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The
Crude Story, Part II
Brian
Trumbore
President/Editor, StocksandNews.com
Note:
What follows is a continuation of last week's piece,
more from our mystery analyst, a well-respected figure
who spends his days tracking the oil industry for
a large money management firm. This series is particularly
timely in light of the Yukos debacle and oil breaking
through $43 a barrel the week of 7/26/04.
This
time the analyst focuses on the supply-demand conundrum,
Saudi Arabia, and the outlook for prices. Some of
it is a bit technical in nature, but in editing his
extensive report, I wanted to give you a sense of
the real issues facing those doing research on this
fascinating and vitally important sector of the global
economy.
--The
Editor
---
I
am modeling 2005 global oil demand to grow at 1.5
mm b/d, which is significantly down from the torrid
2004 growth rate of 2.2 mm b/d. However, if there
is a risk in this number, it's that the number is
too low. I am modeling China's oil production to grow
at only 400,000 b/d day in 2005, down from the 600,000
b/d growth rate in 2004, but given what is going on
in China this number may again be too low. We have
consistently underestimated oil demand for China over
the last four years, to do it again in 2005 would
almost be predictable?.
My
analysis indicates that it is hard to see the global
oil market softening in the next several years. The
fundamental condition of weak, or little, non-OPEC
supply growth, coupled with demand growth which has
returned to its 30-year trend line, means that OPEC
capacity utilization will move to 100% in the next
two years. What prices will do is anyone's guess,
as we have never been there before, but my guess is
that higher prices will result. Based upon my modeling
I think that oil prices will average $40-$45 per barrel
in 2005, and $45-$50 in 2006. It is imperative to
keep all energy positions in place?.
With
the tremendous increase in oil demand that is occurring
in 2004, it looks as if we may reach 100% capacity
utilization in 2006. [According to my calculations,
we are currently at 97- 98% of capacity utilization.]
Because we appear to be nearing this point so quickly,
there are several important points to be made concerning
the size and nature of OPEC's production capacity.
1)
OPEC's capacity utilization outside of Saudi Arabia
is either at 100%, or very close to it.
2)
In the short term, little growth can be expected from
OPEC outside of Saudi Arabia. Oil production from
several OPEC members appears to have peaked, and they
are struggling to arrest production declines.
3)
Saudi Arabia's total pumping capability is somewhere
between 9.3 and 10.1 mm barrels per day.
4)
There are plans to bring on four new field developments
in Saudi Arabia in the next several years. Depletion
rates on existing production will offset these additions,
and it will be hard for the Saudis to show any sustained
production growth in the next five years.
---
OPEC
(ex the Saudis) has reached 100% capacity utilization
The
production capacity from the 10 OPEC countries outside
of Saudi Arabia looks to be 100% utilized. Presently,
the production from two OPEC members is in decline
and both cannot meet their quotas (Indonesia and Venezuela).
Seven other members are producing at, or above, their
quotas, and pumping near their estimated 100% capacity
utilizations. Although Iraq still has some excess
pumping capability, terrorist and related disruptions
call into question the sustainability of its current
2.5 mm b/d production rate.
Little
Short Term Growth Possible
Among
the OPEC members, only Algeria and possibly Libya
appear to have the ability to boost oil production
in the next several years. If western oil companies
are able to invest in Libya in 2005, we could see
some production growth in 2006. Over the longer term,
we should see growth in oil production from Iran and
Nigeria, although there seems little reason to believe
that production, given the lack of capital expenditures,
will grow in the next three years.
Kuwait's
production must be watched carefully. Over 90% of
Kuwait's production comes from the old (and giant)
Bergan field, which is showing increased water production
and some declines in production. Although Kuwait has
talked about opening up its north fields (along the
Iraq border) to western oil companies for development,
no plans have advanced, and the issue has gone quiet
in the last year. In the meantime, unless further
investment is made in either Bergan or in the north
fields, Kuwait will find it very hard to maintain
its 2.3 mm b/d pumping rate.
