And what the fundamentals say about 2009.
Matthew R. Simmons, Simmons & Company International, Houston
Fifteen years ago, in January 1994, I began writing my first annual World Oil outlook article about crude oil markets. Its title was It is not 1986! Oil prices had collapsed from a high of over $20 a barrel to $14 as 1993 came to an end. This price was lower, on an inflated-adjusted basis, than the price of crude in 1986. I pointed out how strong the underlying oil fundamentals were as 1994 began, despite the price drop. Ironically, I mused at the end of this article that paper barrels being aggressively bought or sold can temporarily create an illusion of a market too tight or with too much of a glut. Months later, the world learned that the entire collapse was due to Metallgesellhaft AG (MG), a German trading firm whose long positions in paper barrels had to be liquidated. Once this exercise ended, crude prices quickly rebounded to their old highs.
I was tempted to use the same headline 15 years later as the price of oil in 2008 went on its wildest ride ever. The year began around $100 a barrel-far beyond what most price forecasting groups thought possible. And over the next seven months, the price continued to climb, finally setting a new all-time high at $147 a barrel in the first week of July.
Oil prices then fell back to a trading range of $115 to $130 over the next seven weeks. But on September 22, 2008, oil prices literally collapsed in a virtual free-fall and dropped by an eye-popping 74% in the last three months of 2008.
As this price plunge gathered speed, news of collapsing oil demand, oil gluts so large that tank farms around the world were brimming over and reports of an armada of VLCC supertankers loaded with oil floating around on the high seas, grew exponentially.
But as happened in both the 1973−’74 and the 1997−’98 price drops, no observed great oil glut ever materialized, at least not through early 2008. In reality, it is extremely expensive to actually buy physical oil and store it. Moreover, the world has few empty tank farms to suddenly start filling up with oil. Reports of armadas of tankers sailing the high seas loaded with oil are always true because countries around the globe import over 40 million barrels of oil from afar daily. But almost all of this oil is being delivered to refineries, not to speculators storing excessive oil.
There were many important circumstances that shook up oil markets in 2008, including growing civil unrest in Nigeria, the continued decline of the North Sea and Mexico’s Cantarell Field (by 30% per year), tight rig markets and tightness of almost all supplies, soaring costs of all new oil supply projects, etc. But the oil story of the year, or perhaps the decade, was the rise in oil prices and their subsequent abrupt collapse.
Many key questions face the oil markets in 2009. First among these is whether the current price collapse will be as short lived as previous “price collapses.” Or will this time be different, given the financial woes of the global economy?
Another key uncertainty is how quickly low oil prices will begin to hurt oil supplies as projects are canceled or postponed and drilling rigs are laid down. Will OPEC actually cut its announced current output and, if so, for how long? When will too many cuts start to draw finished stocks below their minimum operating levels? How would OPEC even know if it cut too deep until it was too late to correct? How low might many key usable stocks really be at the start of the year?
These are all burning issues facing the global oil markets as 2009 begins. The importance of these questions, in both the short term and long term, has never been greater. It will likely not take long into the New Year before we have far better visibility of what is really happening in oil demand, supply and oil inventories getting “too low.”
In the midst of this unbelievable volatility, it is important for key stakeholders in this oil game to ask why oil prices rose so high and so steadily over the past decade and more importantly, why prices then plunged so fast. How much did the sharp rise in oil prices lead to the financial instability we now face? Conversely, how much could the financial credit crisis have impacted the price collapse? What role have “speculators” played in world oil markets’ wild volatility? What sets the price of oil in the first place? Why are sellers of oil always “price takers” instead of trying to become “price makers”? Why is there not a more sensible way to value what is arguably the world’s most precious natural resource? Can the industry cope with this violent volatility? If not, how does the industry “re-group” before it self-destructs?
