Oil Rises, Oil Falls
The History of Oil Meets the Perfect Energy Trifecta
by James J Puplava CFP, President & CEO, PFS Group. January 28, 2009
F rom the drilling of the first oil well in 1859, the oil industry has been locked into a perpetual boom-and-bust cycle. During the early days booms and busts were brought on by dramatic swings in the supply vs. demand equation. Generally, "get-rich-quickers" were in a race to find and produce as much oil as possible. The market for oil—mostly for lighting, although naphtha, benzene, gasoline, and paraffin also had limited markets—grew at an extraordinary rate, but the amount of oil reaching markets grew even more rapidly, resulting in wild price swings and frequent collapses in the market. It was the wild price cycles driven by overcapacity that drove John D Rockefeller to singlehandedly consolidate the industry in 1870. To Rockefeller, the production of oil was risky, volatile, and far too speculative. In an effort to eliminate cut-throat pricing, overcapacity, and lack of profits Rockefeller created in effect the first "integrated oil" company—Standard Oil of Ohio—and spent the next few decades buying up the competition, as well as seeking vertical control of US oil production, refining, and shipping industries. By 1878, Standard's control of the US oil market was almost total: it represented 90% of US refining capacity: Standard was no longer victim to the vagaries of supply vs. demand pricing, or the greed of inexperienced oil well owners.
Rockefeller's stranglehold on the oil industry lasted long enough to make him an extremely wealthy man, but by the late 1890s, anti-trust/anti-monopoly sentiment against the company was on the rise. Although global competition and new discoveries from Baku, Azerbaijan to Spindletop, Texas had been challenging Standard's iron grip on the industry throughout the early 1900s, the final blow to Standard Oil came in 1911, when the US Supreme Court required the company to be broken up into 34 smaller, independent companies. It would not be until the formation of the Organization of Petroleum Exporting Countries (OPEC) in 1960 that similar attempts would be made to control the price of oil. Instead of an amalgamation of companies under one umbrella that controlled pricing through elimination of competition and vertical control of the oil production, refining, and distribution process, OPEC was/is a cartel of oil-producing countries. Like Standard Oil, OPEC would face the same challenges to its pricing control from new discoveries, this time from the North Slopes of Alaska (Prudhoe Bay, 1968) to the North Sea (Ekofisk and Montrose, 1969; giant Forties, 1970; Brent, 1971).
The combination of new discoveries, energy efficiencies, along with the supply/demand rhythms of business cycles (recession-->recovery-->prosperity-->contraction) kept oil prices in a narrow trading range between $10–$20 a barrel for close to two decades. Despite the formation of OPEC, the largest business in the world has been incapable of taming the price of the principal product it produces. For the most part, the oil industry has settled for being a "price taker" rather than a "price maker."
It has been 150 years since "Captain" Edwin L Drake drilled the first commercial oil well in Titusville, Pennsylvania. The energy industry has matured. It has become highly sophisticated, employing advanced technologies instead of the "seep wells" of the early days. We know a lot more about finding and producing oil today then we did in Drake's day. However, despite the great technological advances that have been made, the industry still suffers from the boom/bust pricing cycles of Rockefeller's day. This is clearly evident after reviewing last year's dramatic rise and fall in the price of oil.
West Texas Intermediate Crude
We began 2008 with oil prices close to $100 a barrel. Oil prices rose rapidly during the first half of last year eventually setting a record high at $147 a barrel during the first week of July, a price very few thought was possible. In a single year the price of energy rose nearly 50%, than collapsed by 74% during the final quarter of the year. From reaching a low of $10 a barrel in 1998 until the apex in July of 2008, oil prices rose nearly fifteen-fold in only 10 years. From a record low to a record high, oil's price advance continued to confound the experts throughout its historic price run. A litany of excuses and scapegoats were given to explain its meteoric ascent. They ranged from the second Gulf War, to terrorist attacks, to weather, to the falling value of the dollar, to everyone's favorite—"speculators." The most common explanation given for oil's thespian rise was that it was due to speculators entering the market and driving the price up. Six months later, this still seems to be the common perception held by today's mainstream media from CBS's 60 Minutes to FoxNews' The O'Reilly Factor.
West Texas Intermediate Crude
However, it is clear from reviewing a chart of oil prices over the last decade (above) that something else was occurring beneath the surface. The real price driver was largely due to fundamental supply and demand factors. The demand for oil was growing faster than the supply. What was driving demand was that the world economy expanded at its fastest pace in decades, led by explosive growth in emerging market countries. From 2004 to 2007 world economies grew by close to 5% per year with a concomitant growth in oil consumption of 3.9% per year (Interagency Task Force on Commodity Markets, "Interim Report on Crude Oil," July 2008, p 3).
