United States: Prices and Supply

Careful data analysis argues not to bet that the strong growth in oil demand will suddenly end while supply is clearly getting hard to grow.

Matthew R. Simmons, Simmons & Company International

For several years, global oil markets have been full of surprises, led by the “astonishing continued rise” in oil prices that defied almost all energy experts. Are these surprises now behind us, as many experts confidently predict? Are world oil markets amply supplied with crude and the right types of petroleum products as Saudi Arabian Oil Minister Ali Naimi, on the eve of the December 5, 2007, OPEC meeting, so vehemently stated? Is the surprising continued growth in oil demand, which far exceeded most energy experts’ predictions, now nearing an end? Have high oil prices started to curb demand as so many experts predicted was the inevitable consequence of oil prices exceeding $30 to $40 a barrel?

Guessing the right answers, or at least the most informed answers to these questions, frames the uncertainty surrounding the 2008 oil markets. Many oil observers remain confident that tightness in oil markets, the unplanned growth in demand and the surprising disappointments in perceived fast-growing oil supply are now over. Thus, oil prices should soon slide back to a more reasonable level. These observers use the same faulty reasoning that they employed in the past few years, when oil conventional wisdom turned out to be utterly wrong.

Let’s start with oil demand. Almost all oil experts confidently predicted oil demand was nearing a peak from 1988 through 1995. The reason behind this observation was that, during this period, global demand was mired between 66 and 67 million barrels a day. What the “experts” missed was the simple fact that collapsing oil demand throughout the Former Soviet Union (FSU) and Eastern Europe accidentally offset a steady growth in oil demand in almost every country around the world, outside the FSU. This phenomenon was a classic “two ships passing in the night”-the wake of one cancelling the other.

By 1995, the FSU’s falling oil demand finally bottomed out. Suddenly, the underlying steady growth in oil demand started becoming noticeable-like the tip of a giant iceberg that had been submerged just below the ocean’s surface. As a result, for the first time, global oil demand crossed the 70 million-bpd mark. Once this barrier was pierced, it took a mere 12 years for demand to soar to 86 million bpd (i.e., 16 million bpd additional demand). This equates to the output of almost three North Seas. This unplanned (or more accurately, unobserved) demand was fueled not only by relentless growth in China and the rest of the Far East, but almost everywhere else as well, except in parts of Western Europe and Japan.

Three factors suppressed any significant growth in Europe’s oil demand. First, much of Western Europe, and Germany in particular, was struggling to absorb a good part of Eastern Europe. Second, most of the European economies had already matured with many alternative transportation options other than cars. Third, and perhaps most important, Europeans fell in love with the highly energy-efficient turbo-diesel engines that realize higher mileage per gallon than gasoline-fueled vehicles. In contrast, these efficient motors were banned in most US states due to environmentalists’ dislike for diesel. This switch from gasoline to diesel had a one-time impact on lowering total transportation demand.

Japan was undergoing a transition from a two-decade boom to a more mature economy with an aging population. Otherwise, the rest of the world’s oil demand growth defied near-term economic slowdowns, strong or weak currencies and increasing traffic congestion, not to mention the impact of oil prices growing almost tenfold from early 1999 to November 2007.

A more serious question than whether oil demand growth is over, or at least slowing down, is whether there is any simple way to lower what is now unsustainable growth in demand. A series of weakening economies around the world could have some impact on slowing down demand growth, but the correlation is not nearly as high as most economists assume.

There is also no evidence (other than wishful thinking) that China will slow down its historic transition from a Dark Age economy to one that is proudly emerging to enjoy the inherent strengths and talents of this industrious nation. Similar economic growth is occurring in Vietnam and other parts of Southeast Asia. India’s growth in oil demand lagged behind China’s until India finally started addressing the sad state of its highway infrastructure. Now, a multitude of signals suggest that India is about to sprint in the growth of its car fleet and miles traveled. If this happens, watch India’s oil demand soar, too.

The Middle East is yet another source of surprising growth in its own oil use. High oil prices are transforming most Middle East economies into boom towns. As this transformation continues, additional internal demand for Middle East oil will be inevitable. As this oil demand grows, and if Middle East oil supply begins to flatten, let alone decline, this will have a material impact on the amount of Middle East oil available for export. If the Middle East, with a population of 200 million, ever creates a genuinely prosperous middle class, the impact on added oil demand could be stunning.

So, the oil demand story still remains strong, regardless of the increasing economic gloominess triggered by the sub-prime mortgage fiasco. It is easy to bet that demand growth seems to be slowing down, but this bet has been a losing gamble for over a decade. Are times about to change? I certainly would not bet on it!

