Umbilical Oil - Part 2 (demand)

'Organic' Demand


It should come as no surprise that oil is the most valuable widespread global commodity in Western civilization. In relative value terms, oil has surpassed gold. A broad range of uses including energy, transportation and non-energy/material uses are, in large part, the reason for this. Industry uses just under ten percent of the refined crude oil in order to manufacture goods and services. Commercial, residential and agricultural sectors use just under thirteen percent--much of that for heating and electricity. Non-energy uses of hydrocarbons include plastics, synthetic clothing (eg. polyester), cleaning and lubricating agents, as well as binders like asphalt. Eighty percent of the asphalt refine is used for building roads. Which leads to the sector that consumes the largest volume of crude oil--transportation. Only a few modes of widespread transportation don't consume any oil; walking, cycling and electric trains are among the few examples of these. I don't have statistics on this, but the percentage of motorized vehicles that don't consume refined oil products is probably less than 1% (hybrid-electric vehicles are still powered by oil). Between cars, trucks, boats and planes, the world consumes about sixteen billion barrels of oil each year.


Industrial consumption is already at it's lows. Heating and electricity loads are unlikely to change much in the near term (alternative energy and efficieny improvements could chip away at this in the long term). Non-energy sources are also pretty static as far as demand goes; there is an obvious reluctance to return to cotton diapers and no one likes driving on gravel roads. That pretty much leaves transportation sector to the task of reducing demand.

There are essentially two ways to reduce organic demand in the transportation sector (1) improve efficiency and (2) reduce volume. Improving efficiency implies activities like purchasing new, fuel efficient airline fleets and passenger vehicles. This requires significant capital investments and thus time before it can become a reality--even if it makes economic sense to do so. Industry leaders such as GM and Tesla Motors estimate it will take ten years and lots of government subsidies before hydrocarbon-free transportation vehicles start to become competitive in the mass markets. It will take even longer (30-40 years)^* before significant market share is acquired by alternatively powered vehicles. On the volume side, while per-capita car ownership in the United States has probably peaked, passenger car ownership in emerging economies continues to skyrocket. This is part of the reason why the transport sector only amounted to 45% of total oil consumption in 1973 and is now over 61%. China and India alone would need 2 billion cars to approach the rate of car ownership that the United States has.

Given that any major initiatives to reduce dependency on oil will take time, there is really only one way to reduce near-term organic demand for oil--higher prices.

That being said, there is a level above which the price of oil will not only be self-limiting but potentially even catastrophic in contributing to a recession. In early 2008, when oil prices pushed well past $100, the transportation sector began to collapse along with the eventual low at the end of that year. This was made worse by other issues such as the subprime housing crisis, but the bottom line was that people could no longer afford to fill up their gas tanks and thus prices necessarily fell.

Given the continued weakness of the U.S. economy, along with rising unemployment expected to peak in 2010, a high enough price could contribute to another recession and result in another price collapse. This instability price point is probably above $80 and not as high as $150. Filtering out price corrections, the trend for oil prices would appear quite bullish based on supply and demand alone.

There is however, one final part to this story: the measuring stick (the dollar).

Umbilical Oil - Part 1 (supply)

Crude oil, unlike natural gas, is a commodity in much shorter supply at current prices. While a vast amount of total reserves still exist, the marginal cost of production of these reserves continues to increase. Impressive technological improvements have only partially offset the increase in finding, development and operating costs of these deeper, tighter and less permeable hydrocarbon reservoirs.


Worldwide, average recoverable oil reserves have historically been around 30-40%. In other words, for every 100 barrels of oil we find, we can only economically produce 30-40 of those. Natural gas recoveries, by comparison, have historically been in the 70-90% range. Of course, if market prices are higher, economic recovery rates also go up as energy companies can spend more capital and energy to improve efficiency. Physics and thermodynamics however, ensure that this relationship is typically a logarithmic one--doubling the oil price could, for example, only lead to 5% more recovery. On the gas side, it's much easier to move the relatively small independent methane molecule across the reservoir rock and to the wellbore than a large viscous molecule of crude oil. Two of the largest undeveloped reserves of oil in the world are deep offshore oil and unconventional resources like the oilsands. Both have the potential to produce a vast amount of oil, but it will take a lot more to fill up the gas tank if we are to rely exclusively on fuel derived from these sources.

