FIFTY DOLLAR OIL ANYBODY?

by Marshall Auerback
August 10, 2004

[Reprinted with permission of the author]

The President of the OPEC cartel unsettled the oil markets last week by blurting out something long suspected by a number of prominent independent energy analysts: namely, that Saudi Arabia, the world's largest exporter, could not increase production immediately to offset crude's seemingly relentless rise. The proximate cause for the historic surge above $45 per barrel for the first time ever was the ongoing conflict between the Russian government and the country's leading oil producer, Yukos. Although the heat appears to have been taken out of this particular dispute with the announcement by the Russian Ministry of Justice that Yukos could pay for its ongoing business from its hitherto frozen bank accounts, this has not stopped crude's relentless rise to new historic highs.

The stubborn strength of the oil price continues to defy most analysts' prediction of a return to the US$30/bbl level. The structural reason for high oil prices is clearly growing demand for oil in the fast growing developing world at a time when America still consumes around 25 per cent of world oil production, not "political instability", as conventional wisdom would have you believe.

The 10 members of OPEC excluding Iraq are operating close to full capacity, nullifying their historical ability to bring down prices by opening the production taps, or even merely threatening to do so. The result is that crude oil has risen some 35 per cent so far this year, 25 per cent in the last 6 weeks alone.

Until recently, it was commonly assumed that Saudi Arabia still had sufficient surplus production capacity to increase its output but, OPEC president and Indonesian energy minister, Purnomo Yusgiantoro, blurted out an unpleasant truth to markets long inured to the effects of substantially higher energy costs: there is little additional supply coming imminently from Saudi Arabia.

Of course, the Saudis themselves have sought to blunt the impact of this alarmist confession by continuing to insist that it would produce 9.5m b/d in August, sustaining production as high as 10.5m b/d if needed. But even a (highly questionable) promise to provide an additional 1.5m barrels per day of crude production is a thin reed on which to base continued forecasts of sub-$30 oil (the 10 year crude futures price of oil is $24 per barrel, 25 below current spot prices, reflecting the prevailing consensus that today's high prices are but a temporary aberration). This figure amounts to less than 2 per cent of total global production, which provides a minimal cushion against other possible supply disruptions.

Additionally, demand for oil has ensured there is barely a fraction of spare refining capacity left. As the Lex column of the Financial Times noted last Saturday, "Even if Saudi Arabia soothes supply worries by extracting more oil, a bigger problem may lie in making this oil usable."

There is also the manner in which such oil is being extracted, notably in Saudi Arabia, which is now giving rise to heightened concerns in the markets. Saudi Aramco, the country's national oil company, said last week that it had brought two fields into production earlier than planned, which would boost its planned capacity by 800,000 barrels a day. Unfortunately many contend that such increased production is largely the product of dangerous water injection extraction techniques, which deplete the underlying resource in a manner highly inimical to ensuring the field's long term sustainability.

Leading independent oil analyst Matt Simmons, who has conducted an extensive audit of many of Saudi Arabia's major fields, has been at the forefront in terms of expressing concerns that the Kingdom can no longer open the tap wider at its key oil fields as the world's "plug" producer in meeting steadily increasing world oil demand. He argues that giant oil fields, such as Ghawar, might already have peaked and could start into rapid decline in as few as three years. In a recent interview with Petroleum News Contributing Writer, F. Jay Schempf, Simmons disputed Saudi Aramco's claim that it has discovered 85 oil fields in the country and has so far developed just 23 of them, implying ample future oil supplies.

In the interview with Schempf, Simmons maintained that only a handful of fields accounted for virtually all Saudi Arabian oil production. The aforementioned Ghawar - the world's single largest oil field - has accounted for about 60 percent of all the oil the country ever produced, he said. Today, he added, Ghawar still produces about 5 million barrels per day of the current Saudi oil output of 7.5 to 8 million bpd. Five other fields produce the remainder, but it is fair to say that whither goes Ghawar, goes Saudi oil production.

Based on his analysis, Simmons contended oil supply would be constrained in the coming decade to an unprecedented degree. He, like Henry Groppe of Groppe, Long & Littell, and Colin Campbell, have long taken the view that exploration success in global oil has been in decline for decades and that the world has been living off of the major fields discovered literally decades ago. Recent exploration, all note, has gone in large part toward exploiting more effectively these major fields. As a consequence, the rate of depletion of these fields has increased, implying looming supply problems ahead. To a considerable extent this fall off in major exploration success has gone unnoticed because the large increase in the real oil price in the 1970's led to a significant decline in price elastic demand which has made oil supplies adequate and has kept oil prices stable at a level that is well below the peak levels of the late 1970's and early 1980's.

The so-called "depletion dynamics" thesis is not new. It has been associated with a group of futurologists called the Club of Rome and it was laid out in a book entitled "The Limits to Growth", written in the 1970s. The thesis was in essence a simple one. Commodity supplies had increased ever since the onset of the industrial revolution for two reasons: 1.) the discovery of new lands, and 2) improvements in production technology. These two factors led to a rate of supply expansion that, ex ante, exceeded the growth in commodity demand at any constant real commodity price. As supply must in the end equal demand, commodity prices had to fall in real terms to clear the market. The Club of Rome argued that, by the early 1970's, mankind in its search for resources had effectively scoured the globe. The easy to produce resources had been found and exploited. The supply of commodities would continue to increase due to technical progress in the production process, but the discovery of new lands would no longer help increase supplies of resources as it had in the past.