If oil demand continues to grow, a far bigger looming question is: How easy will it be to supply the world with an additional 1, 2 or even 3 million bpd of oil over the next 12 to 18 months? The answer is far more complex, since it involves many moving parts. Moreover, a total absence of any reliable data on the rate of decline occurring in most of the world’s giant oil fields makes this critical question extremely hard to answer. Without a solid grasp of the rate at which many basins are now declining, predicting future supply is simply a “stab in the dark.”

The main reason the world failed to enjoy the supply surge that was predicted by so many is not because many projects were cancelled. In fact, many significant deepwater oil fields were added, and major oil supplies were brought on in places like Sudan and Chad. But almost all of this growth was offset by declines in mature oil fields, including a steady decline in US crude oil supply-a 30-year trend that was briefly interrupted by deepwater Gulf of Mexico oil increases, the North Sea, where oil production is in a free fall, and Mexico, whose giant oil field, Cantarell, peaked in May 2005 and is now entering its own irreversible decline. The growing list of oil producers in decline is far larger than the handful of countries that are realistically forecasting sizeable production growth.

Reliable field-by-field Middle East oil production data is non-existent. The region remains as cloaked in production secrecy as ever. The party line from all Middle East oil-producing countries is that their supply is in good shape and that the Middle East still has ample excess productive capacity. But these statements are never backed by any specific field-by-field data, and too many senior officials are beginning to admit, albeit quietly, that many Middle Eastern oil fields are very mature and now in decline. How many key giant oil fields this includes, and their respective decline rates, remains a closely guarded state secret for key producers like Saudi Arabia, Kuwait, Iran and the UAE.

To me, this cloak of secrecy is unacceptable for the world’s well-being, particularly when our oil markets are so tight and risk getting even tighter. Despite repeated assurances that all these Middle East producing countries have ample oil, no auditor has been allowed to verify any detailed field-by-field production data. We should learn an important lesson from the history of the Cold War. Would we ever simply trust the old FSU’s assurances that they would never launch a nuclear attack or that they would disarm, but on their own timetable? Of course not. That would be foolish and dangerous.

It is time for the world to demand a “trust but verify” oil policy. If this transparency policy were to materialize in 2008, it would be a great achievement. The longer we wait, the more dreadful the surprise will be when we learn one day, and possibly sooner than many think, that Middle East declines can be as real as Cantarell’s and the North Sea’s.

The most troubling piece of historic oil supply data available in the public domain comes from the US Department of Energy’s Energy Information Administration (EIA). Every month, the EIA publishes its best estimate, on a country-by-country basis, of the world’s crude oil and condensate supply. This supply ignores natural gas liquids, biofuels and refinery processing gains, even though all three now plug a critical gap between crude oil supply and how the world satisfies total petroleum demand.

This seldom-scrutinized set of EIA crude oil production data is not perfect, but it is as accurate as any other estimate in the world. What the EIA data interestingly shows is a steady growth in crude oil output until world crude output finally blew through 70 million barrels a day, setting a new annual record of 72.5 million barrels a day in 2004. Soon this all-time high crude output sputtered. For 9 out of 12 months of 2005, it remained in the 73 million-per-day range, only exceeding 74 million barrels a day in April, May and finally December. The all-time crude oil output record, as best we now know, was realized in May 2005, when the world produced an average of 74.3 million bpd of crude. This peak quickly slipped under the 74 million-bpd level. Ironically, this record was set in the same month that Cantarell, Mexico’s giant oil field, peaked and then went into decline.

Average world crude production in 2005 was 73.8 million bpd. In 2006, it fell to 73.5. Preliminary data through August 2007 indicates the seven-month average was 73.1 million barrels per day. Reported 2007 crude production slid to 72.8 million in June 2007, and then 72.5 million in August 2007. Is this slide over? If it is not, it becomes hard to envision getting back to the May 2005 record, let alone sustaining the production growth needed for global petroleum use to cross 90, let alone 100 million barrels per day.

Could this May 2005 record be the point at which global crude oil production peaked? The answer to this should become obvious within a year or two at the most. Oil supply analysts at the EIA shrug off this peaking as simply being typical of how crude oil output climbs in spurts, only to retreat and then be followed by yet another spurt.

A careful analysis of the underlying country-by-country production estimates indicates too many key producers in what now appear to be irreversible declines. At the least, these declines raise the bar for oil companies to quickly find enough new supplies to grow production back to 2005 record, which is almost 2 million bpd more than what is now produced (see figure).

So the world enters 2008 with most experts assuming demand growth is slowing down, while oil supply is set to surge. Yet careful data analysis argues not to bet that the strong growth in oil demand will suddenly end while supply is clearly getting hard to grow, due not necessarily to resource limits but simply to the fact that too much of our oil supply comes from giant old oil fields now in decline.

