oil, money &
Economists tend to think in terms of widgets. Key elements of their analysis is demand versus supply and equilibrium prices. There is always that " perfect" price where supply and demand comes into " perfect" harmony. In economic theory, we live in an ideal market economy. No outside forces like a planning board or political authority tell economic participants what to do. In this theoretically perfect world, the markets are free and competitive with no legal restrictions between buyers or sellers for goods and services. Government’s role in this perfect world is limited to defining and protecting property rights, enforcing contract law, and protecting people from fraud, while enforcing the rules of the game.
The Laws of Demand and Supply 101
Modern-day economics and analysis of the financial markets operate along this demand and supply continuum. It is one-dimensional in its theoretical precepts which often leads to misleading conclusions, distortions, and malinvestments in the economy and in the financial markets. Nonetheless, it is the world in which we live. It also provides us with much of the framework for our understanding of the economy and the financial markets. The demand curve isolates the impact of price on the amount of a product produced or consumed. Because the laws of supply and demand are one-dimensional, they leave out other elements that impact the supply and demand curve. This often leads to mistakes and failure to distinguish a change in demand and supply. There is no other area that illustrates this point more than the world of energy. Unlike the world of widgets where equilibrium is determined by a price that brings the forces of supply and demand into balance, the oil markets are multi-dimensional. As the diagram below illustrates, the oil markets include three other elements that impact the supply and demand curve and ultimately equilibrium, they are geo-politics, the financial markets, and geology.
Oil Markets Are Multi-Dimensional
In the financial world, the oil markets are too often analyzed in financial terms instead of demand fundamentals. Other factors that impact price -- politics and geology -- are seldom considered. Oil and gas are both economic and political assets. If politics were removed from the equation, the price of energy would be much cheaper and far easier to predict. Geology should not be a separate element in the equation. Plain and simple: the truth is oil and gas are depleting assets. Understanding the world of energy necessitates an understanding of the role that geology, financial markets, and politics play in influencing the supply and demand curve.
The energy markets are too often treated like widgets in terms of financial analysis. If prices rise, it is assumed that demand decreases and users of energy will find substitutes. To some extent this works in the short-run. Last year, we saw utility companies switch from natural gas to oil and other energy substitutes as the price of natural gas soared. As the price of natural gas rose, producers were provided with incentives to produce more natural gas, which ultimately led to higher supplies of natural gas. This increased supply in turn led to lower prices in natural gas. There were other factors that impacted the price of oil and natural gas. Milder temperatures and an economic recession also reduced demand for energy, which led to lower prices. So far so good. The economic model of demand and supply has provided us with an explanation of the rise and fall in the price of energy. This review of last year's prices could be explained according to the economic laws of supply and demand. And yet. . . the laws of demand and supply did not fully explain the sudden spike in the price of energy or the power shortages experienced in some parts of the country. That is because the price of energy is a confluence of not only supply and demand factors, but also geological, financial, and geopolitical.
I. GEOLOGY AND OIL
The Law of Depletion
What is missing from the demand and supply argument is the concept of depletion. Depletion is the gradual exhaustion of a natural resource through consumption. The concept of depletion has tremendous implications for our future world that could play havoc with world economies and ultimately, war or peace.
In the early 50’s the eminent geophysicist, M. King Hubbert, combined the principles of geology, physics and mathematics into a predictive model for forecasting oil production decline curves. Hubbert's predictive analysis was published in 1956. His model enabled him to predict that crude oil production in the U.S. would peak in the early 70’s and then go into decline. Hubbert’s predictions generated a lot of controversy at the time since it was widely believed that U.S. production would remain high due to new discoveries and the application of technology. Hubbert’s analysis was uncannily accurate. Oil production in the U.S. peaked in 1970.1 From that point forward, U.S. oil production went into decline. The U.S. would no longer be energy independent. From the early 1970’s to today the U.S. has become increasingly dependent on foreign sources of oil and gas to meet its energy needs. Since the 1970’s the U.S. began its transition from oil surpluses to oil deficits that have grown in each decade.
Hubbert: A Prophet of His Day
At the time of Hubbert’s prediction in 1956, many inside the oil industry rejected his conclusions. American oil production was continuing to grow. As the world’s largest exporter of oil, it was inconceivable to think that U.S. production would ever go into decline. Hubbert's critics were numerous, with many of them inside the oil industry. There had been many Cassandras before Hubbert’s time that had cried wolf. After Hubbert made his prediction, the industry actually grew instead of declined. So Hubbert was considered to be another false prophet. Hubbert actually made two estimates of when oil production would peak in the U.S.. His first estimate was that it would peak in 1965. His second estimate was for oil production to peak around 1972.2 His more generous estimate of 1972 was dead on. Actual production in the U.S. peaked in 1970. Hubbert could see what his peers could not: oil reserves were declining even though production was still rising. The production of oil, without replacing that production with new reserves, was leading to a decline in reserves.