This Club of Rome effect is now widely recognized as having been operative in the U.S. gas market since the 1970s, but the collapse of oil during the mid-1980s gave rise to the perception of an endless glut of oil in the world. In fact, it is noteworthy that although there has been some production increase in Iraq, Iran, Nigeria, Canada, and the former Soviet Union, on balance, for most global oil fields, peak production was reached long ago and any new super giant fields (defined as over 5Gb of reserves) which have been discovered over the past 5-7 years will likely prove insufficient to offset contracting supply from existing mega-fields.

What is the state of these important existing mega-fields? There are four of them in the world today which produce over one million barrels per day. Ghawar, which produces 4.5 million barrels per day, Cantarell in Mexico, which produces nearly 2 million barrels per day, Burgan in Kuwait which produces 1 million barrels per day and Da Qing in China which produces 1 million barrels per day. Mounting problems at Ghawar, the largest oil producing field in Saudi Arabia, appears to be the key new variable currently roiling the energy markets.

Today the world produces 82.5 million barrels per day which means that Ghawar produces 5.5 percent of the world's daily production. Should it decline, there would be major problems. Although the Saudis have persistently claimed that Ghawar is capable of producing a further 125 billion barrels, the claims are being met by growing skepticism in a manner which suggests increasing acceptance of the depletion dynamics thesis. Notes the Aberdeen Press & Journal Energy:

It seems a growing number of analysts are falling into line with the Simmons & Company International view that Saudi Arabia may be running out of steam and may not be able to perform the role of global swing producer for many more years, despite being credited with oil reserves in the order of 260 billion barrels. The Centre for Global Energy Studies hinted at the beginning of the year that the kingdom appeared to be heading for difficulties. Now one of its analysts has said that having reserves does not equate to production capacity. Citing the Haradh field, he said it required 500,000 barrels per day of water injection to get out 300,000 bpd of oil. Moreover the problem is even more serious in the Khurais field.—"Doubts grow about Saudi As Global Swing Producer," Aberdeen Press & Journal Energy, April 5, 2004

In layman's terms, Matt Simmons maintains that the Saudis have instituted huge waterflooding programs relatively soon after completing field development at Ghawar in order to maximize production:

All of these fields are old, but Saudi Aramco has managed them in a 'gold standard' fashion by instituting careful and rigorous water injection to maintain very high reservoir pressures. They're effectively sweeping the reservoirs until the easily recoverable oil is gone. In so doing, they have defied the standard decline curves. With water injection, they've maintained reservoir pressures above the bubble point. The trouble is, once they finally finish the sweep, they've done both primary and secondary depletion. There isn't any Act 2. —"Simmons Hopes He's Wrong" - as quoted in Petroleum News, F. Jay Schempf

No Act 2, especially if one assumes that the official supply/demand data on the oil market is incorrect. Until recently, the market consensus, which has been continually shocked by each successive rise in the oil price, has attributed the rise to several special one-off factors, but has not tended to question the official statistical framework for the market from the IEA. However, there is, as we have pointed out in these pages before, an alternative view. Henry Groppe, of Groppe , Long & Littell, has analyzed the global oil market for almost four decades. Henry has called many of the major turning points in the oil market over the last three decades, is widely esteemed, and is quite close to the current US administration. Groppe has a very bold thesis on the current oil market: the IEA data which everyone accepts is very wrong, supply is overstated, demand is understated, the market has been and is currently in deficit, and global inventories are falling.

The work of Simmons and Colin J. Campbell also seem to lend support to the notion that the IEA erroneously projects a market that is well supplied and implies higher inventories than may not in fact exist, as does the poor historic record of the IEA itself. Past IEA published supply/demand data from the 2000-2001 period implied a cumulative increase of global oil inventories of 2 billion barrels. Not only should this increase have shown up in visible stocks; it was not physically possible to store such a high increase in global oil inventories. In the words of GLL:

Chronic overstatement of production has become deeply rooted in the press and in Oil Market Report (OMR) published by the International Energy Agency. The infamous 'missing barrels' - large increases in stocks outside the industrialized world - are the result of that practice.—Oil Statistics, February 2001, Groppe, Long & Littell

In other words, supply/demand data have been skewed by an accumulation of relatively small data errors over a long period of time, leading to a highly flawed statistical framework, on which most oil analysts continue to base price assumptions, which have persistently proven to be too low.

Last week, the Dow fell to its lowest level of the year. It might be the case that the markets are finally beginning to assess the unpleasant economic ramifications of a world no longer swimming in cheap oil. Because investors are no where near to digesting the full implications of this analysis, the markets have become becoming increasingly rattled as the reality of perpetually higher energy prices begins to seep in. OPEC, particularly Saudi Arabia, is clearly losing the battle to maintain control of oil prices. Matt Simmons and others have begun to sound the alarm: what the Saudis are attempting to giveth, geology taketh away.