Energy Bull Market Fundamentals Remain Strong
By Chris Puplava, April 23, 2008
Not only did oil break $100/barrel despite widespread disbelief, it is now knocking on the door of $120/barrel. The strength in oil prices is even taking the most ardent energy bulls by surprise despite a U.S. slowdown. Some attribute the rise in both gold and oil to the weakness in the dollar, but the decline in the dollar can only explain part of the move in oil and gold. For example, oil and gold are up over 50% and 40% respectively, while the dollar has declined roughly 10% since August of 2007, clearly not a one to one ratio in terms of movement in opposite directions.
As oil prices have continued to climb over the last several years both politicians and the public alike have labeled energy prices as a bubble waiting to burst with the recent price spike blamed on "speculators." However, as the "speculators" were right in the past as viewed by the IEA, they may be right again as the fundamentals support their bullish bets.
It is fair to say that politicians have greeted most sharp rises in prices over the past eight years as a symptom of speculation. But, in hindsight, have the price moves been irrational? Ali Al Naimi, Saudi Arabian Oil Minister, said last week that oil prices would not go below $60/bbl because that is the cost of alternatives. With current marginal costs and demand trends, he may be right. Short-term prices could dip below this level, but if they did so, then investment in non-OPEC supplies could suffer, creating upward price pressures for the future. Only a protracted and severe global recession would justify a sustained dip in oil prices below these levels.
In 2003, moves above $30/barrel were widely cited as speculative and irrational. Now they are seen to reflect the increasing cost of accessing and developing reserves. If it was a speculative push in prices, the speculators were right. Then we have to ask what base is appropriate and how fast it is rising (with continuing service-sector inflation and dollar weakness contributing to ongoing upward pressures). Some academics suggest long-term oil prices should be reflected as a multiple (roughly three to four times) of finding and development costs (F&D). Others would disagree. But we cannot deny that F&D costs have been rising: discussions with industry have put them at $10-$30/bbl, and the EIA in a recent report estimated US offshore costs at $64/bbl.
We are in an era of higher oil prices, and so if we look at $100/bbl oil we have to do so with an understanding that prices are unlikely to return to levels seen in the early part of this decade. But even if cost inflation and a weakening dollar put further upward pressures on the oil price, we have a duty to ensure that the impact of these is not exaggerated.
One of the reasons the IEA used to explain higher oil prices are the spiraling costs just to extract oil out of the ground and ocean. Rising costs are leading to double-digit inflation rates for many of the major international oil companies of the world. For example, Exxon Mobil has been experiencing double-digit inflation rates over the last five years as their lifting costs have exploded since 2002. Exxon Mobil simply isn't getting as much bang for their buck as inflation rates push up the lifting costs for energy companies. For this reason a large share of the $125 billion capital expenditure program announced by the company simply won't buy them what it once did, with real capital expenditures showing little reinvestment relative to nominal dollars.
Rising inflation within the energy complex is shown below with the PPI data for oil field and gas field machinery. Inflation rates for the oil field and gas field machinery industry cooled down starting in 2007, but have picked up again and are approaching double-digit inflation rates. The total rig count is likely to start picking up again under favorable pricing power for the oil field service industry. Oil service economics are currently at their most profitable levels as measured by GlobalSantaFe's SCORE Index, which stands for Summary of Current Offshore Rig Economics. The index reflects current rig day rates as a percent of the estimated rate required to justify building new rigs on speculation.
Source: BLS/ Baker Hughes Incorporated
Source: GlobalSantaFe Corp
Part of the reason for spiraling inflation rates within the energy complex is that much of the easily accessible oil has already been extracted and oil companies are having to go to great lengths and high costs to find new oil reserves. For example, the Wall Street Journal released an article yesterday highlighting Saudi Arabia's most ambitious project, the Khurais complex.
Saudis Face Hurdle In New Oil Drilling
Next year, if all goes well, Saudi Arabia will turn the spigots on the largest oil field to come online anywhere in the world since the late 1970s.
The Khurais complex, sprawling across a swath of red dunes and rocky plains half the size of Connecticut, is expected to add 1.2 million barrels a day to an oil market caught between growing demand and a paucity of significant new discoveries. The twin forces have led to historically high prices for crude oil, which settled at a record $117.48 on Monday.
But the project also illustrates a darker point: Even in Saudi Arabia, home to more than a quarter of the world's known recoverable reserves, the age of cheap and easily pumped oil is over.
To tap Khurais, Saudi Arabian Oil Co., known as Aramco, has embarked on the most complex earth- and water-moving project in its history. It is spending up to $15 billion on a vast network of pipes, oil-treatment facilities, deep horizontal wells and water-injection systems that it calls "one of the largest industrial projects being executed in the world today."