Hubbert estimated world oil reserves at 1.8 trillion barrels. Since that time and including new discoveries, the estimate has been raised to 2.0 to 2.1 trillion barrels of oil. We now have data on world oil production going back to 1850. Colin J. Campbell of Petroconsultants has made a country-by-country estimate of the world’s oil reserves. His estimates match those of Hubbert at 1.8 trillion barrels. With updated data, there has been no significant bulge or dip in the world's production curve as originally estimated by Hubbert. Using production decline curves from known oil reserves, petroleum analysts using Hubbert’s methods have now been able to estimate the peak in world oil production. According to these estimates, world oil production will begin to peak between the years of 2004 and 2008. A few of the top geologists, including Colin J. Campbell, think that peak is in 2003. The point to understand is that we are depleting our oil reserves at an annual rate of 6% a year; while demand growth is growing at an annual rate of 2%. In order to simply keep even, the world’s oil industry would have to find the equivalent of 8% a year of new oil reserves from new discoveries. This is not happening. The world consumes 76 million barrels of oil a day. This oil is not being replaced.
There is nothing going on in the Caspian Sea, West Africa, or the South China Sea that would come close to replacing what we are now consuming. There aren’t any conservation measures like more efficient refrigerators, better gasoline mileage for autos, better insulated homes, or longer lasting light bulbs that could conserve enough energy to make up the difference between demand and supply. For that matter, there are no renewable energy projects on the horizon that could immediately help us to avoid a future energy crisis. Political leaders and the public are totally oblivious to this fact. They are not paying attention. Last year's energy crisis has now been forgotten. The news media explained the crisis in terms of industry price gouging, regulations, taxes, and distribution problems. No one is paying attention to world production declines in the U.S. or elsewhere. This means there is nothing that can be done now in order to avoid a future crisis. It takes years from the time of discovery of new oil to the time it is produced, shipped, and refined and consumed as energy. The oil that is discovered today won’t reach the markets for another 8-10 years. An unprecedented crisis is just over the horizon because of inattention and neglect.
Oil Takes Time
Oil is a scarce resource that has taken millions of years to form. Oil comes from very specific layers of source rocks. Without these source rocks, there is no oil. These rocks convert organic matter into oil with heat. Chemical reactions require time and temperature. For geologists, most of that work occurs deep below the earth’s surface at depths ranging between 7,500-15,000 feet. This range is known as the “oil window.” 3 In the early days, oil was discovered at much shallower depths because once oil is liberated from its source rocks, it can migrate to the surface to form shallow oil fields that often appear as surface oil seeps. These source rocks are often found in organic rich sapropels. These geological nutrient beds are formed intermittently over time. It is time that turns these organic-rich source rocks in the ground into oil. The catalyst is heat. The hotter the environment below the surface, the faster these source rocks produce oil. Unfortunately, nature has its own time clock and there is nothing we can do to alter it.
The point that needs to be understood is that finding large deposits of oil and then turning that oil into useable energy takes time. It is not a process that can be turned on and off at will. When demand exceeds supply and that supply is depleted, it presents problems that turn into an energy crisis. The problem we have today is that the issue of energy is still mainly understood from an economic perspective. Economists believe that energy is an economic issue. Throw more money at the problem and it will be solved. It goes back to the widget theory of supply and demand mentioned earlier. It isn’t that simple. Geologists look at the problem differently. Money doesn’t increase the supply of oil in the ground -- only nature does that.
World Production Estimates
Despite the accuracy of Hubbert’s analysis, his work has never been fully accepted by economists and politicians. The economic and political world still thinks in terms of widgets. The result is that the U.S. now imports over 60% of its oil needs and is heavily dependent on foreign sources of oil for its economic security. The truth is, we have supply ... it's just not in our own backyard. The economic debate has transformed the energy issue from a domestic one to an international issue with the same principles applied to an understanding of supply and demand in determining price equilibrium. Even though we disregard Hubbert's analysis, Hubbert’s method of analysis has been used to predict with a high degree of accuracy decline curves in energy production for the rest of world. U.S. production peaked in 1970, Russia in 1986, North Sea production could peak this year, China in 2005-2006, Mexico in 2007, and Canadian production could reach its peak towards the end of this decade. OPEC production is predicted to peak between the years of 2025-2030. However, non-OPEC supply will peak between the years of 2005-2007.4
Even with advanced technology and considerable dollars invested in finding new sources of oil, there have been no new major oil field discoveries. New oil deposits are still being discovered, but they are smaller, harder to find, and require more money and technology to extract the oil. This same condition exists for natural gas where despite significant new dollars invested and wells drilled, no significant source of supply has been brought on stream. It is true that technology has improved over the years allowing the industry to get at hard to reach reserves. However, that technology is also used to increase production output per well at a much faster rate. This has resulted in a much faster depletion decline curve.