The
Saudis True Capacity
There
is a large debate surrounding Saudi Arabia's pumping
capability, but I think that basic arithmetic and
some historical insight, coupled with recent Saudi
statements, give us a good idea of what that rate
is. In the late 1970s, during the Iranian revolution,
oil production from Iran was disrupted for close to
a year. During that disruption, the Saudis were able
to pump a sustained 10 mm b/d. - at the time assumed
to be their maximum pumping capability. With oil in
the high $30s and with everyone believing that oil
was a scarce commodity, the Saudis had every incentive
to maximize production. I think it's reasonable that
the 10.0-10.2 mm production per day rate was most
likely their maximum rate.
Since
1980, only two factors have changed in the Saudis/
ability to pump oil. One factor has been the gradual
decline of the Ghawar field, the foundation of the
Saudi Arabia oil industry. Back in the late 1970s,
Ghawar's total pumping capability reached 6 mm b/d.
Since then, water production (a classic sign of field
maturity) has continued to increase, resulting in
declining oil production. According to Schlumberger's
"Middle East Reservoir Review," production from Ghawar
at the end of 2001, stood at "around 4.6 mm barrels
per day, down from 5 mm barrels per day over the past
year or so." From that statement, it appears that
Ghawar has lost 1.4 mm barrels per day in pumping
capability over the last 20 years. The second factor
is that during that same time period, the only new
field to come on-line has been the Shaybah field.
This field has been technically difficult to develop,
but has added 700,000 barrels per day to capacity.
Since
no other field development has taken place in Saudi
Arabia, (except for future projects which are not
pumping), my analysis shows that the country's current
pumping capability should be approximately 9.3-9.4
mm barrels per day (10 mm b/d in 1980, subtract 1.4
mm b/d lost in Ghawar, and add .7 mm b/d from Shaybah).
This, I should point out, is the rate at which, in
February / March 2003, the Saudis claimed to have
exhausted their capacity. All the numbers, combined
with what the Saudis said under pressure last year,
add up?.
Although
we don't know specifically what Ghawar's long-term
decline rate is, we do have a small piece of information
that I have used to construct a model of future Saudi
production. Earlier this year, Abd Allah Al-Saif,
Aramco's senior vice president for exploration and
production, confirmed that Saudi production has a
2% base decline embedded in it?.Even with production
ramp ups coming (from other fields), this will only
be enough to cover the depletion coming from the production
base.
Unless
the Saudis undertake further massive field development
projects, current planned expansions will do nothing
to lift total future pumping capability. As I mentioned
earlier, if demand next year increases by 1.5 mm b/d
and we have only 400,000 b/d day of non-OPEC supply
growth, then the world oil market will be operating
at 100% capacity utilization in 2006 - something it
has never done before.
Demand
and the Real Price of Oil
At
the current high price levels, the question about
whether these prices are high enough to induce economic
slowdown or recession becomes an important issue.
In 1973, 1980, and 1990, large increases in the price
of oil first prefaced economic slowdown, and then
recession. Could today's higher than expected prices
lead to economic weakness, causing demand destruction
and balancing the market at a significantly lower
equilibrium price - disproving my belief in a secular
bull oil market?
There
is general agreement over the way in which energy
shocks hurt the economy through, among other ways,
their effects on consumers' disposable income, and
corporate margin contraction with its related disincentive
to hire labor and invest capital. However, there is
little agreement over how much economic growth has
been lost because of the relatively high prices we
have been seeing, and whether these prices are high
enough to turn expansion into recession. Recently,
the European Central Bank increased its 2004 inflation
rate forecast to 2.1% from 1.8%, and a Dallas Fed
study predicts that .3% will be lost from U.S. GDP
over each of the next three years because of higher
oil and natural gas prices. Conversely, it is also
argued that oil prices are up because of increased
demand, not reduced supply; hardly a precursor of
future economic weakness and reduced oil demand.
Irrespective
of the size of the impact on it, in many ways the
U.S. economy is better prepared to deal with the effects
of higher oil prices than it was during previous price
shocks. There have been energy efficiency gains by
many industries such as the airlines (engine power
and efficiency increases) and even SUVs; fuel injection
and better transmissions increased their fuel efficiency
from 1990 to 2000 by 5%....