Moreover, with the project, Aramco is dipping into one of its last big basins of oil. After Khurais, Saudi Arabia will have only one known mega-field left to fully develop, the even more challenging Manifa field, offshore in the Persian Gulf.
"Khurais and Manifa are the last two giants in Saudi Arabia," says Sadad al-Husseini, a former Aramco vice president for oil exploration. "Sure, we will discover dozens of other smaller fields, but after these, we are chasing after smaller and smaller fish."
The Khurais project is at the heart of an all-out effort by Saudi Arabia to keep abreast of natural declines in older fields while trying to preserve its status as the oil world's lone safety valve. To do that, Aramco is scrambling to boost its overall production capacity, currently just over 11 million barrels a day, to 12.5 million.
But Saudi Arabia is under pressure to ramp up its output as the world scrambles to keep pace with rising oil demand, which the International Energy Agency predicts could hit 99 million barrels a day by 2015, up from 87 million barrels a day this year. With output declining or flat in Mexico, Venezuela, the North Sea and Russia, all eyes are on the Saudis to fill much of the gap, even as oil demand soars within Saudi Arabia itself.
Skepticism runs deep in oil quarters over whether Saudi Arabia can overcome a slew of challenges, both geological and economic, to turn the Khurais field into what Saudi officials hope will become the fourth most productive oil field in the world, after Ghawar and fields in Kuwait and Mexico.
"This is the big one," says Matthew Simmons, a Houston energy investment banker whose 2005 book "Twilight in the Desert" challenged Aramco's petroleum prowess. "If Khurais falls short of its advance billing, then Saudi Arabia is going to struggle to fulfill its promises."
Aramco has suffered lately from soaring costs and increasing project delays. Through most of the 1990s, it cost Aramco around $4,000 to add one barrel of daily production capacity. A huge project called Shaybah, finished in 1997, required Aramco to run roads and pipelines deep into the country's forbidding Empty Quarter and cost around $2 billion. For that, Aramco got 500,000 barrels a day in oil-production capacity.
Some experts estimate that it now costs the company closer to $16,000 to add one additional barrel of daily production capacity. Several big projects are running behind schedule because of a shortage of steel and manpower. A project called Khursaniyah was meant to bring on 500,000 barrels of daily capacity by the end of last year, but Saudi officials now say it may not hit that target until the end of the year.
Some doubt that Khurais will reach the promised 1.2 million barrels a day of oil production or be able to sustain that level if it does. Mr. Husseini, the former Aramco head of oil exploration, who retired five years ago, says he doesn't doubt the company can extract that much at least briefly. "The question," he says, "is how long you can sustain it and at what price."
Neil King Jr.
The Wall Street Journal, 04/22/08
Unfortunately, spiraling inflation costs are not the only headwind facing the energy complex as they also have to contend with geopolitics and geology as Jim Jubak from MSN Money explains below.
When oil rises above $27 a barrel, the Russian government takes 80% of any additional revenue in taxes. That means at $67 a barrel, an oil company gets just $8 more a barrel in revenue than at $27. If the price climbs to $107 a barrel, the oil company's revenue increases by just $16 a barrel from what it was at $27 a barrel.
That may delight U.S. consumers who believe oil companies are making obscene windfall profits from soaring oil prices, but it hasn't made companies eager to sink their money into developing new oil in Russia.
The production decline in Russia would be serious enough if it were an isolated problem. But it's not. The same conjunction of geology and geopolitics is crimping production in Nigeria and Mexico, for example.
In Nigeria, a third of the country's oil output by 2015 is at risk, energy advisers to Nigerian President Umaru Yar'Adua have warned, because the government hasn't been paying its share of the costs of joint ventures -- about $3 billion to date -- with Royal Dutch Shell, ExxonMobil, and Chevron. If the government's failure to pay jeopardizes the joint ventures, Nigeria can kiss plans to double its production goodbye. Instead, total oil and gas production will fall 30% by 2015. Where has the money gone that was supposed to go into the joint ventures? It's in the pockets of just about any Nigerian government official with any clout.
Mexico faces a similar shortfall in investment capital. The country's massive Cantarell oil field in the Gulf of Mexico is dying. Production fell 12% in 2006 and 18% more in 2007, according to data from the national Energy Ministry.
Mexico's total oil production, which peaked at 3.4 million barrels a day in 2004, fell to 3.08 million barrels a day in 2007. If trends continue, Mexico, the fifth-largest oil exporter in the world, exporting 1.9 million barrels a day, could become a net oil importer within 10 to 20 years.
Mexico does have ways to replace this production, but it will take money and technology. Developing the massive Chicontepec onshore field in eastern Mexico will require drilling 13,500 to 20,000 wells at a cost of $30 billion to $38 billion over the next 15 years, according to Pemex, the Mexican national oil company, because the oil occurs in isolated pockets.