What we are now seeing is acceleration in the depletion of our global resource base of crude oil and natural gas. Producing oil with no new discoveries lowers reserves. Each day of the year the world consumes approximately 76 million barrels of oil a day. That is 76 million barrels of oil consumed that isn’t being replaced by new oil discoveries. The oil industry is now producing twice the amount of oil that it is finding each year. Absent from the debate is that the discovery of new oil peaked in the 1960’s and that new oil discoveries fell below production by the late 1980’s. As stated, the economic and political world still thinks and talks in terms of widgets. If more money is spent and new technology is applied, then the supply of oil will increase as if there were an endless supply of widgets. Technology has played a role in arresting the decline in oil and postponing production declines. Enhanced recovery techniques, new seismic methods for finding oil, new drilling and fracturing methods have all helped to increase supply and recovery. But, these new methods have not created oil, nor have they increased reserves.
The Future Price of Oil
Technology hasn’t been able to detract from the predictive abilities of Hubbert’s models for oil production decline. The world is still running out of cheap oil. This will eventually lead to a new era in the pricing of oil and gas and all forms of energy. The price of oil will no longer reflect the simple laws of supply and demand that exist in a free market. To a greater degree, the price of oil will be based on monopolistic principles determined by a handful of producers located in the Middle East. As the margin of non-OPEC oil and gas production and reserves decline, the price of energy will steadily rise and be freed from the constraints of economist’s supply and demand models. Until we find a bountiful alternative to hydrocarbons, the world will be forced to pay whatever the monopolists demand.
II. THE SUPPLY AND DEMAND OF OIL
While the world has failed to replace existing production with new discoveries, demand continues to grow around the world. This table shows daily demand estimates from 2000 to 2002. Demand increased last year by a mere 100,000 barrels a day, one of the smallest increases since 1985. So even with the economies of the major industrialized nations stuck in recession, demand still grew albeit at a slower pace. Even with recession, there were still increases in consumption with isolated pockets of strength such as found in Japan, Korea, and in parts of Europe. In 2001, U.S. demand for oil was about even with the previous year. As I will show shortly, the drop in energy costs had more to do with weather and commodity speculators than it did any serious fundamentals of the energy markets.
As the table below indicates, supply by Non-OPEC countries increased slightly; while OPEC production fell sharply as a result of planned cutbacks. As the next table illustrates between 1998 and 2002(e), total non-OPEC supply, excluding the FSU, grew at less than 2%. The major source of supply is still OPEC and the FSU. They are the only major producing entities that are capable of filling a void in energy demand. This is setting the stage for conflicting market forces. There is upward pressure being exerted on oil prices through OPEC cutbacks and lower Iraqi output. This is contrasted by reduction in throughput from refineries because inventories remain relatively high due to reduced industrial demand for oil. Eventually, this will reduce inventory levels before another rebuilding cycle begins. So we now have reduced demand for oil by refiners that is being balanced by increased cuts in production from OPEC.
These are the short-term forces that are playing havoc with the price of energy. It needs to be repeated that demand is still rising even at a time of economic weakness. In addition to rising demand, that demand is being met with declining oil reserves. The daily consumption of 76 million barrels of oil a day isn’t being replaced. Nor are there new major discoveries on the horizon that will soon replace that diminished supply. What the world and its leaders are not seeing is what Hubbert understood back in 1956. Although production has increased slightly (less than 2%), reserves are still being depleted. So a major precious asset is consumed and no one sees it besides the scientists. All anyone knows at the moment is the price of oil in the markets and the cost of gasoline at the pump. No one is paying attention to the fact that reserves are declining and that major oil fields in Alaska, the lower 48 states, and the North Sea have reached their peak and are now in decline. The supply has been there when we need it, but that supply is coming from only one region of the world -- the oil fields of the Middle East and the Caspian Sea. Basically Russia and OPEC have bailed the world out of an energy crisis. They are the only entities with spare capacity that are capable of meeting excess demand. Until their oil wells run dry, these nations are going to have a major say in world economics. This influence will increase, creating a powershift over the next few decades as other oil-producing areas pass their peak production.
