A P: Oil - stronger for longer?

For some time to come, oil prices will be higher and more volatile

With extremely high oil prices persisting through the first quarter of 2004, more and more investors are beginning to accept the view that the higher than trend oil prices are here to stay for the foreseeable future. It has been more than three years now wherein the oil pessimists have been expecting oil prices to decline to a range of $20-22 per barrel, but to no avail.

In fact since calendar year 2000 oil prices have averaged nearly $29 per barrel (WTI). Just for some perspective ,current WTI (West Texas Intermediate) prices of $37 per barrel are greater than 98 per cent of daily oil prices over the past 15 years and near all-time highs.

Of course history is littered with dire predictions of impending oil crisis (especially when oil prices are elevated), with all the fears of the world running out of oil having come to nothing.

So why should one believe that it is different this time and that we have entered a new era wherein oil prices will remain higher than current consensus and for longer ? Is this not another case of "crying wolf"?

If one were to examine the evidence the case seems to be quite compelling.

First if we look at the demand side, there is the obvious anomaly that the whole of Asia with 3.6 billion people consumes less oil than the 285 million people living in America. (Asia consumes approximately 20 million barrels per day, compared to 22 million barrels in the US, out of a world consumption of 76 million barrels per day).

Within Asia, similar to most commodities, it is China which is driving incremental demand. Chinese oil demand grew by 11 per cent in 2003 (source: International Energy Agency) and is expected to grow at 10 per cent in 2004, with imports meeting the bulk of incremental demand.

While Chinese oil intensity of 1.6 barrels of oil consumed per person is very low, the country's overall energy consumption per dollar of GDP is actually very high at six times Japan's, reflecting inefficiency in energy use. This disparity between oil intensity and overall energy consumption reflects China's enormous dependence on coal.

Over the coming decade the increase in oil consumption due to economic growth in China will be compounded by a shift in energy use from coal to oil or gas as environmental issues gain prominence. Just to get a sense of the numbers we are talking about, if by 2010 just the population of the coastal provinces in China (500 million) were to achieve half the oil intensity of South Korea today, the increase in demand would be 8-9 million barrels per day (on an existing consumption base of 20 million barrels for all of Asia). Obviously what is true for China also holds true for India with a lag.

Thus making an assumption that oil demand in Asia will double over the coming 12-15 years does not seem outlandish. The question of course is will the world be able to provide for this additional 20 million barrels of Asian demand, not to mention growth elsewhere? And if so at what price?

On the supply side the question of true world-wide production capability is the critical issue. The key question is how quickly large but mature producing fields in Europe and North America will decline relative to new fields being brought on line in areas such as West Africa, Caspian and Brazil.

Unfortunately the news on this front is not very positive. We are currently discovering on an average new conventional fields at a rate of less than 10 billion barrels of oil production potential per year, compared to annual global consumption of 27 billion barrels (we are effectively replacing less than a third of the oil consumed/produced every year). There was a clear discovery peak in the 1960s in terms of finding new giant oil reservoirs.

Since then the productivity of exploration has declined drastically with only one of the currently largest 371 oil reservoirs in the world having been discovered in the 1990s. Most of the large and easy to produce oil reservoirs already seem to have been discovered and there is a clear sense of diminished returns from exploration. Current discovery rates are less than a third of the 1960s and much less than annual production.

Moreover most new large discoveries tend to have political or quality problems. Peaking of discovery is always followed by peaking of production and if discovery peaked 40 years ago when will production peak?

Many industry consultants expect global production to peak sometime in 2005-2010 using a peak production lag of 40 years from discovery. What is not well known is that 14 large oil fields (average age 44 years) provide 20 per cent of the world's crude supply. The world's 120 largest oil fields (out of 4,000 globally) provide 50 per cent of our crude.

As these fields mature and decline how will we replace their production, given the poor recent record of new discovery? How will we meet the coming demand surge from Asia?

Shell estimates that we need to build new production capacity of 40 million barrels/day (mbpd) by 2020 (on a current base of 76 mbpd) to account for new demand and existing fields depletion. Where will this oil come from, given that we will completely exhaust conventional reserves of crude oil within 30 years?

There is currently very little excess oil production capacity available, with the IEA estimating the spare capacity in Opec being in the range of 1-2 mbpd, not a lot on a consumption base of 76 mbpd. All of the world's spare capacity is in Opec as non-Opec producers have no incentive to curtail production and keep oil off the market at current prices.

In reality what really matters is the level of spare capacity and production growth in the rest of the world and not Opec. Unless non-Opec countries can increase production to meet the anticipated increase in demand from Asia, Opec will control the marginal barrel of oil and will maximise its economic value.

Fifty per cent of the population in West Asia is below the age of 20, and Opec needs oil at a minimum of $20/barrel to balance its national budgets. This economic break even price for Opec rises every year.

Current oil prices may be artificially high due to very large speculative positions built up by financial investors and low physical inventories and clearly have some element of risk premium built in due to the threat of supply disruptions. Thus there is a very good chance we will see a correction in prices from these elevated levels and high volatility given significant hedge fund activity.

However there is a reasonable probability that given the above demand/supply dynamics, oil prices over the coming few years will remain higher than the past decade and higher than the still largely complacent investor consensus.

Eventually oil prices will come down from these high levels as the markets will work to equilibrate demand and supply. High prices will permit new sources of non-Opec oil to be developed ( that is, Canadian Oil sands, deep water prospects) and world wide demand will be negatively impacted by high prices.

As the history of previous oil shocks has shown, while the short run price elasticity for oil may be low, the longer run elasticity is much higher. This will lead to a large negative price impact on demand over time.

While we may not be in a totally new era, be prepared for higher and more volatile oil prices for some time to come.