But Pemex doesn't have the money to invest in drilling all these wells or for buying this pumping and separation equipment. As in Russia, the government has used the oil industry as a cash cow. About 40% of total government revenue in Mexico comes from Pemex. And as a symbol of the country's economic independence from the United States, Pemex is prohibited from signing joint-production agreements that would let the company trade oil for the technology and investment it needs.
MSN Money, 04/22/08
The geopolitics and geology highlighted by Mr. Jubak are leading to decline rates in oil production in mature oil fields all over the world, reducing available supply. The IEA's observed decline rates for non-OPEC producing countries from 2000-2007 supports Mr. Jubak's claims, with their findings presented below.
This periodic review of non-OPEC oil field decline rates focuses on mature crude oil and condensate fields showing sustained, yearly output decline over periods of at least 12-18 months. Aggregate decline rates are production weighted, and reflect mangaged, rather than natural, decline, according to prevailing investment levels. The results from 1999-20007 production data suggest aggregate non "OPEC decline of 7.7% per annum"
The mature producing areas of the OECD tend to show the sharpest decline. Depleted assets in the North Sea, Australia and offshore US all exhibit typical decline of at least 15% per annum (as indeed to parts of Mexico's offshore production, included here alongside non-OECD Latin America). Newer fields in these areas - often deepwater, smaller accumulations of oil - are also prone to rapid build to plateau, followed quickly by sharp decline.
Declining production rates coupled with spiraling industry-related inflation that is curbing real investment could not come at a worse time. The IEA now expects global demand growth for crude oil to rise 2.0% in 2008, that despite a slowdown in the U.S. The following figure below shows that Asia's 2008 demand growth exceeds the demand decline in North America by an 8.8 ratio, indicating Asia's is consuming 8.8 barrels more for every one barrel less coming from North America. What is also astonishing is the rapid growth in oil consumption in the Middle East, with the Middle East consuming more than four barrels for every one barrel decline in North American consumption.
Two of the dominant players in terms of growth in oil consumption are China and India, with both countries oil demand in January exceeding 2007 levels by a sizable margin with demand outside the five year range. The same can not be said of the U.S. where demand is at the bottom of the 5-year range for oil product demand.
Figure 7. India Oil Product Demand
Source: IEA - Oil Market Report (03/11/08)
Figure 8. Chinese Oil Product Demand
Source: IEA - Oil Market Report (03/11/08)
Figure 9. U.S. Oil Product Demand
Source: IEA - Oil Market Report (03/11/08)
As shown above, the headwinds facing the energy complex at a time of rising emerging market consumption growth is resulting in higher energy prices. Higher energy prices are fundamentally supported, though they may be temporarily overextended to the upside. As the IEA noted above, the world needs to start getting used to higher energy prices as the floor for oil keeps rising as its cost of production continues upwards. As energy prices continue to rise so too will bubble calls from the media who have continued to be as wrong in calling the top in energy as the bottom in housing. Do not be fooled, we are no where close to a top in energy.
The mania period for energy carried the sector from a 15.3% weighting in the S&P 500 in July 1978 to over 29% at its zenith in November of 1980. At the start of the recent bull market in energy, the sector had only a 5.3% weighting as of November 2003. With energy outperforming every sector since 2003 its weighting has increased by more than two fold to 13.3%, though still a far cry from the peak seen during the last energy bubble.
As highlighted over the previous two Observations in regards to the so-called "commodity bubble," hard assets are currently experiencing a secular bull market in the context within a secular inflationary environment that typically lasts for 20 years with the current period beginning in 2003. With the current secular inflationary trend still in its infancy, commodities can hardly be described as bubble as the still have a long ways to go as paper assets will continue to lose strength relative to hard assets.
During the mania stage in energy in the 1970s the sector's weight was nearly 7 times the weight of the financial sector. As the secular inflationary period that lasted from 1962 to 1982 ended and was replaced by a disinflationary environment, hard assets declined relative to paper assets with financials outweighing energy by more than a 4-1 ratio by the end of 2003.
Figure 11. Energy/Financials Relative Market Weight +/- 2 Std. Dev.
Despite the energy sector's relative outperformance this decade it still has not returned to its average weighting relative to the financial sector and is no where close to its previous mania high. For this reason as well as the underlining supply and demand issues, the energy sector is likely to retain its leadership relative to the broad market!
Translation: THERE IS NO BUBBLE IN THE ENERGY SECTOR!
At the close, the S&P 500 ended with a gain of 3.99 points to finish at 1379.93, with the DJIA ending higher by 42.99 to close at 12,763.22. On the NASDAQ, prices moved higher to gain 28.27 index points finishing at 2405.21, while the 10 Year Bond moved higher on the yield, with yields edging up by 1.0 basis point to finish at 3.73%.
© 2008 Chris Puplava