Where Will Future Oil Production Come From and How Can Investors Profit Today?

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It is always impolite to ask a lady her age. But the oil bull market is certainly no lady, besides which, we know she is about ten years old.

Earlier this week, NYMEX crude oil futures, in un-lady like fashion, bolted to an intra-day high of US$127.27. It capped an exuberant dash which saw oil gain over 8% in six trading days, 30% since the beginning of the year, and 100% in the last twelve months. It’s just the sort of thing you’d expect from a ten-year old.

Here is an astonishing fact: on December 10th, 1998 the spot price for a barrel of West Texas Intermediate crude was exactly ten U.S. dollars and ninety eight U.S. cents. Nearly ten years and one thousand and sixty two percent later, it is time to ask some impolite questions about oil.

Impolite questions are not always obvious questions, though. The obvious question is to ask how high oil can go. Arjun Mutri and his team at Goldman Sachs have told us a disruption in supply could send oil to another “super spike” over US$200. Two years ago, the “super spike” was supposed top out at $100. Maybe it will be US$500 two years from now.

It is easy to keep raising the figure, but is probably more useful to ask a different question. The important investment question is not how high oil can go from here. The impolite but important investment question is where future global oil production will come from at all.

The answer, according to a new report from UBS, lies with just eight oil companies, one of which investors can’t even buy. Below, I’ll look at where future production may come from, who stands to profit the most, what investors can do now, and three “Black Swan” possibilities for the oil market that no one has prepared for.

Why Are Oil Prices So High?

An obvious question on the lips of anyone who buys petrol is, “Why are oil prices so high?” Consumers trained in the ways of the free market—and used to cheap clothes and electronics made in China—are right to ask the question.

In a fully-functioning free market, rising demand tends to attract rising supply. The reason?
Profit.

When a market is imbalanced and demand exceeds supply, prices rise. At that point, opportunistic new producers tend to rush in and grab some of the profits by brining on new supply. Prices fall and, for awhile anyway, equilibrium is restored.

That’s how it works in textbooks. That is not how it’s been working in the real world. According to the International Energy Agency, world oil demand has increased in each of the last three years, from 84.9 million barrels per day in 2006, to 86mbbl/day in 2007, to this year’s rate of 87.2mbbl/day. The IEA’s most recent forecast calls for global demand of 87.8mbpd for the rest of this year.

In response to this increase in global demand, OPEC oil production promptly declined by 265kbpd in February (the latest period for which official figures are available) to around 32mpbd. Not exactly helpful. And latest survey from Platts predicts a March decline in production of 347kbpd from the February figure. This brings average OPEC production below 30mbpd for the month.

This past weekend, U.S. President George Bush travelled to the Kingdom of Saudi Arabia, politely requesting the Saudis increase oil production to bring down gas prices in America. The Saudis demurred, and told the President oil production was more than sufficient to meet global demand.

OPEC blames the oil price on the weak U.S. dollar, but admits prices could go higher still. OPEC President Chakib Khelil explained the situation to journalists in late May, saying:

The prices are high due to the fact of the recession in the United States and the economic crisis which has touched several countries, a situation which has an effect on the devaluation of the dollar, and therefore each time the dollar falls one percent, the price of the barrel rises by $4, and of course vice versa.

In other words, OPEC blames the oil price on the sliding U.S. dollar and not inadequate supply. Khelil added that, “If this (the dollar) strengthens by 10 percent, it is probable that (oil) prices will fall by 40 percent.” At today’s prices, that would put a barrel of crude at US$76.

Froth vs. Fundamentals

If you can say with assurance why oil prices are US$127, you are more assured than most. OPEC believes oil strength is really just U.S. dollar weakness. A stronger dollar means lower oil prices, and probably lower commodity prices in general. There are other theories that seek to explain the high oil price, including a “fear premium,” oil as an inflation hedge, and pure speculation by professional traders.

But there are three other possibilities to consider. Exploring them gives us a clue about where oil prices are headed and where future production might come from. These possibilities are:

  1. OPEC won’t increase production because it doesn’t want to
  2. OPEC can’t increase production
  3. Non-OPEC countries cannot increase production enough to bring prices down

It is impossible to answer the first question. Oil producers, from OPEC to large multi-nationals, plan with long time horizons. They view oil markets as cyclical and do not base capital expenditure plans on pie-in-the-sky price forecasts. They are reluctant to recognise and respond to what your editor (among others) believes is a structural revaluation in global energy prices (not a cyclical bubble).

But this institutional skepticism about how long high oil prices can last does not account for the slump in this year’s production. OPEC’s production has fallen this year because of continued disruptions in Nigeria (see table below). Rebels in the Niger River Delta have reminded us all of how vulnerable the global energy system is to systematic sabotage. But excluding Nigeria, the rest of OPEC is running at near capacity.

That leaves the last two options. Prices send production signals. Either OPEC and non-OPEC producer are ignoring those signals—or they can’t respond to them in order to boost supply and take advantage of the high prices. And if OPEC is unable to increase supply now, how will it be able do so twenty years from now, when demand is much higher?

This presents global oil users (and producers) with a big problem, a problem that can be seen in the form of a chart which falls into seldom-used research category of “science fiction fantasy.” The chart shows that the IEA expects global production of liquid fuels to reach 117 million barrels of oil and oil equivalent by 2017. That “oil equivalent” includes ‘unconventional hydrocarbons’ like biofuels, oil shale, and tar sands.

If you do the maths, that means global oil production will have to increase by 37%, from 86mbpd today to 117.7mbpd by 2017. If you wish to express it in numbers, that means the world needs another 32mbpd of production—in addition to maintaining current production—to meet the IEA’s projected demand in 2017.

Or simpler still, the world needs another OPEC!

If only world oil production could increase with a simple act of mitosis. But OPEC is not a biological creature, programmed to replicate itself automatically. It is a political creature facing the physical realities of finding and producing more oil.

That doesn’t seem to bother the IEA. In last year’s World Energy Outlook, the Agency said OPEC could account for the entire needed increase in global oil production if starts spending the money now. The IEA forecast’s OPEC oil production of over 61mbpd by 2030.

Also predicted are the discovery of the lost city of El Dorado, the return of the gold standard to the global economy, and a Chicago Cubs victory in the World Series of baseball. [ed. Note : the Cubs have not won baseball’s top price since 1908]

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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