The Third-World Variable
There is a growing demand for energy that is coming from the lesser-developed regions of the world. These same regions are also experiencing the greatest increase in population growth. When you add the desire of growing populations of industrial countries to maintain their standard of living with those of the developing world, it isn’t hard to see that we face a crisis ahead of us. This desire for an increased standard of living coupled with a continuous rise in population growth is going to create an exponential demand on the earth's remaining energy resources. As the graph of the International Energy Agency (IEA) demand estimates indicates, demand for oil will continue to grow in each decade rising from today’s 76 mb/d of consumption to 96 mb/d by the end of the decade. By the end of the following decade, that demand will expand to 115 million barrels of consumption per day. By that time, all of the major oil fields in the world will be in decline outside the Middle East.
III. FINANCIAL MARKETS AND OIL
Price: A Conspiracy Theory
At the moment, the price of oil and natural gas is still determined by short-term supply and demand perceptions. Demand has been weakened by a global recession and milder weather conditions, especially in the U. S.. The market's perception is that there is a glut of oil and natural gas and there is an endless supply of both. So, energy prices have fallen. Price drives the market. Lower energy prices have caused the energy crisis to be forgotten. Many even believe the energy crisis never existed. When it comes to energy, and in particular in the U.S., cheap energy is viewed as an entitlement. Any increase in the price of oil and gas is viewed in conspiratorial terms. A rise in the price of energy, whether it is oil or gas, is most often not seen in depletion or geopolitical terms, but in light of conspiracies. They believe energy companies and their distributors are price gougers. The vast majority of consumers think that energy prices are rigged. The financial markets tend to think that if the price is down, then there must be more supply than demand. They believe the fallacy. The fact that the U.S. oil and gas industry has spent record amounts of money on oil and gas exploration, and has been unable to increase supply significantly, is woefully absent from the debate.
An Energy Bear Market
At the moment, prospects for another energy crisis have subsided. Energy prices have come down off their highs. California is no longer experiencing power outages or wrestling with a shortage in power. The energy crisis has long been forgotten. What a difference a year makes. Now instead of an energy crisis, we face a financial confidence crisis with Enron. However, the crisis in energy isn’t over. It has only temporarily receded contrary to those who have pronounced its demise. There have been four major price declines over the last decade: 1991, 1993, 1997-1998, 2001-2002. In each decline, the forecasters hailed the end of high energy prices and the growing insignificance of oil. In their view, the technology revolution had rendered energy to be of less importance to the economy. Technology would free us from its dependence. As it turned out, technology actually created new demands on energy as the Internet Revolution required more computers and servers to power it.
The Real Culprits: Weather & Speculators
In every one of the energy bear markets in the past decade, prices came roaring back, making the price declines short-lived. Even now as demand has weakened, prices are working there way back in oil as OPEC slashes production to counter a perceived weakness in demand. The steep falloff in energy prices was attributed to a decline in economic activity around the globe and especially in America, the largest consumer of energy in the world. However, as it turns out, it was weather and commodity speculators that were the major forces behind the drop in oil and natural gas prices. Weather was the dominant force behind moderating the demand for energy. The weather cycle in the U.S. with a cool summer and an unusually warm winter lessened the demand for natural gas and heating oil. This kept U.S. energy consumption in 2001 about even with the previous year. As the previous table indicates, due to colder weather conditions in Europe and in various parts of Asia, demand for energy actually rose. In fact, total demand for OECD countries was about the same; while demand actually increased for non-OECD countries. It has become apparent from observations of the above data that weather more than any other factor has a more profound impact on total energy demand. The change in the GDP of a country plays less of a role in terms of energy demand than originally thought. Industrial demand still plays a major role in the demand for energy, but it is weather that has become the more dominant factor.
Other factors contributing to lower energy demand that weren’t economically related were higher natural gas inventories from increased drilling activity the prior two years and lower electricity prices. Lower natural gas prices reduced the incentives to burn oil for power generation. Utilities reversed their fuel-switching pattern from oil back to natural gas as a result of lower natural gas prices.
The Speculator Factor
Another influence on the energy markets last year was the role of the speculator. As the graphs below show, speculative short positions (below the zero line) in all energy sectors grew disproportionately in relationship to demand fundamentals. By the Christmas season, non-commercial speculative short positions had reached close to 80,000 contracts. As these graphs indicate, speculators were short almost the entire year with a major increase in short positions during the fourth quarter of the year. This coincided with the steep plunge in energy prices as depicted in the graphs below these four oil and gas charts. As these contracts have unwound, the price of energy -- and in particular oil -- has begun to rise again. Non-commercial speculative positions for WTI on the NYMEX have been reduced from their peak prior to Christmas.