In the fog surrounding oil, one thing is clear: The price for oil is now dangerously low and will negatively impact supply quickly. Ironically, oil prices at the start of 2009 are one-third higher than what most oil experts ever thought they would be only four to five years ago. But since the cost to find and extract oil rose dramatically, the cash investment it takes to simply try to keep current production flat will dictate that oil prices stay far higher than even $60 or $70 a barrel. Otherwise, supply will drop fast.
What the fundamentals say. A few truisms have materially impacted oil supply and demand. And a few trends have been steadily moving in opposing directions for the 15 years that I have been writing this annual review of oil markets.
The first trend has been the relentless and steady growth we have seen in global oil demand. It seems hard to believe that in 1993, global oil demand was around 67 million barrels per day. By 2000, had grown to 76.7 million; today, it’s about 86 million. Thus, in the 15 years I have been writing this annual overview, global oil demand grew by over 18 million barrels a day. This represented a dangerous growth trend that is simply not sustainable as crude oil supply growth wanes.
While much is made of weakening oil demand as a recession spreads around the world, in reality, supply could not continue to keep up with the growth we saw, even with $147 oil prices. Oil demand might decline in 2009-then again, it might not. If it does, it would be the first decline seen since a brief dip in the early 1990s. But if we have a decline, it would possibly be a blessing disguise if supply can no longer grow.
It is both enlightening and alarming to see how the crude oil and condensate component of liquid hydrocarbons only grew from 68.5 million barrels per day in 2000 to just 73.0 million in 2007, supplying only 60% of the world’s growth in total petroleum use. To bridge this gap, NGLs had to grow by 1.3 million barrels per day, other liquids and refinery processing gains increased over 1 million barrels per day and, occasionally, the demand gap got filled by liquidating usable inventories of crude and finished petroleum products. This is a dangerous game of Russian roulette that is not sustainable and is inherently unsafe for the world’s economies.
So, why did prices rise so high in the first half of 2008? Blame a weak dollar, blame speculators, blame war risk premiums or any other reason for why oil prices rose so high, but remember that this rise did not start as the year began. The price went up almost 15-fold over the last decade (from about $10 to nearly $150). The real culprit for this unprecedented decade-long rise was a steadily tightening market fed by unsustained demand growth that too often got topped off by stock liquidation.
If the price rise was so steady and happened over such a prolonged period, what then caused oil prices to collapse in the final three months of the year? There are no statistics to explain this drop. None! A probable immediate impact of the credit freeze, which coincided with oil prices falling, certainly caused some key oil trading firms to liquidate many “paper” oil contracts. This is the only plausible, but still unproven, answer for why prices could fall by 74% in such a short time.
Another key issue loomed ever larger as 2008 unfolded. The global oil system ran out of spare drilling rigs, welding equipment, oil country tubular goods and virtually all other services and products vital to keeping oil flowing from old wells and new wells being drilled. As the year wore on, the tightness worsened. This was the end game of the industry massively underestimating its relentless need to drill more wells.
Production decline rates in virtually all mature oil fields around the world, and the rapid declines in almost all new oil fields, particularly in deep waters, went almost unnoticed by most industry observers. These declines effectively created an invisible treadmill to keep supply flat. What made this worse was a failure to add the assets needed to keep drilling an ever-increasing number of wells. If the world had an abundance of additional rigs and related services and equipment, crude supply might have kept up with demand growth, but the tools were not there.
Add to these challenges two other serious issues-“people” and “rust”-and a picture of an industry barreling toward a brick wall quickly emerges.
There is a serious shortage in trained workers to replace a retiring workforce. The people shortage is endemic-from roughnecks on the rig floor to trained engineers and petroleum geologists. The cause of this shortage is simple. For two decades relatively few new candidates entered the oil industry, and in every down-draft in oil prices, too many people were laid off. While diagnosing the problem is simple, there is no easy solution to the workforce issue. The recent price collapse will unfortunately bring an end to any recruitment success throughout much of the industry, and indeed layoffs have already begun.