Offshore Oil
For comparison's sake, I will compare BP's recent 'huge' Tiber oilfield find to Ghawar. Ghawar, the world's largest and most prolific developed oilfield, has produced 48% of the 131 billion barrels it's operator, Saudi Aramco, expects to recover. It has a very favorable set of geological preconditions that we have yet to find anywhere else in the world. The number of large oil discoveries is dwindling and those that have been made also have more fragile economics because of the engineering (and political) complexities involved. BP's recent Tiber oil sits 10.6 km below the ocean floor--that's more than the height of Mount Everest. It also sits in 1.2 kilometer deep water--deeper than the crush depth of the most advanced military submarines. Some submersibles and special unmanned vehicles can get this deep, but it speaks to the challenges involved. Challenges that will ensure the oil does not come out of the ground cheaply. Even when the infrastructure is in place and capital expenditures have been made, early recoverable estimates for Tiber of up to 1 billion barrels would only sustain current global oil consumption for 12 days (a thousand barrels a second is about how much the world currently consumes).

Oilsands
Unlike offshore oil, oilsands are typically very shallow and geographically accessible. It is the quality and flowability of the hydrocarbons that present challenges--the oil is too viscous to be produced using a conventional oil well scheme. The oil is typically either mined and extracted from the sands using steam, or it is produced 'in-situ' using a steam-assisted gravity drainage (SAGD) technique where high-energy steam is injected to lower the viscosity of the oil enough that it can be produced in a horizontal well. Both techniques use vast amounts of steam, which itself requires lots of energy to produce (currently most of the steam generation is produced by burning natural gas). Unlike conventional crude oil, the resulting hydrocarbon slurry then needs to be either upgraded or mixed with lighter hydrocarbons before it can be pipelined to a refinery. These processes often involve several steps such as distillation, cracking the large molecules into smaller ones, removing sulphur and heavy metals and in some cases dilution with lighter hydrocarbons (i.e. condensates). One of my textbooks from elementary school said that the oilsands would never be commercially viable. The authors were wrong--but producing the heavy oil isn't cheap by any means. Not to mention the potential of added costs due to environmental regulations and CO₂ reduction or sequestration.

"Currently oil at about $60 to $70 per bbl we think is not enough to justify some of the significant projects we are contemplating, especially on the mining side," says Jean-Michel Gires, CEO of Total E&P Canada. The energy company CEO went on to predict a sustained price of at least $85 was needed to make many these projects commercially viable.


From the supply side, it appears as though the fundamentals might support an oil price of around $80/barrel, with a continued ascent upward as the elephants* mature and decline. But that's just the supply side--stay tuned for the demand side (part 2).

*the term 'elephant' refers to a very large oil field, typically one that contains at least 100 million barrels of recoverable oil.

Hurricane Update

There have been many predictions about what the price of crude oil will do as a result of Hurricane Gustav, which is expected to make landfall very close to where hurricane Katrina did. Gustav is also expected to make landfall as a category 3 storm (Katrina had been a category 5 but weakened to Category 3 before making landfall).

Idle Production
Currently, nearly all oil production in the area is shut in, with all personnel evacuated. According to Bloomberg, "96 percent of offshore oil output and 82 percent of gas production" is currently idle. The Gulf region produces a quarter of U.S. domestic oil production and 14 percent of natural gas production. Nearly all operations personnel have been evauated while many refineries and piplines in the area have also been closed.


A couple of days of reduced supply isn't enough to raise prices significantly. The large price spikes in 2005 were due to the damage in the aftermath of Hurricane Katrina that took months to fix, rather than these temporary shut-ins. It's also quite likely that this increased idling simply means oil producers are better prepared and less damage will ensue from the hurricane season this time around. Any production lost due to downtime and minor damages can easily be replaced with oil from the strategic petroleum reserve, which was intended for--and only capable of--replacing temporary and unforeseeable supply disruptions like Hurricanes (rather than to stabilize normal market price volatility, a purpose some people thought of it earlier this year).

Up Or Down?
Sixteen economists polled last week were split almost evenly three ways (I don't recall which poll). About one third said prices would simply fall after the hurricane passes. Another group said prices would remain about the same. The last third of these economic experts said prices could rise significantly. Prevalent Canadian economist Jeff Rubin of CIBC's World Markets thinks gas prices could hit $1.75-a-litre if this year sees "[a]ny replays of the 2005 hurricane season". Ultimately though, what happens will depend on Mother Nature (or global warming for those who speculate that this is the case). Many others think this scenario is unlikely.

