against a backdrop of unprecedented
financial fragility. The inexorable tightening of supply
is destabilizing oil markets, which now manifest extreme
price behavior in response to the smallest potential
disturbance. Higher oil prices continue to increase the
strain on consumption, particularly in the US, while
simultaneously reducing disposable income. How well
equipped are we to deal with substantially higher energy
prices? This is a question that no policymaker has
honestly confronted yet. The markets remain in denial,
but high energy prices are the new economic reality.
If there is indeed an "October oil surprise",
the resultant shock is likely to be one which neither
consumers, nor Western policymakers will appreciate,
since it could entail prices sharply higher than those
currently prevailing. The days of cheap oil prices are
over; the only question is, how high and how fast from
here?
Marshall Auerback is an
international portfolio strategist for David W Tice
& Associates, LLC, a USVI-based money management
firm. He is also a contributor to the Japan Policy
Research Institute. His weekly work can be viewed at http://www.prudentbear.com
.
(Copyright 2004
Marshall Auerback.)
This article appeared on http://www.tomdispatch.com, compiled
by Tom Engelhardt.
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