While demand grew by 3.9% per year, supply struggled to keep pace with demand. Non-OPEC supply growth slowed, OPEC's spare capacity shrank, and OECD (Organization for Economic Co-operation and Development) oil inventories fell. As a result any new supply disruption from hurricanes, to refinery shutdowns, to geopolitical events, exacerbated an already tight supply chain resulting in price spikes.
Source: Interagency Task Force on Commodity Markets, "Interim Report on Crude Oil," July 2008, p 7, figure 1; data source: Federal Reserve Board & International Energy Agency. World GDP aggregate weighted by world oil consumption shares.
In addition, as the imbalance between demand and supply grew, the persistence of this growing imbalance began to permeate market psychology. This led to upward pressure on prices and greater market reactions to any actual or perceived disruptions in available supply.
Two reasons supply failed to grow were 1) the lack of new discoveries and 2) the rise in world oil field depletion rates.
As the accompanying table illustrates, world oil discoveries peaked in the late 60s and have fallen in each succeeding decade. Recent discoveries have been fewer and smaller in size.Oil Field Discoveries
Excludes Russia, Saudi Arabia, Iran, Kuwait, UAE, Iraq
Source: Matthew R Simmons, "Peak Oil: Is It Real? When Might It Occur?," presentation to Northern Trust Bank, Vero Beach, FL, 27 January 2008, p 34
There are 70,000 oilfields in production worldwide; however, the bulk of our production comes from 20 super-giant oilfields, which account for over 25% of daily world production. Of even more concern, the vast majority of these fields were discovered 50–70 years ago.
In addition to the dearth of new discoveries, depletion rates are rising as old fields mature and decline. Remember, newer discoveries over the last two decades have been fewer and smaller, and many of them have been offshore. Smaller oilfields and offshore oilfields deplete at much faster rates than some of the "old giants."
In its latest World Energy Outlook, the International Energy Agency (IEA) estimated that the average observed decline rate worldwide is currently 6.7%, and is projected to increase to 8.6% by 2030. Decline rates for the super-giants are 3.4%, 6.5% for giant oilfields, and 10.4% for large fields. Moreover, natural decline rates (a natural decline rate strips out ongoing investment in new production) are estimated at 9% for post-peak fields. The implication of these large and accelerating decline rates is alarming: "The implications are far-reaching: investment in 1 mbd of additional capacity—equal to the entire capacity of Algeria today—is needed each year by the end of the projection just to offset the projected acceleration in the natural decline rate" (p 43).
Source: IEA, World Energy Outlook 2008, p 239
In order to arrest natural decline rates in maturing fields the IEA estimates it will require a cumulative investment of $26 trillion (in 2007 dollars) between 2007–2030. This investment is necessary to counter natural decline rates in existing fields and to meet rising demand. Given the precipitous decline in oil prices over the last four months major investment seems unlikely with integrated oil companies and national oil companies announcing cutbacks in capital expenditure (capex) over the next several years.
The IEA, which completed a comprehensive study of 800 producing oilfields, accounting for the bulk of the world's oil production, began and ended its study with the following conclusion: "The world's energy system is at a crossroads. Current global trends in energy supply and consumption are patently unsustainable—environmentally, economically, socially…. Time is running out and the time to act is now" (p 37, 49).
Whether you have read the recent IEA World Energy Outlook 2008 report, Dr Roger H Bezdek & Dr Robert L Hirsch's "The Peaking of World Oil Production: Implications, Opportunities & Pitfalls," Oil Shockwave, or the works of Matthew R Simmons, one unmistakable conclusion is clear: the world is running out of time and cheap energy.
Oil Shock, Record Oil Prices Ahead
I now want to address the reasons behind the recent price run-up experienced in this decade and why I believe we are headed for another oil shock and record oil prices in the years ahead.
In reviewing oil prices over the last two decades, oil has tended to rise by an average of 25% following a year of decline. This has tended to hold true for most of the last two decades. However, by the beginning of this century oil prices started to deviate from past price patterns. After following a decline of -25.97% in 2001, oil prices rose for six consecutive years.
This deviation from past price patterns was the first clue that something different was developing in the energy markets.
