FSO Editorials

$80 Oil, Here We Come!!!
by Bill Powers, Editor
Canadian Energy Viewpoint
November 4, 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 1970s. 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.

© 2004 Bill Powers, Editor
Canadian Energy Viewpoint
See Mr. Powers' Cover Page for Bio and Archived Editorials

Contact Information
Bill Powers
773-271-7574
Email
| Website

Information presented in this newsletter was obtained from sources believed to be reliable, but accuracy and completeness and opinions based on this information are not guaranteed. Under no circumstances is this an offer to sell or a solicitation to buy securities suggested herein. The editor may have an interest in the companies mentioned. All data and information and opinions expressed are subject to change without notice.

Contact Us | Copyright | Terms of Use | Privacy Policy | Site Map | Financial Sense Site

© 1997-2011 Financial Sense® All Rights Reserved.

The opinions of the contributors to Financial Sense® do not necessarily reflect those of Financial Sense, its staff, or its parent company.