If you need any more proof that the markets are not an efficient discounting mechanism, look no further than the price of oil.
Oil prices in the high $30s to low $40s are nothing short of a ticking time bomb under the world economy, but you wouldn’t know it from watching the commodity markets. Once the global downturn slashed $100 off the price of a barrel, the issue of oil supply seemed to simply fall off the radar of market observers. Falling oil demand is all that anyone seems to care about, but we may pay dearly for taking our eye off the ball of supply.
Marvin Odum, the US President of Royal Dutch Shell worried aloud on Bloomberg television yesterday about the loss of policy focus on oil, as renewables and electric infrastructure upstaged it. "The big risk that I see here is what happens to the energy that runs our economy today, that gives us energy that we can afford, and that is primarily oil and gas." According to Bloomberg, the company has delayed investment decisions on expanding its Athabascan tar sands project in Alberta, and upgrading its Mars project in the Gulf of Mexico.
I could scarcely agree more.
While the price of oil has crashed from its highs last summer, the costs of production—including labor, steel, rig leasing, and so on—have not declined nearly as much, and their future prices depend heavily on the health of the world economy. One month ago, Shell chief executive Jeroen van der Veer told the Wall Street Journal that while crude prices have rolled back to levels last seen five years ago, the company’s costs have doubled since then. The costs will eventually fall too, he said, but would lag by 12 to 18 months.
Shell’s budget for capital spending this year is roughly $31 billion, a huge sum. Under a barrage of news reports showing that economic activity is still declining, it’s only prudent to hold off on further spending if a delay could save them billions. It also makes sense to delay production if the same oil could be sold in a year or two at twice the price it would fetch today.
Consider the economics of the Mars field as an example. At a water depth of 2,940 feet, it is believed to contain 500 million barrels of oil equivalent. The platform produces some 220,000 barrels per day, at a reported development cost of $100 million. Prior to the development of BPs Thunder Horse platform, it was the most advanced platform in the deepwater Gulf of Mexico, where the best prospects for new US oil production are. The Mars platform was destroyed by Hurricane Katrina, and rebuilt by Shell at a reported cost of $200 million. Assuming those numbers are still correct, at a $300 million total cost the project would pay for itself in 34 years at $40 a barrel, but in only 14 years at $100 a barrel. (By comparison, the Thunder Horse platform produces oil at about the same rate, but has a total cost of around $5 billion.)
Shell is one of the few companies in the oil patch who are increasing their capital spending and increasing dividends in the current uncertain environment. Revenues are off sharply across the industry, and most companies are taking write-downs on revenue, and cutting costs. Occidental Petroleum has announced a 25% cut in its capital spending for this year. ConocoPhillips has sharply cut back on its spending and staff. Chevron is only maintaining last year’s level of investment. Schlumberger has slashed its worldwide workforce by 6%.
The most recent data from Baker Hughes indicates that rotary rigs drilling for oil in the US—an indicator of oil exploration activity—are down 22% from last year to 260 rigs, comprising just 23% of total drilling activity (the rest are drilling for gas). The Canadian rig count is down 38% from last year.
Production from Mexico, our number-three source of imports, is in serious trouble. Its oil output fell 9.2% in January to its lowest level since 1995, but its exports are falling much faster, at a 20% decline, according to Pemex. (As I explained last June in "The Impending Oil Export Crisis," exports fall faster than overall production.) The decline of Cantarell, one of the four "supergiant" oil fields in the world, has accelerated to 38% per year. At the current rate, Mexico’s oil exports will cease altogether in seven years or less. Widespread civil unrest already plagues our southern neighbor, where drug cartels have taken to open war with the government, and the crashing of its top export is sure to make matters worse.
Things are no better in the Middle East. OPEC reports delays of more than 35 of 150 planned upstream projects, with some postponed until after 2013. Additional project delays are expected.
Too Cheap to Lift
Simply put, the biggest threat to supply is that oil is now too cheap to increase its production. While it’s true that lifting costs for older, mature projects range from $10 a barrel in Saudi Arabia to about $15 a barrel in Russia, Alaska, Norway and the UK, all of those areas are past their peaks and into decline. It’s the cost of new oil that we should be worried about.
