OUTLOOK 2006: United States
Prices and Supply

What a difference 20 years make in crude oil prices

Matthew R. Simmons, Chairman and CEO, Simmons & Company International, Houston

I began writing World Oil’s annual Crude Oil Outlook article on New Years Day, 13 years ago, when prices had just fallen below $14/bbl for the first time since 1986. At the time, conventional wisdom was certain that the world market had entered a new paradigm of ample, diverse supply. This was deemed to have removed a $10 “fear premium” that had been a structural aspect of pricing since the 1973 Oil Shock. Hence, most observers felt that prices ought to trade within a $10-to-$13/bbl range for the foreseeable future, bringing prices back to levels only briefly experienced in 1986, when a genuine supply overhang existed.

LESSONS LEARNED FROM HISTORY

My first article was entitled, “It is not 1986: The oil markets are tight!” I pointed out that global oil demand had risen steadily for a decade following a plunge in demand between 1979 and 1983. Only the collapse of Former Soviet Union (FSU) oil usage created the illusion that global crude demand was peaking at 66 million to 67 million bpd.

I also reminded World Oil readers that oil supplies were not growing as robustly as most energy economists believed. The impressive North Sea growth was a rebound after the Piper Alpha platform accident stalled new supply additions. Once a few sizable new fields went onstream, all future North Sea fields would be small, setting the stage for regional oil output to peak by the end of the 1990s. I also took issue with a widely believed assumption that modern oilfield technology was eliminating dry holes, and reducing finding and developing costs to a fraction of decade-earlier levels.

Instead, technical breakthroughs in 3D seismic, horizontal drilling, multiple well completions and subsea tiebacks allowed tiny oil deposits to be drained rapidly, thereby speeding up depletion of easily producible reserves. Thus, decline rates in many regions accelerated.

I explained that the biggest reason that finding and developing costs fell to such low levels was “predatory pricing” for drilling rigs and other services, which was destroying the oil service industry’s fiber. Soon, the price to drill wells would have to soar, or the number of wells drilled would slowly decline until demand rose above supply.

My article’s conclusion reminded readers that oil prices were being set at the New York Mercantile Exchange (NYMEX). Oil traders selling more paper contracts than other traders wanted to buy could create the illusion of a supply glut, when, in reality, market fundamentals were quite tight.

When I finished this story, little did I realize that this theme of oil market perceptions being out of line with market realities would be repeated constantly over an extremely volatile next decade or so. As 1994 began, it took oil prices less than six months to rise from $13 to back above $21/bbl, where they had been in mid-1992, Fig. 1.

Fig. 1. The peaks and valleys of oil price behavior, as well as the sudden volatility, are easily seen in this chart of the history of NYMEX crude prices.

By the summer of 1997, oil prices had crept higher and were over $27. The market then underwent a demand scare brought on by the “Asian Flu,” which economists believed would arrest oil demand growth for years to come. In the fall of 1997, most analysts, already nervous about weak oil demand, totally misread OPEC’s adjustment of quotas by 2 million bopd.

Instead of realizing that OPEC quotas were raised because the widely anticipated gush of non-OPEC new oil never materialized (forcing more OPEC oil into the market), analysts assumed that OPEC was flooding the market with too much oil as demand growth waned. This misunderstanding of supply-and-demand fundamentals led to the infamous International Energy Agency (IEA) “missing barrels” saga and the resultant price collapse to $10, followed by a dramatic rise to over $37/bbl in September 2000, Fig. 1.

The final oil price collapse began in mid-2001, when economists were certain that $28-to-$30 oil would soon cause a recession and stop the unusual growth in global oil demand (which none of these economists thought could happen). Post 9/11, worries escalated into a nightmare that oil demand would start to fall. By mid-February 2002, the “demand is falling” hype led to record short-selling of NYMEX crude contracts that briefly forced oil prices below $20 for perhaps the last time in history.

Many seemingly astute market observers spent the past decade failing at almost every turn to properly gauge oil demand and supply. The hand-wringing about “don’t trust demand” over two decades turned out to be a collective case of poor data analysis. Over the past two decades, oil demand grew by almost 20 million bpd.