“Rust,” the second cancer the industry faces, is a code word for another issue that has been ignored for far too long. At least 95% of the complex infrastructure that supports the world’s use of 85 million barrels of oil each day, or 3.6 billion gallons of oil products each day, comes from steel-built materials. This delivery system ranges from wellbores and wellhead systems to gathering lines, tank farms, refineries, pipelines, tankers, drilling rigs, fracing and acidizing trucks, etc., all the way to about 500,000 - 650,000 individual fueling stations spread around the world.
There is one constant about steel: It begins to rust the day the steel is cast. The old maritime saying “rust never sleeps” still holds true.
A high percentage of this infrastructure is likely beyond its original design life and, in some cases, significantly so. We need to plan on too much rusting away just like inadequately maintained highway bridges and poorly refurbished old buildings.
Like the people shortage, this rust crisis was entirely predictable but also almost totally ignored. Now, a construction public works project undertaken on a global basis is urgently needed to avoid the double indignity of having accelerating declines in the existing flow of oil coupled with the collapse of the delivery system, making it impossible to deliver a shrinking supply base.
It is impossible to begin gauging the cost in time and material to tackle such a reconstruction effort. It would easily exceed mounting D-Day or the Marshall Plan’s rebuilding of Europe after World War II. My guess is that it would take millions of welders, engineers and construction workers to even begin the task in North America alone. The global cost of this massive replacement program might well exceed $100 trillion, or more than twice the global gross national income. Never in history has so much needed to be spent so fast to save and sustain the world’s most important industry.
In light of all these real supply challenges, there is little likelihood that oil prices can stay so low for very long. This will take too much supply off the market. If supply falls, then demand declines and oil prices could soon soar as the impact of low prices cuts supplies and OPEC cuts too sharply into what are still low inventory levels by any historical basis.
There was one watershed event in 2008 that should have overshadowed the wild rise and collapse of crude prices. It was the first ever detailed field-by-field supply study released by the International Energy Agency (IEA) in mid-November.
As carefully laid out in Chapters 10 - 13 of the IEA’s World Energy Outlook 2008 publication, based on a detailed review of the top 800 producing oil fields in the world (which account for 58% of the global crude oil supply), just to keep current supplies flat would require adding the equivalent of four new Saudi Arabias in the next two decades. Figures 1 and 2 tell the whole story of why strong demand growth has come to an end and why the IEA leadership stated so bluntly in November, “The era of cheap oil is over.”
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Fig. 1. World crude oil production from giant and supergiant fields by field vintage (year of first production).
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Fig. 2. Future world hydrocarbon liquid production components showing sources of crude and other liquids under certain assumptions.
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Figure 1 shows that 25 million barrels per day of our crude oil supply still comes from a small handful of supergiant and giant oil fields discovered before 1970. Virtually all these mature fields have passed peak output and are in irreversible decline. Only a tiny amount of supply comes from those of the 800 largest fields around the world that were discovered in the past two decades.
The IEA study exposed for the first time how reliant the entire world is on only a handful of supergiant oil fields.
Figure 2 shows the high likelihood that the existing producing base will have fallen to 25 million barrels per day even if massive investment is made to offset natural declines. Absent this investment, the existing production base could be as low as 8 - 10 million barrels per day by 2030.
It is truly unfortunate that this extensive supply analysis was not undertaken a decade ago. Had it been, the world would have then understood how fragile the oil supply base really was. We never would have created a blueprint for a global economy that was based on such a voracious appetite for oil.
So the oil market faces perhaps its greatest challenge in history with crude oil supply either already peaked or at an undulating plateau as 2009 begins. The world can likely dig out from all the financial problems it faces, as most are paper problems that can be solved with more paper.
But we lack an Energy Czar to create any solutions to the daunting problems like rust, people, accelerating decline curves, lack of adequate rigs, etc., that are all very real and vital to solve in order for the world economy to continue being powered by a usable engine.
In 2009, one event that would create a victory for oil markets would be to find a way to end excessive price volatility before it destroys the oil industry.
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THE AUTHOR
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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 serves on the boards of several industry and civic groups and art institutions. He is past chairman of the National Ocean Industries 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.
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