Crude oil prices, like many other commodities, are traded on world markets. This of course means that the prices are set by a balance between supply and demand. Markets fluctuate, and at any given time oil can be overvalued or undervalued, but over time the market will correct and average itself out. This is one of the the basic macroeconomic principles for ideal conditions, and historically, it has worked relatively well.
1In order to predict oil prices, one has to comprehend the supply/demand balance.
Demand In general, economists can assume that world demand is mostly independent of price. This is normally a good assumption because people will always need to heat their homes, transport goods, move people, and so on. Given this assumption, it's just a matter of forecasting global economic growth and the corresponding crude oil requirement for that growth. The assumption can fall apart under excessive prices, in which case we can do a price forecast and estimate demand accordingly. Either way, predicting demand for oil is a walk in the park compared to predicting the supply of oil.
Supply I would say there are three major factors when it comes to oil supply: Reserves, Recovery rates and Geopolitics.
- Reserves
Estimating how much oil there is thousands of meters below ground is at best pseudo-science. Especially when those reserves are beneath a seabed hundreds of metres offshore. Seismic technologies can give us a decent initial guess of the volumes in place. Once an exploratory well is drilled, a considerably improved estimate can be obtained using established logging, coring and testing techniques. Many areas in the world have not even been explored yet, but even if exploration in these areas began today, its oil would take over 5 years to hit the market and have no impact on short-term supply.
- Rates and Recovery
Even if we did know exactly how much oil there is in the ground, this tells us nothing about how quickly we can get it out and at what cost. Virgin reservoirs are typically produced in three stages:
- Primary recovery. Virgin reservoirs are at high pressures and produce at high oil-water ratios (lots of valuable oil, not much invaluable salt water). Some wells are termed 'gushers' because they initially flow without even being pumped. Eventually though, external energy is needed by pumps to continue the recovery process.
- Secondary recovery. As pressure decreases over time, pumping alone may not be sufficient to keep the well flowing economically. Fluids are injected into the reservoir to maintain pressure support (most commonly produced water). Most of the recoverable reserves are recovered at this point and at a relatively low operating cost.
- Tertiary recovery or Enhanced Oil Recovery (EOR). Eventually, the produced fluids are virtually 100% water with very little oil. The properties of the reservoir itself must be altered in order to unlock the residual oil trapped in the pores of the rocks. Any combination of steam and/or surfactants and/or other chemicals are injected into the reservoir to achieve this favourable alteration. Operational costs are high and recovery rates are low compared to primary and secondary recovery.
A useful analogy to the recovery stages is that of of drying clothes while doing laundry. No analogy is perfect of course but I think this one illustrates the important points quite well. I'll be coming back to this in my next post so I want to make sure it's clear. Click here to see the analogy.
- Geopolitical Stability
There are many regions of the world that have plenty of reserves with very favourable recovery conditions that have yet to be tapped. Many of the untapped reserves are also in places with high geopolitical instability. Not only can this interrupt supply, it deters investment and also creates a 'fear premium' on the price. Even in politically stable areas, oil exploration can be restricted for both social and environmental reasons.
Do the fundamentals support the current prices or not?!?This is still the subject of much debate. Here are the three basic perspectives:
- Oil is overpriced. This group of people think the market is well-supplied and high prices are mostly due to a very large geopolitical risk premium added to the price by speculative traders. Given the rapid rise, the price escalation is a bubble that will ultimately burst in the form of a market correction. They believe new discoveries and technology will help supply meet world demand for the next 40 years or more.
Support: An article last month inferred that oil prices rose after news that pirates attacked a Japanese oil tanker resulting in "hundreds of litres of oil" being spilt. To put that into perspective, 1000 litres of oil is less than one hundred thousandth of a percent (0.00001%) of daily world crude production. There's absolutely no reason something that small should effect prices. Also, check out Wall Street's crude ways by David Weidner of MarketWatch.
- Oil is relatively well-priced. These people are what I would call the moderate "peak oil" theorists. They believe that while reserves are plentiful, geopolitical risk and depletion of high-quality reserves will keep the prices high indefinitely. Soaring demand from China is believed to be the single largest reason for the increase under this schema.
Support: Demand from China has increased and average of 7% each year since 1991 despite higher prices. If the existing trend continues, China's consumption will surpass that of the United States by the year 2024. Click here to see a supporting chart using data from the U.S. Department of Energy.
- Oil is undervalued. Hard line "peak oil" theorists fall into this category. Most people in this group believe tat world oil production has essentially already peaked and increasing demand will only increase price. Many believe reserves and recovery rates have been largely overstated by the industry (in order to encourage investment). Publicly traded companies are regulated by agencies such as the Securities Exchange Commission, which has rules to minimize this overstatement risk. National oil companies are generally regulated by the fact that foreign investors usually require confirmation of good reserve estimating practices by external auditors. Saudi Arabia, the world's biggest oil producer, is an exception because Saudi Aramco doesn't trade on any public markets nor does it require any foreign investment to operate.
Support: Royal Dutch Shell overstated its reserves by about 23% in 2002, and were subsequently fined $150 million by the SEC and it's British counterpart.* Although this was the highest-profile case, there are other examples of proven reserve overstatments. Dr. Jim Buckee, former CEO of Talisman Energy Inc. has said that peak oil is 'here or hereabouts'* and thinks oil will get to the $150 to $200 a barrel range before it will have any impact on demand.
What's my personal position on oil price? Personally, I'm undecided. I think the days of $40 oil are certainly over, but I'm not yet convinced the excessive rate of increase is warranted. Given the rapid rise in prices, I don't think the market has had enough time to respond yet if a reduction in demand is imminent. The other factor that is rarely mentioned is the recent trend of oil nationalisations. Russia and Venezuela are two of the world's biggest oil producers that have nationalized their oil so far this century. The bigger piece of the pie being taken by these governments is ultimately being passed on to consumers in the form of higher prices. Less imperative but worth noting in this regard is Alberta's recent royalty rate increase.
I guess this would put me somewhere between perspective (a) and (b) with a bias towards the latter. I'm not investing directly in oil at these prices, although I would have in 2006 when prices were well below $70/bbl (I didn't have the capital).
My next post will be on the U.S. economy. As a consumer of 25% of the world's crude oil production I don't think we can ignore the status of the U.S. economy when it comes to predicting demand and subsequently price.
As always, stay tuned..
Notes- I've never taken a course in economics so please correct me if I said something that would offend the founding fathers of economic theory.
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