Moreover, not only China fooled so many “astute” economists. Oil demand grew in virtually every region except the FSU. It grew so steadily in the US, that by late 2005, America’s usage crossed 22 million bopd, an amount exceeding the entire world’s oil use in the early 1960s. The US is the world’s largest oil user by more than three times the second largest user (China, which replaced Japan as number two consumer several years ago).

As demand soared, new oil supplies became smaller. Many new finds were tiny satellite fields that could be tied back to under-utilized production facilities, because primary fields had declined.

DEEPWATER OIL STAVES OFF A PEAK

Had deepwater oil not come of age in the last decade, conventional oil would have passed peak output. Even as deepwater drilling created several million bpd of added oil, non-OPEC supply outside the FSU has struggled for half a decade to stay flat, and now seems clearly in decline. The North Sea is in steep decline, and Mexico, China, Argentina, Oman, Syria, Egypt, Yemen and Colombia seem to be experiencing irreversible declines.

Non-conventional oil from Canada’s oil sands and Venezuela’s Orinoco region makes up about half of both producers’ output. Non-conventional oil is now commercial, but it remains extremely energy-intensive to turn into usable form. Most new oil found globally is either heavy or sour, or both. What seems to have passed peak supply is light, sweet oil – the easiest oil to produce and the simplest to refine into light, finished product.

Until 2005, OPEC had risen to the occasion and supplied constant surges in unexpected demand. Now it is clear – for anyone closely studying OPEC production announcements and other data on the true status of OPEC oil output – that the countries comprising OPEC membership are all producing at maximum levels. Over a dozen giant oilfield upgrades are underway throughout OPEC, but few will add significant new supplies before 2009.

Moreover, all these “new” projects are complex oil fields that were found years ago and lacked the ingredients to be key producing fields. Some of these projects’ performance risks are high enough that nobody should assume that they will happen on schedule, on budget or at projected output targets.

The global lack of spare capacity now extends far beyond wellhead capabilities. By late summer 2005, every capable drilling rig in the world was in use, Fig. 2. The backlog of planned, new wells that awaits an available rig is growing monthly. In the offshore market, the rig deficit by the start of 2005 was about 250 drilling months before Hurricanes Katrina and Rita took another 20 rigs out of commission; some permanently, some for just a matter of months. The resultant offshore drilling deficit compared to planned activities might now exceed 400 to 500 drilling months. Every key oil pipeline and processing facility is also at 100% capacity, as is global refining capacity. The oil system has never been so tight.

Fig. 2. Despite the assembly of extra units from components, plus a large upturn in new unit construction, the global supply of drilling rigs is insufficient to sustain any large increases in drilling activity. Crew shortages further complicate the situation. Photo courtesy of Cheyenne Drilling LP

Also, 2005 will go down in history books as perhaps the poorest year for exploration success for both oil and gas since World War II. This dismal success was not for lack of effort. Record amounts of funds are being plowed into E&P capital spending, which is why all the world’s rigs are now in use.

Global oil markets have come a long way since the bottom of the 1986 Great Oil Depression, 20 years ago. While the Depression is fading in the memories of even many old-timers, it took a savage toll on the industry. The Oil Depression resulted in a terrible work environment, unable to attract quality new people into the business, which led to a very gray labor force.

It created gun-shy industry “experts,” who became the classic “generals” preparing to fight the last war. These constant worriers of how to cope with low prices then contaminated the thinking of most senior industry executives. These individuals spent enormous amounts of time also worrying about how to survive in an era of low prices, instead of planning on how to grow output to meet soaring demand.

Little investment was made to replace existing assets before the assets got so old that they broke, sank or blew up. Because of this, the myriad of manufacturers of equipment spent the last two decades consolidating into a handful of survivors. None made any significant investment in expansion. Instead, all made sure that they could survive the low price/ little investment era that too many experts opined would last forever.

LOGISTICAL CHALLENGES EXIST EVERYWHERE

For oil markets, 2006 will be challenging, unless global economies quickly enter a steep recession. This is about the only event that will moderate demand growth before it outpaces supply. Already, some markets show signs of little demand growth, not because demand is low, but due to the physical limit of oil use having to stay within supply limits. One big “head fake” of 2006 will be when apparent demand seems stalled by lack of demand instead of lack of supply. The two are extremely different events, and hard to judge by a quick glance at weekly changes in EIA’s oil inventory reports.