The combination of years of underinvestment, lack of discoveries, accelerating depletion rates, and rising demand all contributed to the dramatic rise in oil prices over an extended period of time. Furthermore, the costs associated with discovering and producing oil also accelerated steeply, with the industry experiencing double-digit annual cost inflation. In addition, the production of conventional oil began to flatten and then decline. To make up the difference between growing demand and flattening conventional oil production, the industry filled the gap through natural gas liquids, biofuels, refinery gains, and by occasional liquidation of inventory/stockpiles.
Today the gap between conventional oil production of 73 mbd and total consumption of over 85 mbd is made up by unconventional oil. This introduction of non-conventional oil has raised the energy industry cost curve.
Oil YOY% Image Source: Bloomberg
Click here for full size imageSource: IEA, World Energy Outlook 2008, p 218
The cost of CTL/GTL (coal-to-liquids/natural gas-to-liquids) ranges between $40–$120 a barrel. Deep water and ultra-deepwater oil can cost upwards of $65–$75 a barrel. Oil shale costs estimates range between $50–$100 per barrel. Extra-heavy oil and oil sands production costs range between $40–$80 a barrel, and enhanced oil recovery can range between $30–$80. The Middle East and North Africa are two of the few places left globally where conventional oil costs typically range from less than $10 to a high of $40 per barrel (IEA, World Energy Outlook 2008, p 215–219). The Middle East is one of the world's last remaining reservoirs of cheap oil, and many of its giant fields are dying out.
The combination of declining oil discoveries and declining conventional oil production and the increased use of unconventional oil raised the tipping point for oil pricing. From 2004 through the first half of 2008, the world experienced a precipitous rise in the price of oil. This was driven by strong emerging market demand growth against a string of supply disruptions and increasing declines from mature oil fields. Beginning in 2004 as demand began to outpace supply, sharply higher prices were necessary in order to take demand out of the system and keep the markets in balance. An unbalanced oil market combined with a series of supply disruptions from refinery shutdowns, severe cold weather, to civil unrest in Nigeria led to price spikes and record oil prices. From 2004 on, price became the demand limiter leading to declining demand in OECD countries once oil broached $100 a barrel. Prices reached their extreme limit during the first half of 2008 with oil prices peaking during the second week of July.
The second half of 2008 was the flip side of the first half of the year. Instead of supply disruptions financial disruptions triggered a wave of deleveraging in the financial markets. A series of policy mistakes led in rapid succession to the government takeover of Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers and AIG, and the shotgun weddings of Merrill Lynch, Washington Mutual, and Wachovia. As financial institutions failed or were merged the credit system began to freeze up. Credit spreads blew out and volatility in the markets reached record extremes. By the fourth quarter the sharp deterioration in credit conditions spilled over into the general economy. There was a paradigm shift in the markets, which moved from a focus on supply disruption to a focus on demand destruction. Market psychology had changed overnight. Markets were now concerned about the impact of economic uncertainty on the energy markets, rather than on the fragility of the supply chain.
As the impact of credit paralysis spilled over into the general economy, the headlines were filled with economic reports that pointed to a sharp drop-off in global economic growth (and, by association, in energy demand). The financial media became obsessed with demand destruction as a means of explaining why oil prices fell 74% in the final months of the year. However, something didn't add up. It took nearly a decade for the price of oil to climb from a low of $10 in 1998 to its peak of $147 a barrel in July of 2008. The price rise was gradual, relentless and prolonged. As Matt Simmons recently pointed out in "2008: A Wild Ride for Oil Markets" (not-yet-published white paper, quoted with special permission), "There are no factual statistics to rationalize this drop. None! A probable immediate impact of the credit freeze, which coincided with oil prices falling, certainly caused some key oil trading firms to liquidate many oil paper contracts. This is the only plausible, but still unproven, answer for why prices could fall by 74% in such a short time" (p 9).
Traders, financial pundits, analysts, and media talking heads became obsessed with the idea of demand destruction. They focused on future demand reductions by the IEA, the EIA and OPEC. Buried in the headlines was the IEA's increase in global depletion rates to 6.7%, with natural declines rates of 9%. The IEA's admonition that the world's energy system was at a crossroads and unsustainable with time running out went largely unnoticed. A cacophony of lesser-informed voices drowned out the warning.
It seems hard to conceive that a decade-long advance in oil prices driven by relentless demand and struggling supply could have been abruptly brought to an end. Has demand fallen to such an extent as to justify a 74% decline in price? If it is widely believed that speculators were behind oil's spectacular rise then are they behind oil's precipitous decline? If the decline in consumption is estimated to be 2–2.5 mbd then oil depletion rates alone would bring demand and supply into balance. If global observed depletion rates are running 6.7% with natural depletion rates as high as 9%, has demand fallen by a similar percentage globally?