With the world’s oldest, largest, and cheapest fields either already in decline or soon to be, we are now depending completely on difficult, unconventional oil projects like deepwater, tar sands, and oil shales to manage any increase at all in supply. My research suggests that oil needs to be at least $65/bbl to sustain investment in these incredibly capital-intensive projects.
According to a new study by Deutsche Bank, the cost of new oil projects in the world’s remaining growth areas—namely, the Gulf of Mexico, Brazil, Nigeria and Angola—plus a 15% rate of return ranges from $60-$68 a barrel.
According to a recent study by Brad Setser for the Council on Foreign Relations using data from the IMF and other sources, Saudi Arabia, Kuwait, Algeria and Libya all need $50-60, and Russia needs $70, to break even on production and meet their budgetary needs. (These numbers are averages across many different kinds of reservoirs with different cost structures, but do reflect the real forward production cost.)
Saudi oil minister Ali al-Naimi has warned that the world needs $75 oil to ensure future supply, and that current prices "are wreaking havoc on the industry and threatening current and planned investments."
The real bar is probably even higher. Credible experts maintain that oil will have to remain above $100/bbl for a good length of time before oil companies are willing to commit enormous amounts of capital to the expensive, risky, and decades-long projects that remain to be developed.
Clearly, no one is going to step up to spend billions of dollars to develop new oil projects until oil is holding firmly above $60.
Without those projects, we are headed for a quick slip down the back side of Hubbert’s Curve. Deutsche Bank calculates the global loss of oil production due to poor economics at 700,000 barrels per day with oil at $30 a barrel, of which more than half would be lost production from tar sands. At $20 a barrel, fully 3.5 million barrels per day (mbpd) would be uneconomical to produce.
Tar Sands Troubled Too
The Canadian tar sands were until recently the great black hope for non-OPEC supply, with a production cost for older projects in the range of $28 a barrel. However, Shell chief financial officer Peter Voser says the company’s current cost is around $38 per barrel. But the cost of new tar sands projects is much higher: According to an analysis by Merrill Lynch, it doesn’t pay to invest in new tar sands projects until oil sells for about $80 a barrel. I have seen other recent estimates putting the cost at closer to $90 a barrel. More than $90 billion worth of projects in the tar sands have been postponed since oil prices started their sharp decline.
Accordingly, the government of Alberta just announced a one-year repeal of its revised royalty structure, which went into effect at the beginning of this year. The royalty rate will be cut from the current 15%-25% to a maximum of 5% as an incentive to encourage junior oil and gas explorers to resume their investments.
This is no surprise to me, as the Stelmach provincial government has twiddled with the royalty rates no less than four times in the last two years, much to the dismay of tar sands producers seeking a clear investment outlook. As I wrote a year and a half ago in "Tar Sands: The Oil Junkie’s Last Fix," "If the royalties on the tar sands were allowed to rise to anywhere near the normal levels for oil—around 40%, not 1%—the entire industry would cease to be. The profit would vanish, simple as that."
The slowdown in tar sand production casts further doubt on the expectation that it will ever rise from the current 1.5 mbpd to 5 mbpd by 2030. I have estimated that it might peak at 3.5 mbpd by 2030, but the confluence of macro factors now pointing to serious energy shortfalls and a global economy on the brink in the 2012-2013 time frame makes me doubt we’ll reach even that.
Scary Decline Rates
The rate of decline from mature older fields is now of paramount concern, as new investment has faltered.
The most recent accepted estimates on decline rates are from the International Energy Agency (IEA), which puts the average global rate of decline at 5.1% (a somewhat squishy number; see here for details) for "observed decline rates." The agency’s "natural decline rates," which is what you get without continued investment, now average 9% and will increase to 10.5% per year by 2030.
At a 9% rate of decline, the world would lose 7.6 million barrels per day of supply each year—roughly double the world’s current spare production capacity!
Continued reports of oil project cancellations and postponements have prompted the IEA to intensify its drumbeat of alarms about future supply. Last week the agency warned that if oil demand recovers in 2010, global spare capacity would fall to zero by 2013. "That is our concern. Investment, investment, investment, that is what we are asking," Executive Director Nabuo Tanaka said at a conference in Lisbon. The agency estimates that the world will need 45 million barrels per day of new capacity—the equivalent of four Saudi Arabias—just to meet decline by 2030. That’s right: just to keep production flat!