Traders' excessive short positions
contributed to lower prices
Speculators moved to increase their short positions throughout 2001 on the basis of a weakening economy. There were other factors that triggered speculation in energy -- chief among them was the perception that supplies had increased significantly. This had a lot to do with supply and demand estimates, which are imprecise. Surprisingly, despite the fact that energy is the world’s largest business, energy data is still imprecise. It takes a few years before most estimates are validated with actual data. Over the years, the difference between production estimates and actual demand has given way to an illusion of a glut in oil.
A Theoretical Surplus
The difference between what the IEA estimates as demand and supply and final data reports has created the so-called “Missing Barrels” phenomenon. However, no one can account for these surplus barrels. At one point, that surplus of missing supply got as high as 700 million barrels! It is the belief of many professionals in the industry that those reserves don’t exist. There aren’t very many places in the world that have the capability of storing such a surplus. Even the U.S., which has the largest storage facilities, can hold less than 300 million barrels. In the words of Matthew Simmons, "In retrospect, the 'Missing Barrels' were non-existent.” 7
Nevertheless, the commodity markets live and breathe on these estimates. Weekly inventory levels provided by the American Petroleum Institute (API) can move major energy markets as if they were gospel. These numbers are often revised even as soon as a week after being given out. Unfortunately, traders who eagerly await the next week’s numbers in formulating their trading strategy, ignore these revisions. As imprecise as these numbers are, the markets still trade by them. It is ironic that speculators and traders, rather than the industry itself, control the world’s largest business.
According to the IEA’s latest figures, we are once again experiencing theoretical surpluses that can’t be accounted for by known accountable inventories. These theoretical surpluses watched by traders and speculators move them to trade against excess theoretical supplies as shown in the short position graphs above. Last year's markets moved on the perception of a supply surplus that may not actually exist. Its very existence is questionable because the majority of that surplus has never shown up.
Source: The Weekly Trade Report, Randall Kippes, COTThe Undeniable Truth of Weather
These theoretical surpluses may actually help to set the stage for another energy shock that is directly ahead of us. We now have OPEC cutting back production and at the same time that Hubbert's Peak is rapidly approaching. The fact that another El Niño weather pattern is forming in the tropical Pacific could create weather patterns that directly impact energy demand. We could get warmer than normal weather this summer that is followed by colder winters in the Northern U.S.. The Southern Oscillator chart shown at left measures the results of the cyclic warming and cooling of the surface ocean temperatures of the central and eastern Pacific Ocean. The shades of red below the median line indicate the warming temperatures that could be the start of another El Niño weather pattern. The blue lines above the median represent La Niña or a period of cooling ocean temperatures. Although it is still too early to tell, it is worth mentioning. As discussed previously, the greatest impact on energy consumption is weather.
Natural Gas Variables
Like oil, natural gas prices have come down as a result of the perception that supplies are plentiful. Natural gas storage levels continue to be drawn down as the supply of rigs drilling for gas is removed from the market. Despite three years of record investment in new drilling for natural gas, well completions failed to surpass the record set back in 1981. Furthermore, natural gas storage levels never rose to above-average levels of the last decade. Inventory levels over the last thirteen years have averaged close to 3.1 trillion cubic feet of gas going into the winter heating season. This winter, those levels got as high as 3.3 trillion -- hardly a level that would suggest a glut of gas. In fact during a harsh, cold weather spell, demand for heating gas can increase by 25 billion cubic feet a day. One cold weather storm lasting several weeks or more could remove any surplus. The reason prices remained low was due to mild winter weather, a natural vagary of the energy markets. Weather is unpredictable and can change at any moment.
With natural gas prices back to below-average price levels, the number of rigs working and exploring for natural gas has come down sharply by 35% from their peak back in 2000. Gas well completions are down by 30% as a result. The fact that record expenditures and drilling failed to add significantly to reserves should provoke worry rather than complacency. All of this is occurring at a time when the U.S. aggressively pursues building gas-fired power plants to meet its future energy needs. It is estimated that 65,000 megawatts of new plant capacity will be added this year and another 45,000 next year. Instead of the winter heating season, the natural gas markets will now have to contend with summer heat spells and the demand from gas-powered air conditioners. Normally, natural gas stockpiles are replenished during the summer months in preparation for winter demand. Depending on summer temperatures, those stockpiles could be drawn down. This will limit summer injections in the future because supplies will be needed to meet peak summer demands. This could once again lead us towards another supply shock should next winter's weather prove to be less benign.