Recent
trends in U.S. demand point out that rising prices
have done nothing to curb demand. In the second quarter
of 2004, on the refined product side, gasoline demand
in the U.S. continued to surge 1.3% year-over-year
despite gasoline prices that are up 26% year-over-year?.
It's
useful to get a feeling for how high energy prices
(particularly oil and gasoline) need to rise before
we experience new highs in real dollar terms. Depending
on to whom you listen, the all-time high in average
gas prices is around $2.90 per gallon in today's inflation
adjusted dollars ($1.38 per gallon in 1981). $40 oil
is around half of the historic peak price of more
than $70 per barrel in 2004 dollars that occurred
in the 1970s. From a global perspective, remember
that in Europe, much of the oil price rise has been
negated by a weakening U.S. dollar. For the Europeans,
priced in euros, oil is barely above its four-year
average. I don't think that oil priced in the mid-thirties
threatens global expansion; I think current levels
are sustainable.
Risks
If
my thesis is correct that current oil prices are sustainable
and do not threaten future oil prices through demand
destruction, are there other risks to my bullish outlook?
Besides the possibility of exceptionally high prices
that approach the all-time highs in real dollar terms,
I believe there may be one risk to the price of oil
that no one is focusing on, and that is the price
of gasoline. To understand why this is so, it is important
to understand that U.S. gasoline consumption is the
single largest component of global crude oil demand
(12%).
Presently,
U.S. gasoline inventories, because of tremendous demand
growth in the first 6 months of 2004, are near record
lows. We are now entering the strong seasonal demand
period for gasoline in a very precarious position.
During this time, it is common to see demand for gasoline
jump by over a million gallons a day. Near record
gasoline imports from Europe have helped the U.S.
inventory a little, but anecdotally we are starting
to hear that European refineries are also approaching
full capacity utilization.
My
fear is that if the U.S. spikes gasoline prices this
year, say to $2.50 to $3.00 a gallon, this could eventually
curb gasoline demand. Although gasoline demand this
year has risen strongly in the face of rising prices,
at some point price elasticity must kick in. Given
that U.S. gasoline consumption is the single largest
component of total global crude demand, a drop in
U.S. gasoline demand would curb crude oil demand,
with a resulting inventory build. Under this scenario,
we would definitely see the price of crude oil fall,
especially since U.S. crude oil inventories have been
trending toward normal over the last six months. This
view is certainly not consensus, but nevertheless,
I see it as perhaps the only way that oil prices could
be knocked down through an economic slow-down (barring
a massive exogenous 9/11 type shock).
Although
this scenario is a potential risk to the price of
crude, I really don't think that this is going to
happen. I think that a combination of refineries operating
at full capacity, in addition to gasoline imports,
should enable us to get through a strong seasonal
demand period with adequate gasoline inventories.
It is more probably that we draw down crude oil inventories
through a combination of slowing non-OPEC supply growth
and strong global demand. In this scenario, the price
risk to oil is higher, not lower, with price spikes
above $50 quite possible.
Conclusion
I
am sure that if you put 100 investors in a room, and
asked them this question: "Will oil prices average
higher or lower in 2005 vs. 2004," 99 would say "lower."
However, my analysis says that oil prices could very
well be higher in 2005 and even higher in 2006. Little
research is being done on what the fundamental supply-demand
situation looks like in global oil markets in 2005
and 2006. Analysts have consistently overestimated
non-OPEC supply and have underestimated total global
demand. This error in analysis is still being carried
over into the analysis of the oil market in 2005 and
2006.
The
analysis and models (I have presented) point to an
oil market that will continue to tighten in the next
two years. Also, a new incorrect perception is developing
in analyzing the global oil market. I think that analysts
are overestimating the potential for Saudi Arabian
oil pumping growth and little research is being done
on what true Saudi Arabian oil pumping capability
is. My analysis says that Saudi Arabian oil pumping
capacity cannot grow significantly between now and
the end of the decade. Incorporating this research
into my models leads to a prediction that global capacity
in the global oil industry could reach 100% by 2006.
We have never been in this situation before. I believe
the risk to oil prices remains to the upside.
---
*Thank
you for understanding that I was unable to divulge
the source for the above. And, as always, I will continue
to express my own opinions on this topic in my "Week
in Review" column.
Brian
Trumbore
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