The not-so-bullish case for energy prices | FT Alphaville

The not-so-bullish case for energy prices

The bullish case for oil has been fairly well established by the likes of Goldman Sachs, Barclays, Merrill Lynch at al.

But, as it turns out, there’s a convincing bearish case to be made too — and the man putting it forward most recently is Edward Morse, director of economic research at LCM Commodities.

In a piece published in the latest edition of Foreign Affairs Magazine Morse makes the point that oil only went to $147 per barrel in 2008 because of the coincidental convergence of a number of supply-related circumstances unlikely to be repeated any time soon.

As he writes (our emphasis throughout):

Most oil industry analysts expect high prices to return soon, along with economic recovery. This is probably a mistaken view; more likely, the prices for oil and other commodities will be range-bound again. This would be a happy development, as it would provide unusual opportunities to tame the volatility in prices.

But actually, he says, the key factor behind soaring prices in 2008 was the disappearance of Opec spare capacity:

… in 2002–3, the overhang in production capacity evaporated rapidly and unexpectedly. Some analysts invoked the so-called peak oil theory and blamed the situation on an unprecedented acceleration in the decline of oil production caused by the gradual exhaustion of underground resources. But there were more reasonable explanations for what put pressure on oil supplies. Even those countries with plenty of oil resources suffered political impediments to production that could not easily be removed. Venezuela’s state oil company went on strike in protest against President Hugo Chávez, civil disorder over living conditions in the Niger Delta crippled Nigeria’s oil sector, Iran failed to put in place an investment regime to attract foreign capital, the United States launched a war to oust Saddam Hussein, and resource nationalism in Russia and other non-opec countries reduced production growth.

In short, he says, the virtual disappearance of surplus oil-production jolted the market and the lost cushion surprised both consumers and producers — not least Saudi Arabia, which depends above all on its   ‘producer of last resort’ status for political clout both within Opec and the world.

With that in mind, Saudi Arabia had a big incentive to raise production. And it did so, remarkably successfully Morse adds, to 12.5m barrels a day by 2009, with another 1m on standby by 2010.  That should bring Opec’s total production capacity to 37m per day in 2010 — more than 10m barrels per day above today’s level. Which is why it stands to reason, as Morse states:

The disappearance of spare Saudi production capacity was the most critical element in driving up prices from 2003 to 2008—and its reemergence should be the most critical element in keeping them low over the next three years (or more, if global demand fails to rebound enough). Saudi Arabia wants spare production capacity for multiple reasons, including, importantly, to give it influence in the g-20 (the group of finance ministers and central-bank governors from the leading economies) and other international forums. Riyadh’s ability to increase production is the key to its being taken seriously.

The bullish argument, of course, also focuses on non-Opec production declines squeezing prices again. But here again, Morse disagrees:

For one thing, these analysts ignore the fact that the lead-times in finding and developing oil are long, sometimes as long as ten years. Investments from the past half decade will start to bear fruit over the next few years, which means that even the price downturn of late 2008 will have little impact on supplies in the years ahead.

The Saudi national giant Saudi Aramco massively increased its investments to develop new resources after 2003. So did oil firms large and small throughout the world. But unlike their Saudi and other Middle Eastern state-controlled counterparts, international oil companies did not have an inventory of discovered but undeveloped fields readily available.

They had to go out and find new ones. Some energy analysts have suggested that these firms’ efforts were hindered by diminishing prospects, hikes in production taxes, or moves by the governments of producing states to reserve increasing shares of potential finds for their state-owned firms. In fact, there were plenty of deep-water resources waiting to be tapped—in the Gulf of Mexico; off the coast of Brazil; in the eastern Mediterranean; in the Gulf of Guinea; in the Caspian Sea; oª the shores of India, China, Indonesia, and Australia; and along the shores of Arctic-bordering states (the United States, Canada, the United Kingdom,Denmark,Norway, and Russia)—and oil companies spent increasing sums to do so.

If there was an obstacle, it was not a lack of hydrocarbon reserves— deep-water resources appear to be even more abundant than was thought a decade ago—but a lack of equipment to discover and produce them. Fewer than two dozen drilling vessels (each costing $1 billion) were available in 2000. But as contracts were put in place at the time of very high oil prices, the fleet of vessels started to expand. By 2012, there should be closer to 150 such units available for finding and developing deep-water resources.

Meanwhile, Morse adds, there’s also been major technological advancements allowing for hydrocarbon production in regions previously considered energy deficient — specifically in the form of shale gas out of the United States and Europe. As he explains:

The United States used to be considered a country that would eventually suffer a long-term natural gas deficit and be condemned to import supplies, some piped from Canada, others shipped as liquefied natural gas (lng) from around the world. But high gas prices—as high as $13 per million btus in 2008, some 160 percent more than prices today—have spurred phenomenal developments in technologies to drill for natural gas trapped in shale rock throughout the United States.The Haynesville Shale, in Louisiana, is so large and prolific that even as the use of gas rigs has fallen in other parts of the United States, current activity there makes up for a quarter of the decline elsewhere. Even at today’s lower natural gas prices, total production in Haynesville could increase tenfold by late 2010.What is more, the Marcellus Shale, which stretches from West Virginia through Pennsylvania and into New York,may contain as much natural gas as the North Field in Qatar, the largest field ever discovered. Shale resources in North America are so vast that plans are being made to develop them for export as lng from Canada’s west coast.

Shale resources are also widespread throughout Europe, and in the aftermath of Moscow’s hardball diplomacy vis-à-vis Ukraine in early 2008 and early 2009, interest is growing among European governments to find replacements for Russian supplies.

Finally there’s the demand-side argument. Morse, for example, believes a return to prior growth rates is actually quite unlikely.

For one thing, the market is responding to last year’s high prices. Tracking the trend, the International Energy Agency has lowered its estimates for oil demand in 2030: it forecast 106 million barrels a day in its 2008 report, down from 116 million barrels a day in its 2007 report. Projections of future demand will inevitably be cut even further: one extraordinary lesson of the last 60 years is that after every spike in oil prices, demand growth flattens considerably.

Related links:
A very bullish oil presentation from Goldman
– FT Alphaville
Natgas, literally under pressure
– FT Alphaville
What is happening to Saudi Arabia’s capacity as Khurais comes online? – FT Energy Source
Peaking oil demand – FT Energy Source