At the moment, what we do know is that the price of natural gas has come down off its highs and that long-term fundamentals are now improving. Demand is increasing; while supply is decreasing. However, due to unusually warm winter weather, inventory levels still remain high and will need to be worked off. This means in the short run that the high current storage levels that exist before the summer injection season begins may limit and force production curtailments. This could weaken the price of natural gas in the short run. Longer term the lack of significant production growth and the current reduction of drilling activity will result in declining natural gas production and consequently higher prices.
U. S. Demand Met By Foreign Supply in Natural Gas
In the case of natural gas, just as with oil, America’s voracious appetite for energy (5% world's population consumes 25% of the world's energy) is being met by an increasing supply of imports. Canada supplies about 15% of U.S. daily gas demand. Yet at a recent industry conclave in Calgary, the biggest question was, "Will industry production grow this year?" Like the U.S., Canadian natural gas production and supply forecasts are totally dependent on price and geology. Many producers are cutting back on capital spending because of the current price for natural gas. Moreover, companies are struggling to find reserves to replace production. Like the U.S., gas drilling in Canada has more than doubled to 8,000 wells per year with only a 10% increase in production. Canada doesn’t lack new gas discoveries, it is just that most of the remaining gas to be exploited is deeper and located in smaller pools. This makes its extraction more expensive and time consuming to bring to market. 8
Consolidation and Acquisition
Today, more companies are turning towards acquisitions to replace their diminished reserves. However, acquisitions will not increase the supply of oil and natural gas coming to the market. The fact that the industry is consolidating tells us a lot about the prospects for discovery. There aren’t many new elephant fields waiting to be discovered. (Elephants are production fields that produce 1 million bpd.) The peak in global oil discovery occurred during the mid-1960s. Most of the world’s oil basins were mapped during the 20 years following World War II. Most of the oil we are consuming today was discovered 25 years ago. During the 1970’s there were 15 oil fields producing 1 million barrels of oil a day. Today there are only 2 and they are located in the Middle East.
Source: Oil & Gas Investor, January 2002 Vol 2 No 1
The inability to find new major oil fields is why the industry is consolidating. There are no major projects outside the Middle East, the Caspian, and the South China Seas worthy of a major oil company’s consideration. So the big fish keep swallowing the mid-size fish while the mid-size fish keep acquiring the smaller fish. Exxon bought Mobil. British Petroleum bought Amoco and Atlantic Richfield. Chevron acquired Texaco. Conoco is merging with Philips. With the price of oil and gas down along with share prices, the big fish are using their cash to buy reserves through acquisitions. With valuations remaining or staying flat and the price of money remaining cheap, the majors could tap the bond markets to acquire a large E&P company. The big fish, like Royal Dutch or Exxon-Mobil, don’t need to tap the capital markets to acquire a mid-tiered company. They have the cash sitting in the bank. That is why investors should carefully consider their oil companies now in view of their ability to keep volume growth intact while maintaining their long-life reserves in an age of diminishing supply.
Once again, the current consolidation phase isn’t adding to reserves. It is merely reshuffling them into bigger pockets. The world’s oil and gas reserves are consolidating into fewer and larger hands. There will be a few large companies and a handful of nations that will control the world’s supply of oil and natural gas. All of this will occur at a time the world's emerging nations are industrializing; while their populations continue to grow. In 2000, China was the world’s second-largest primary consumer of energy and the globe’s third-largest consumer of petroleum products. In the last few years, China has gone from energy independence to a net importer of crude oil. China’s annual growth rate of oil production was 1.7% in the last decade; while its consumption grew at an annual rate of 6.4%. That is why it is moving to ensure its long-term security by building pipelines into Russia, Kazakhstan and Turkmenistan. At the same time, it is building up its blue water navy in an effort to secure the sea lanes from the Middle East.
The Pendulum Will Swing
At some point this year and in this decade, oil will become the fulcrum upon which the axis of war or peace will rest. Precious minerals have been involved directly and indirectly in warfare throughout much of human history. More often they have been the cause of war by nations that wanted these materials or took them by force. In the last century, oil played a key role in waging war. It was used as energy for the major weapon systems used in war like tanks, ships, and planes. Oil was behind many of the battles that were fought during World War I. To the victors of that war went the spoils of the Middle East. In his book, Environment, Scarcity, and Violence, Thomas Homer-Dixon cites a study by Arthur Westing, ”… There have been twelve conflicts in the twentieth century involving resources, beginning with World War I and concluding with the Falklands/Malvinas War. Access to oil or minerals was at issue in ten of these conflicts.” 9 I would add the Persian Gulf War to these conflicts to make resources the cause of eleven out of thirteen conflicts.