If demand has fallen faster than worldwide depletion rates what about supply destruction? The industry's "all-in" marginal costs, which include cash production costs, capex, taxes, and return on investment, are still above $85 a barrel according to industry experts. Even with lower input costs the geological elements haven't changed. I haven't read anywhere where governments are reducing production and export taxes. With government revenues in decline politicians are considering raising energy taxes, not reducing them.
As a result oil prices below $60 a barrel is leading to reduced capital spending by the energy industry on long-term investments. A fall in oil prices to $40 will only hasten capex reductions. Declines to $30 will lead to shut-ins, which approach cash operating costs for a sizable amount of production. According to IHS Herold, capital spending by exploration and production companies is expected to decline by 13% in 2009.
From the desert sands of the Middle East, to the Canadian oil sands in Alberta, to the Barnett shale in Texas, oil companies are cutting back on production, curtailing existing projects, or delaying new investment plans. Since mid-summer Saudi oil output has fallen by 2 mbd to 7.7 mbd. In addition to production cutbacks the Kingdom is also delaying bidding on construction of two new refineries that it has partnered with ConocoPhillips (COP) and Total (TOT) to build. At a time when the IEA is calling for annual investments of $350 billion a year in upstream investments, the industry is cutting back. At the same time field-by-field declines in oil production are accelerating.
The situation today harkens back to 1998 when oil prices fell by almost 50%. The Asian crisis of 1997 was followed by the failure of Long Term Capital Management and Russia's debt default in 1998. The perception in the markets at that time was that the world was awash in oil. The front cover of the March 4th, 1999 edition of The Economist featured a story "Drowning in Oil." The Economist predicted that over-production by Gulf states could send the price of oil crashing to as little as $5 a barrel.
Source: "The Next Shock," The Economist (print edition), 4 March 1999
The magazine also pointed out how modern economies were less dependent on oil. Yet instead of crashing, oil prices rose fifteen-fold and demand grew by over 25% over the next decade.
Today perceptions abound that the world is once again awash in oil. Numerous references are made to a collapse in world oil demand in the fourth quarter of 2008 as an explanation for the plummeting price of oil during that time. This misperception is reinforced by recent downward projections by the IEA, EIA, and OPEC. There is near-hysteria in the commodity trading pits over the buildup of oil inventories at Cushing, Oklahoma. The current 33 million barrels of oil stored is higher than the norm, with a buildup of over 18 million barrels in the last quarter. However, in the grand scheme of things Cushing inventories are insignificant in comparison to other major grades of crude such as Brent and Dubai.
The recent inventory build at Cushing reinforces the developing oil glut story. The market seems obsessed with the Cushing inventory build, with numerous stories circulating that trades are being made in the front month, and sold simultaneously in the far month with oil being stored on tankers or at Cushing. Bloomberg recently reported that Frontline Ltd (FRO), the world's biggest owner of supertankers, said 80 million barrels of crude oil are being stored in tankers, as traders seek to take advantage of higher prices later in the year. If this is the big story that traders are making it out to be, then why aren't tanker rates rising? Ed Hyman's International Strategy & Investment Group (ISI Group) did a study of the contango/storage story and found that tanker rates continue to decline around the globe from the US Gulf to Singapore.
Currently West Texas Intermediate Crude (Texas Light Sweet) oil prices are trading at a steep discount to other grades of crude such as Brent, so there is an economic disincentive to bring new supplies to Cushing. According to ISI Group "supercontango" reflects situations where there is excess near-term crude supply. A supercontango is resolved from supply reductions (i.e. OPEC production cuts). In regards to the recent contango extremes, looking back over the last two decades contango extremes have historically coincided with oil price bottoms. ISI Group concluded that the extreme fall in energy prices over the last quarter is more reflective of a major fund or group of funds deleveraging than it is a demand destruction or supply glut story; a similar conclusion was reached by Matt Simmons. To quote Matt: "In reality, it is extremely expensive to actually buy physical oil and store it. Moreover, the world has few empty tank farms to suddenly start filling up with oil. Reports of armadas of tankers sailing the high seas loaded with oil are always true because countries around the globe import over 40 million barrels of oil from afar daily. But almost all of this oil is being delivered oil [stet] to refineries, not speculators storing excessive oil" ("2008: A Wild Ride for Oil Markets," p 3).
