 $80 Oil, Here We Come!!!
Bill Powers
Canadian Energy Viewpoint
November 5, 2004
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:
http://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.
Lack of new
discoveries in both OPEC countries and non-OPEC countries has
led to the current situation in which the world consumes far
more oil each year than it discovers. According to Dr. Campbell,
the world consumes four barrels of oil for every one it discovers.
Clearly this situation cannot continue indefinitely since discovery
and consumption must mirror each other.
Another pillar
of many analysts' belief that oil prices will drop is the notion
that high oil prices will choke off economic growth which in
turn will lead to lower prices. In a wonderfully researched white
paper published in 2003 entitled "Price Signals or Cheap
Oil Noise?" economist Andrew McKillop provided substantial
evidence to suggest that high oil prices and economic growth
are not mutually exclusive. Below is an excerpt from his white
paper:
"The US
economy achieved its highest ever postwar growth of real GDP,
achieving today what 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 fact of economic history, Cheap
Oil is still regarded by uninformed sectarian opinion as a passport
to economic growth."
- Andrew
McKillop,
"Price Signals or Cheap Oil Noise," 2003
Despite record
high oil prices in the third quarter of 2004, the entire developed
world achieved economic growth. Part of the reason for this growth
is that oil prices are still not high enough to substantially
alter spending habits. Spending on gasoline and home heating
oil remains a small percentage of many consumers' disposable
income. To put today's oil price in perspective, let's compare
the price of oil to the cost of housing.
In 1981, the
cost of a barrel of oil domestically produced was $31.77 (Source:
US Department of Energy) and the average cost of a new home in
the US was $83,000 (Source: National Association of Home Builders).
In 2003, the average price of a new home was $246,300 (Source:
ibid) and the average cost for a barrel of domestically produced
crude was $27.56 (Source: ibid). Over the course of 22 years,
the average price of a home has tripled while the price of a
barrel of domestically produced oil went down in
price. With the exception of weakness in select markets in the
late 1980's and early 1990's, the price of housing has gone straight
up for nearly a quarter of a century. Even with today's low interest
rates, spending on housing consumes a larger percentage of household
income than at anytime in history. If the price of oil kept up
with the price of housing, domestically produced oil would cost
$95.31 a barrel today.
The last reason
that I believe we will see $80 oil within the next 24 months
is that worldwide oil supply is dropping and prices have not
yet reached levels high enough to choke off demand. Despite record
gasoline prices in the US last summer, we saw demand increase
4% over 2003 levels. While Western economies will see modest
demand growth due to the slow-growth nature of their economies,
the developing world will see explosive demand growth for the
foreseeable future. In 2004, China became the number two consumer
of oil and the number two importer of oil behind the US. With
Chinese oil imports up 30% from 2003 levels (despite today's
record prices), it is quite clear that oil prices would have
to achieve much higher levels before Chinese demand recedes.
What does $80
oil mean for investors? Quite a lot. It is difficult to overstate
the impact that $80 oil will have on every unhedged publicly
traded oil and gas producer. While most companies in North America
are extremely profitable at $35 oil, $80 oil will generate earnings
that will dwarf the so-called "windfall profits" of
the 1970's. While many Wall Street and Bay Street analysts continue
to use $35 oil in their assumptions for 2005, savvy investors
should realize that the average price for oil will be far higher
and should adjust their portfolios accordingly.
Bill Powers
Editor, Canadian Energy Viewpoint
Email: bill@canadianenergyviewpoint.com
Website: www.canadianenergyviewpoint.com
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321gold Inc
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