Scarcity Will Be The Source of Conflict
Of all of the resources known to man, none is more likely to provoke a major war between states in this new century than oil. The only other resource capable of moving states towards war is water. Modern industrialized states can’t survive without energy. In this case, that means oil. In the words of Homer-Dixon, ”…in the coming decades the world will probably see a steady increase in the incidence of violent conflict that is caused, at least in part, by environmental scarcity. Developing countries are likely to be affected sooner and more severely than developed countries. They tend to be much more dependent on environmental goods and services for their economic well-being; they often do not have the financial, material, and human capital resources to buffer themselves from the effects of environmental scarcities; and their economic and political institutions tend to be fragile and riven with discord.” 10 Homer-Dixon went on to describe five kinds of conflicts affecting these countries: disputes over environmental degradation, ethnic clashes arising from population migration, civil strife from scarcity that affects economic productivity, scarcity induced war over resources (i.e. water), and North/South conflicts between developed and the developing world. 11
Homer-Dixon’s Model For Conflict
Nonrenewable and Renewable Resources
Homer-Dixon breaks down natural resources into two distinct groups: nonrenewables which are minerals and oil, and renewables which include freshwater, forests, fertile soil, and the earth’s ozone layer. The key to understanding future conflict and the players who will wage it is to differentiate between the two kinds of resources. Renewable resources are mostly likely to generate conflict between smaller states, but they won’t lead to war. That is because these states have weak governmental structures with poor economies that do not allow them to wage war. The major wars of the future as distinguished from conflict are most likely to be waged by major powers over nonrenewable resources like oil. The only exception to oil regarding future wars between states is water which is necessary to all. However to wage war, a state has to have the means to buy, equip, and maintain an army -- and that takes money. Smaller states have resources at their disposal to wage war, but it will be a different kind of war as we are now seeing being fought by al Qaeda against the U.S..
The Future of War
These future wars are likely to originate in the Persian Gulf and Caspian Sea region. The current Middle East borders are barely 70 years old, an insignificant amount of time given the long enduring history of the region as the cradle of civilization. In the minds of many of the Arab countries that occupy the region, the region's borders remain fundamentally flawed. They are the artificial creations of foreign powers. This is one of the main reasons behind many of today’s border disputes in the Middle East. The region's geography of desert oceans that form featureless borders became hard to mark and delineate until the discovery of oil. Once oil was discovered, borders and boundaries became more important. A few miles "here and there" suddenly took on new significance when it would determine who would have an outlet to sea, control of an oil field, or possession of scarce water resources.
Oil is Geopolitical
This brings up another dimension to oil that isn’t factored into today’s modern economic laws of supply and demand. In the 21st century, oil is geopolitical. Oil isn’t a mere widget whose price can be determined by simple supply and demand equations. Oil is a depleting asset which will take on greater political dimension in the decades ahead. Oil was recently a source of conflict in the Middle East in the last war, and it may be again. The Middle East and the Caspian Sea contain the last major reservoirs of oil in the world. Nations will go to war to defend and gain access to that oil. Does anybody really question why the U.S. spends about $50 billion a year in order to maintain troops and warships in the Persian Gulf?
The Middle East is a geopolitical cauldron with the Caspian States on its eastern flank and the Mediterranean on its western flank. The Middle East is a geographical land bridge between Europe, Africa and Asia. All of the current wars' important battlefields are located within this region; from Iraq and Iran to the West Bank, and Somalia and Sudan. They will become more important as the U.S. War Against Terrorism enters its second deadly phase. The War Against Terrorism will spread to other regions of the Middle East this year. The President has already mentioned some of the possibilities.
The "Great Game" Continues
In this series' introduction, I wrote about "The Great Game” played in the Middle East during the 19th century culminating in the First World War. Now the next phase of that “Great Game” is about to unfold. This war will be about terrorism as much as it will be about oil. Many of the battlefields of this current war crisscross the boundaries of the Middle East and Asia. These territories are also the principal routes from which oil is produced and transported to various regions of the world. Shortly after the attacks on September 11th, an article appeared in the San Francisco Chronicle called “Energy Future Rides on U.S. War -- Conflict centered in world’s oil patch,” Frank Viviano wrote, “The defense of these energy resources -- rather than a simple confrontation between Islam and the West -- will be the primary flash point of global conflict for decades to come….” 12 These conflicts will come into sharper focus as we approach the inevitable decline of Hubbert's Peak which will see the rapid decline of western oil reserves. This coming conflict will be addressed in my next installment of Powershift Part 2: The Politics of Oil.