As the rig shortage worsens and rates rise to dramatic levels, many newly planned projects will not materialize. There will also be a slowdown in deepwater exploration wells or drilling of necessary deepwater development wells. Rigs are insufficient for both to happen. The lack of rigs is also an easy proxy for all other key services needed to drill and complete complex wells that comprise most new projects.

The industry is in the early stages of a people crisis. This people shortage will worsen throughout 2006. There is already widespread “stealing” of competitors’ key people, or oil companies raiding the scarce personnel of their key service providers. New drilling assets coming onstream during the year will further strain the people shortage. For instance, when both land and marine rigs are added together, there are about 250 rigs on order for delivery in the next 12 to 18 months, Fig. 2. Since an average drilling operation needs 35 to 50 people on-site on a 24/7 basis, this equates to a need to recruit and train 26,000 to 37,000 new drilling hands in a very short period. This figure assumes prompt delivery of new equipment and that the industry puts these units to use as added rigs instead of replacing worn-out, old rigs.

Adding as many as 250 new drilling rigs might sound like a big expansion until it is put in perspective. There are about 3,000 drilling rigs in the world, so this “expansion” is only a little over 8%. Because most of the 3,000 existing rigs are about 25 years old, the industry soon needs to gear up for the challenge of how to replace the entire fleet over the next decade or two. The wear-and-tear of land and offshore rigs is like running a car in a demolition derby. If the industry leadership fails to address how to renew the drilling fleet, it will ensure a serious oil supply crisis.

Two years ago, in this same annual outlook column, I ended my story by musing that 2004 was likely to be a year when many postponed problems would all come home to roost – a literal gathering of the global Murphy clan of the infamous “Murphy’s Law: when one thing goes wrong, something else usually goes wrong, too.”

In hindsight, the Murphy clan arrived in the global oil system in full force. Since the Murphys were uninvited, many industry observers spent the last two years complaining that oil prices were too high, and predicting a quick return to low prices. Their rationale was that demand was obviously slowing down, and high prices would soon bring a flood of new supply. This failure to see how spare capacity disappeared will be one of the great chapters of my book, “How Conventional Oil Wisdom Was Consistently Wrong.”

WHAT PEAK OIL REALLY MEANS

Like it or not, 2006 will be eventful for oil. It will also be the year when the Peak Oil topic intensifies into a debate on the scale of climate change/ global warming. So far, this Peak Oil debate has been muted to a very separate, small group of “extreme optimists” battling a small group of geologists, petro-physists and, on occasion, energy analysts or economists.

Optimists often do not properly understand what “peak oil” means. They dismiss any worries by saying the world is unlikely to run out of oil in the next 30 to 75 years. Instead, these optimists need to grasp the simple fact that peaking does not mean running out. It means that supply no longer can grow, and it generally means the pending arrival of a production decline.

Depending on the oil field type and the manner in which it has been produced, this decline can be either gentle or so steep that it resembles a production collapse. Optimists who scoff at peak oil also argue that new oilfield technologies will come to the rescue and make new supplies easy to create without realizing that there are few new technologies being invented today. This “embrace technology” group fails to appreciate that this same technology created the steep decline curves occurring in most oil provinces.

Many leading peak oil advocates assume that this event is still a decade away, but they argue that steps to mitigate peak oil’s arrival take so long to implement that the world must create a mitigation plan today. In my opinion, the most important peak oil aspect is defining peak as “a level of oil output that can safely be produced for at least a half-a-decade or more.” Whenever an oil-producing field or region begins to approach this sustained peak productivity level, the safest formula to avoid a pending steep decline is to lower field production rates. Based on this definition, the world might now have exceeded sustained safe production. 

How the peak oil debate unfolds will likely shape the next 20 years of markets as profoundly as the many analytical mistakes about supply and demand that shaped the past two decades. 

THE AUTHOR
	Matthew R. Simmons, Chairman and CEO 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.