In the background of these supply worries lurks the extremely real and limiting factor affecting the addition of significant new oil discoveries. This concerns a real and physical limit to global drilling rig capacity. Oil production is still totally dependent on a quality drilling rig and many other oil-service assets being at the wellsite before new oil can be found and developed, along with a steady increase in drilling once a new field comes onstream. Almost all quality rigs are now in service. Furthermore, most other oil service assets that are essential to support drilling activity also face the same limits to further growth, absent a major drilling equipment construction boom.

This limit is most acute, or most observable, in offshore drilling. Moreover, the world’s fleet of about 500 usable competitive offshore rigs is also extremely old. In 2008, the average age of an offshore rig will be 26 years. For most of the offshore oil industry history, 25 years was deemed to be the end of a rig’s useful life. Now the entire fleet is too old, and most of our working rigs must soon be replaced; otherwise they risk sinking, as old corroded parts, exposed to the elements over years, rust away.

Further complicating the industry’s future is its graying workforce. Some estimates now predict that over half of the oil industry’s entire workforce, from the rig floor to the executive suite, is nearing retirement.

It takes years to adequately train skilled oilfield workers. In today’s highly technical world of oil production, almost all key jobs are highly skilled. No plan has ever been devised for how the industry’s workforce can reinvent itself, determine ways to find more oil with fewer trained workers, or entice retirees back into the workforce. We have no Plan B to address the looming people shortage.

To compound matters, the oil and gas industry’s entire infrastructure-from steel casing and tubing to gathering systems, tank farms, pipelines and refineries-is old. Every link of this complex system is built from steel, which corrodes. Patching does not prevent rusting. Soon, every link of these components will need to be replaced.

A recent study released by the UK government found that over half of the North Seas’ 100 offshore assets, ranging from fixed platforms to offshore rigs and boats, were in need of significant upgrade or repair. Many are either approaching or have passed their original design life.

Only two decades ago, the North Sea boasted the industry’s newest and shiniest collection of offshore assets. Now the rusting infrastructure encompasses and extends far beyond the North Sea. How quickly the oil industry addresses and reacts to this rusting issue will have an enormous impact on whether the industry infrastructure is genuinely sustainable through even the first two decades of the 21st century.

How will the oil markets behave as 2008 begins, and what will the industry look like as we approach 2009 a year from now? It’s hard to envision an end to the stress and tightness that created today’s high oil prices. The underlying fundamentals that led to this stress are too basic and will be hard to change.

When oil prices almost crossed $100 a barrel several weeks ago, was this price unsustainably high? To answer this, one needs to convert a mysterious “barrel” of oil into terms ordinary consumers can understand: the price per cup. To do this, divide a barrel by 42 to obtain the price per gallon. Divide this by 16 to get the price per cup. The answer is that $100 per barrel of oil equates 15 cents per cup, making oil still the least expensive substance of any value one can buy in the world.

Like it or not, today’s oil prices, when properly analyzed, are still far too inexpensive and need to rise far higher to begin slowing down inefficient uses of oil, which were stimulated by prices that stayed too low for too long. Higher oil prices will generate massive cash flows. These funds should be swiftly and wisely reinvested to rebuild oil infrastructure. This would constitute the world’s single largest construction project, and the prosperity this would generate will offset any dislocations from oil price advances that were so unplanned.

This year will be a great challenge for the oil industry. If the industry can rise to these challenges, the year can be very exciting. If the industry’s leadership and opinion shapers stay in denial about the relentless underlying growth factors that forced oil demand to its current highs, but instead stay fixated on how much new oil supplies will soon grow and how fast demand will slow, we are heading into dangerous times.

The biggest risk in 2008 is that oil demand silently slips ahead of all usable forms of supply, including oil inventories that can be drawn down very painlessly until minimum operating levels are breached. Then a genuine risk of regional shortages looms. 

THE AUTHOR
	Matthew R. Simmons, Chairman of Simmons & Company International, graduated cum laude from the University of Utah and received an MBA with distinction from Harvard Business School in 1967. He served on the faculty of Harvard Business School as a research associate for two years and was a doctoral candidate. After five years of consulting, he founded Simmons & Company International in 1974. The firm has played a leading role in assisting energy client companies in executing a wide range of financial transactions. He is a trustee of The Museum of Fine Arts, Houston, and The Farnsworth Art Museum in Rockland, Maine. He serves on the boards of several industry and civic groups. He is past chairman of the National Ocean Industry Association, and he serves on the board of the Associates of Harvard Business School, and is a past president of the Harvard Business School Alumni Association. Mr. Simmons’ papers and presentations are published regularly in a variety of publications and oil-and-gas industry journals, including World Oil.