Currently the price of oil is rising again. The perception is that the U.S. economy will recover from recession and an economic recovery will generate increased demand for energy. Oil, along with natural gas and energy-related stocks are rising again. However, to attribute this rise to economic activity is to relegate energy back to the simple argument of supply and demand. As I have discussed throughout this installment, energy is multi-dimensional. There are other issues that drive energy over the long-term. The most important aspects are geological and then political. In the short-term, the price of energy is still driven by the actions of traders and speculators. The debate over energy is still confined to the realm of economics. Unfortunately, the politicians, the economists, and the public are still focusing on the markets and the price of oil. Those markets and prices are greatly influenced by the actions of traders and speculators whose decisions are motivated and driven by imprecise data. The warnings of petroleum scientists that the era of cheap energy is coming to an end are largely ignored. Writing in the Oil & Gas Journal, Ali Morteza Samsam Bakhtiari from National Iranian Oil Company states, ”Those still burying their heads in the sand and believing in the sacrosanct market forces are in for shattering shocks and some will pay dearly in the years to come for having been encouraged to accept these illusions." 13
Although those voices grow louder each day, they still go unheard as background noise. The larger focus is still the financial markets and the price of energy. Several key petroleum scientists like Colin Campbell, Jean Laherrere, and Kenneth S. Deffeyes have written thoughtfully on this coming crisis. They warn that we aren’t going to run out of oil. Instead they warn that oil supplies will soon peak and then begin a long, steady decline. Campbell and Deffeyes believe that decline will begin as soon as next year. To conclude in the words of Kenneth S. Deffeyes, “…it looks as if an unprecedented crisis is just over the horizon. There will be chaos in the oil industry, in governments, and in national economies. Even if governments and industries were to recognize the problems, it is too late to reverse the trend.” 14
What Can We Conclude?
In the short-term, the energy markets are controlled by immediate events and speculators. At the moment, another oil price war may erupt between Russia and Saudi Arabia over who will become the key supplier to the world's largest energy market -- the United States. Right now the two sides are at peace. That could change during the second quarter when Russian export cuts are due to expire. Another misperception that energy is influenced more by short-term economic growth may also come into question. If I am correct in my understanding that the U.S. economic recovery will prove to be weaker than forecasted, this could influence speculators to begin shorting energy again as they did during the second half of 2001. [See above series of 4 graphs.] So, the current price of energy could weaken rather than strengthen on short-term economic news and a developing price war between Russia and Saudi Arabia over market share with the U.S.. With today's unknown variables of weather, war, politics and the economy, volatility in the energy markets is going to soar -- perhaps even this year. For a better understanding of what is about to unfold, I would recommend reading the March/April issue of Foreign Affairs. It is a must read. 15
Some have felt a possible U. S. move on Iraq might cause oil prices to surge as they did during the Gulf War. That may happen, but not for the obvious reasons. President Bush has already secured an agreement with Vladimir Putin to access oil from Russia as a countermeasure against any possible threat from OPEC. The new agreement with Russia will act as a checkmate against threats of another oil embargo. This puts the U.S. in a better position to pursue its military objectives without the threat of an interruption in oil supply. Russian oil executives have been crisscrossing the ocean to Washington in an effort to cement and secure agreements to supply the U.S. with oil in case of war or higher prices caused by OPEC cutbacks. In addition to these agreements, western oil companies like ChevronTexaco, BP Amoco, ExxonMobil, Conoco, and Royal Dutch Shell are working with the Russia's government and oil companies to develop their oil fields with new investment and technology. Exploration and production are booming again along with the development of new pipelines.
This new goodwill may influence the energy markets to the betterment of the U.S.. OPEC may respond by countering Russian moves to take market share away from Saudi Arabia and other Middle East producers. Another oil price war may interrupt similar to 1986 and 1998. But Russia is much stronger today than it was back in 1986. It also has a more powerful ally in the United States. The Islamic world can also fight back, especially the terrorist element. Imagine what would happen if the Strait of Hormuz were blocked by the sinking of major oil tankers. This isn’t the mere fiction of a geopolitical thriller. Osama bin Laden has already threatened to do this. In his mind, the fair market price of oil should be over $100 a barrel.
In this installment's review of the oil markets, we have seen how it has been greatly influenced by short-term events like weather or the trading tactics of speculators. The oil industry has failed to extricate itself from having its business controlled by speculators in the commodity markets. This task will soon to be done for them through political and geological factors coming into play. The most important one is Hubbert’s Peak. Oil is a depleting and finite resource. Production of oil in the western world will shortly peak and then go into decline. That is when energy will be liberated from the supply and demand constraints of economists’ models. In the meantime, the geopolitical aspects of energy should soon move to the forefront -- the subject of my next installment of Powershift, “The Politics of Energy.”
is subject to geology."
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