In summary, the markets are once again making the same mistakes of the past two decades in assuming demand destruction is a long-term trend and that the world is awash in oil. While global demand may have fallen, governments around the globe are pulling out all the stops to reinflate their economies through massive monetary and fiscal stimulus programs.
Amounts counted as share of GDP include stimulus packages and money committed to bank bailouts. Guarantees without money set aside are tallied separately.
Source: Peter Coy, "Enough Shock Treatment?: The risk to the global economy is that governments will do too little," BusinessWeek (print edition), 1 December 2008, pp 26–27; online edition "Fighting the Global Slump: Less Is Dangerous," 20 November 2008
While governments make every effort to stimulate demand, supply destruction is accelerating through natural depletion and through sharp cutbacks in capex spending.
Another factor is reasserting itself, which is climate change. At the American Geophysical Union in San Francisco last month, Western Washington University professor Don J Easterbrook, PhD made the strong case for another cycle of global cooling. According to Easterbrook there have been 23 periods of climatic warming and cooling over the last 500 years. Each warming and cooling cycle lasted 25–30 years (average 27 years). Recent measurements of global temperatures suggest a gradual cooling trend since 1998. According to his research, the cooling trend will be reinforced as the sun enters a cycle of lower radiance and the Pacific Ocean changes from its warm mode to its cool mode. NASA recently announced that the Pacific Decadal Oscillation (PDO) has shifted to its cool phase, virtually assuring several decades of global cooling. NASA reinforces Easterbrook's assertion on a trend towards global cooling. A global cooling trend will translate into greater energy use through the use of heating oil and natural gas to keep homes warm. ("Solar Influence on Recurring Global, Decadal, Climate Cycles Recorded by Glacial Fluctuations, Ice Cores, Sea Surface Temperatures, and Historic Measurements Over the Past Millennium"; see also US Senate Minority Report: More Than 650 International Scientists Dissent Over Man-Made Global Warming Claims: Scientists Continue to Debunk 'Consensus' in 2008," 11 December 2008.)
Click here for full size imageSource: Don J Easterbrook, "Global Warming and CO2—Are We Headed for Global Catastrophe in the Coming Century?"
What is shaping up is the perfect energy trifecta: rising demand, declining supply, and cooling global temperatures.
During the next energy up-cycle prices are set to rise dramatically, and are likely to surpass the records set in July of 2008. The energy price curve is being reset as a result of accelerating depletion. Whereas in the recent cycle demand destruction did not occur until oil prices surpassed $100 a barrel, I believe this time around demand destruction will take place at much lower prices, perhaps in the $75–$85 range. The much-needed investments to slow down natural depletion rates are not being made. The industry's infrastructure is aging and rusting from the well bore, tank farms, pipelines, tankers, and refineries to drilling rigs. In addition, the energy workforce is aging and will have to be replaced by new geologists, engineers, and business executives. Where will the next energy employee crop emerge? University enrollments for geologists have declined over the last two decades.
What seems remarkable is that energy became the basis of the postwar developed economies. It led to the suburbanization movement in the latter half of the 20th century, both transforming our contemporary landscape and giving us our modern way of life. Today we are more dependent than ever before on oil to sustain us. Oil is embedded in our daily lives in so many ways. It is the lifeblood of suburban communities. It allows us to determine where we live, how we live, and how we travel. Oil is an essential component in fertilizer, which supports agriculture. It is used in manufacturing from chemicals to plastics, and it is an essential fuel in our transportation system. It has become essential in creating the modern conveniences of 21st-century living. The tragedy is that it is given very little thought. Only when its price rises are we reminded of its geological limitations.
Nearly a century and a half has passed since the first oil company offered its shares on the open market. In that time, huge strides have been made in energy production and refinement, yet those advances have been offset by the increasingly numerous, ubiquitous uses of oil and petroleum products in our daily lives. The pricing problems that beset the industry remain the same as they were in Rockefeller's day: the industry has never learned to tame the pricing cycle. The same boom/bust pattern persists. The industry, despite the creation of OPEC, remains a price taker rather than a price maker. By allowing the pricing mechanism to fluctuate as wildly as it does, oil is treated as an ordinary commodity rather than as a depleting resource. Therein lies the tragedy, since it distorts geological realities. Relying on markets to price energy has failed to alert us that our fuel tank gauges are broken. Unfortunately, it is going to take another energy shock to remind us that the geological clock is running out of time.
Acknowledgement - Cover graphic by Adam Puplava
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