As my regular readers know, I believe even that is a conservative estimate. Using the IEA’s own most recent numbers on oil decline rates, I calculate that if world demand grows at a projected average of 1.6% per year, the world will need to add the equivalent of six new Saudi Arabias by 2030. (See "IEA Oil Report: ‘Time is Running Out’") To accomplish that impossible feat, the world would need to spend over $1 trillion per year between now and 2030, an equally unlikely prospect.
The natural decline of oil fields is a relentless force, and it requires continued investment and vigilance to keep up production rates. There are many historical examples of older oil fields that were shut down or starved of maintenance due to poor economics, which failed to return to their previous production levels once investment returned due to irreparable damage. Deutsche Bank’s study of such fields found that decline rates increased sharply during times of past price collapses. The bank estimates that the accelerated decline of mature non-OPEC fields alone could cut as much as 1.5 million barrels per day from global supply.
By my calculations, the world will likely be down to three-quarters of today’s energy budget in 20 years, and down to less than half in 40 years.
Get Long and Stay Long
Despite all the evidence on crimped supply and the warnings of the IEA, the action in oil prices has remained extremely volatile, flip-flopping as much as 10% in a day in recent weeks. This is pure insanity when you realize how crucial it is to essentially all economic activity. Would it make sense to you if the GDP fluctuated 10% from day to day?
Traders are still firmly in control of the oil market, and we should be skeptical of detecting too much signal in all that noise. But I do see prices firming around the $40 a barrel point now, as supply falls and existing stockpiles are gradually depleted. OPEC members are nearly fully in compliance with existing cuts, according to Algerian Oil Minister Chakib Khelil in an interview in Madrid on Monday, and the cartel is considering further cuts at its meeting two weeks from now.
As I have said repeatedly in this column, oil in the $40s is setting up an air pocket in the global fuel line. Once the trade settles down a little and starts reflecting fundamentals again, the name of the game will once again be spare production capacity.
It’s a hard number to pin down, but the current global spare production capacity is probably now in the 3-4 mbpd range. (OPEC claims to have 8 mbpd of spare capacity, but I don’t believe it, for reasons too numerous to get into here.) Even after all the dire reports about demand lost to economic malaise and shut-in supply from OPEC cuts, that’s still only 3-4% of total supply capacity. I think the IEA is right: we could easily blow through that spare capacity by 2013.
This is why I have also said that oil at today’s prices is only adding tension to the price slingshot. As we witnessed last year when spare capacity dropped for the first time to roughly less than 1%, prices go parabolic the closer we get to zero spare capacity. When global oil demand recovers—likely led by China—it will send oil prices skyrocketing in two shakes of a lamb’s tail. It’s impossible to say what that price might be, but I would certainly expect it to surpass last summer’s high of $147. I wouldn’t say that $300 a barrel was out of the question by 2013.
Non-OPEC conventional crude supply has been essentially flat since 2002, fluctuating between 39 to 41 mbpd, and whatever spare capacity they may now have due to depressed prices is of negligible importance. "All liquids" non-OPEC production has increased from 46 to 49 mbpd since 2002, but most of that gain was from biofuels, tar sands, and natural gas liquids, none of which seem poised for any great expansion at this point. We may reasonably expect that only OPEC might be able to provide extra capacity now. But how confident is OPEC?
In a stunningly blunt February address to a Middle East energy conference in London, OPEC Secretary General Abdalla Salem El-Badri made most of the same points I have made here. "Current prices will not sustain the industry," he said. "They are at about half the level required to attract investments to the industry and ensure sufficient production capacity to meet future demand…Uncertain future demand has put this planned spare capacity—as well as the long-term availability of crude—at risk."
Given the increasing tension in the price slingshot, and the increasingly bad outlook for coming anywhere near the level of investment we would have to make over the next few decades in order to compensate for decline, I am now pretty comfortable with getting long on oil and staying there. If oil does go any lower from here, it can’t stay there without seriously reducing production, which would restore the price.
I still recommend being mostly in cash while the market is so fearful and volatile and utterly out of touch with the fundamentals, but for those who are inclined to put a small stake into oil and leave it there for a few years, there is no time like the present to start scaling into those positions.
Until next time,
Chris
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