Inflation Outlook
If the most active part of the hurricane season does create major disruptions to energy supply in the Gulf, the resulting increase in energy prices could kill the plans of the U.S. Federal Reserve Bank to hold rates steady this year. Ben Bernanke expects to see inflation moderate from an annual pace of 5.6% in July if oil prices remain relatively low compared to their all-time highs of $147-a-barrel. The Fed does not want to raise interest rates until some parts of the "financial storm" passes, which include the housing crisis and credit crunch, high commodity prices and a low greenback.

My Prediction
I'd say there are several indicators that show the markets are comfortable with a crude oil price in the $110-$120-a-barrel range for the next couple months, with some spikes possible. Even with a spike, a repeat of Katrina is unlikely and therefore the odds are that the price won't stray too far outside this range, up or down. It also seems like a stable and sustainable range as an OPEC official has said his organization will cut production if oil falls below $85-a-barrel (Iran has less clout but their oil minister wants OPEC to set this floor at $100); on the high end, airlines and car manufacturers start failing if oil goes above $150-a-barrel (Zoom airlines failed last week with oil below $120). My prediction also translates into gas prices in the range of $1.15 to $1.35 for the fall, depending on what the loonie does relative to the greenback.

Meteorologists are about as good as predicting the weather tomorrow as energy analysts are at predicting crude oil prices next week, even without a hurricane. It seems we'll just have to wait and see how these factors come together. At least the one certainty is that the loss of human life this time around won't be anywhere near as bad, assuming that lessons were learned from Hurricane Katrina.

Big Oil: 2nd Quarter In Brief

Two-thousand eight second quarter corporate results were released in the past two weeks. I reviewed the numbers for the oil supermajors (with market capitaliation above $100B US): Exxon Mobil, BP, Royal Dutch Shell, Chevron, Total S.A. and Conoco Phillips.

Average Second Quarter production Rates (mboe/d)*

Major	2008	2007	2006	2005
Exxon Mobil	2,393	2,668	2,701	2,468
Royal Dutch Shell	3,126	3,178	3,253	3,526
Chevron	2,540	2,630	2,669	2,421
Total S.A.	2,353	2,323	2,290	2,506
BP	3,830	3,804	4,018	4,112
ConocoPhillips	1,750	1,910	2,130	1,540
Totals	15,992	16,513	17,061	16,573
Year-over-year change	-3.16%	-3.21%	+2.94%

The highlights are as follows.

• Profits were robust (as expected) due to high oil prices.


• Production rates fell (not quite as expected) despite record capital expenditures.


• All but two saw production decreases from the same quarter last year despite the fact that oil prices doubled in the same period.


• The average year-over-year production drop was over 3% in each of the last two second quarters.

These are the unadulterated numbers. The production drops are under-reported because the companies only highlight production within their control and downplay production drops from the 'Chávez-factors'. For example, in Exxon Mobil's 2008 Q2 press release:

On an oil-equivalent basis, production decreased 7% from last year. Excluding impacts related to the Venezuela expropriation, the Nigeria labor strike and lower entitlement volumes, production was down 2%.

Also downplayed is the effect of asset sales; the reality is that most of such sales are mature fields that already in decline and are no longer material to the company. It seems that while global reserves have edged upwards, our ability to get them out of the ground under free-market conditions is quickly deteriorating, even with oil at record prices. Expropriation of reserves by state-governments is likely why oil prices have increased so rapidly: free-markets are losing control of production to countries like Venezuela, Russia and China. This is very bad for free-market pricing. So far at least, demand destruction has not appeared to offset the bullish market forces including resource nationalization, geopolitical instability and exponential production declines. The entire independent oil & gas industry tells the same story. I'm not predicting $300/bbl oil yet, but I wouldn't fault anyone for holding on to crude oil futures in light of this data.

There is one more recurring theme. Nearly all the refinery and gasoline distribution divisions were the least profitable and in some cases lost money. Exxon Mobil now plans to exit the gasoline distribution market citing very weakening margins. This is bad news for gas prices which have yet to increase by the same percentage as crude oil.

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*mboe/d = Thousand barrels of oil equivalent per day. Natural gas volumes are converted to an oil-equivalent basis at a ratio of about 6 mcf:1 boe.

How High Will They Go?

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.¹

In 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.

1. 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.
   
   
   
2. 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:
   
   
1. 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.
   
   
2. 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.
   
   
3. 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.
   
   


3. 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.

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Do the fundamentals support the current prices or not?!?
This is still the subject of much debate. Here are the three basic perspectives:

1. 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.





2. 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.

   
   
   
   
3. 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..

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Notes

1. 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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