Oil has been markedly absent in the financial headlines lately. While the recent clamor over EU solvency and weak global growth has temporarily displaced its media attention, oil’s crucial importance to the world economy has not dwindled in the slightest. Oil remains the world’s greatest single energy source today, providing over 1/3 of our energy supply. Although it is well understood that the oil price is critical to the global economy, we sometimes neglect to appreciate how tightly oil supply is correlated to global growth. By historical standards, the world has been coping with constrained oil production and high oil prices for most of the past six years. This tightness in oil supply has been a significant factor limiting global growth, and it would appear that no matter what financial solutions are eventually engineered by our politicians, global growth will remain significantly restricted by the real economy’s ability to produce oil. Limited global supply growth means that the Western world now faces significant competition for oil from emerging markets whose citizenry are willing to work much harder for far less. This will continue to result in a narrowing gap of per capita consumption between emerging and developed economies as the emerging economies continue to gain relative economic strength, wage growth, currency appreciation and purchasing power. We believe strategic investments in oil producers and service companies will offer an effective way to profit from this trend.
Production – Where’s the Growth?
We begin with a review of global oil production. We first wrote about Peak Oil back in 2005; and speculated that we were approaching the pinnacle of global crude oil production.1 As Figure 1 below illustrates, since that time, global oil production has grown very little, appreciating by a mere 2% in total production. This production plateau generated the 2008 oil price spike to nearly $150 per barrel. Subsequently, despite the economic stagnation experienced by developed economies, the price of Brent Crude Oil has averaged over $78 per barrel, four times higher than the ~$18 average that Brent traded at in the 1990s.2
Despite this extremely large and sustained increase in price, oil production has failed to grow meaningfully. Over the past ten years, most experts have consistently overestimated future production growth and have continually revised their forecasts lower as a result. Figure 2 from the U.S. Energy Information Administration (“EIA”) below charts production forecasts made in 2000, 2005 and 2010. Over the last decade the EIA has revised its global oil production estimates lower for 2015 and 2020 by 14% and 18%, respectively. In light of these downward revisions, it still seems extremely optimistic that supply will increase significantly in the coming years.
Figure 3 above illustrates that the International Energy Agency (“IEA”) estimates have been just as inaccurate, forcing it to reduce its global oil production estimates year after year. It is also important to reflect on the pricing environments that were predicted years ago when these optimistic forecasts were made.
Above are charts of the EIA’s 2002 and 2010 oil price predictions. Over the last eight years its high case future price prediction has increased by over 600% from the low $30s to north of $200, while the median reference price has gone from below $30 to almost $150 by 2035. Reflecting on these historical price forecasts really puts into perspective the amount that production growth has disappointed. Had the oil price stayed in the EIA’s 2002 predicted price range, global production would have significantly declined. In fact, all of the production growth we have experienced since then can essentially be attributed to high cost oil operations which are economically dependent on very high oil prices.
We highlight the magnitude of these forecast errors not to criticize their sources but to emphasize how terribly unprepared we are to deal with an oil production-constrained world. Economic growth is well correlated with oil consumption as increasing global GDP requires increased energy use that is heavily oil dependent. Conversely, if oil supply is limited or declines, real economic growth tends to stagnate, if not decline, in lockstep. If a country begins to lose its access to affordable energy its economy will likely shrink.
Why are Prices High? – No More Giants
There are a number of reasons why there has been so little growth in supply. First, and most importantly, global supply is struggling to grow because we are not finding and bringing into production any new “super giant” oilfields. This reality was well documented by the EIA in a study it published in 2008.3
The EIA study revealed that the largest 1% of oilfields (798 total fields) in the world account for over 50% of global production. Remarkably, in this group, there are 20 super giant fields which account for roughly 25% of global production. All of these super giant fields were discovered decades ago.
What has been discovered and brought into production in the past few decades are smaller fields, which normally have higher decline rates. As these new smaller fields replace production from larger fields, and older larger fields age, we can expect the global observed decline rate to increase from the current estimated rate of 6.7% (or 4.7 million barrels per day annually).
Rising Production Costs Necessitate High Prices
Oil prices are also high due to rising production costs, and it’s worth noting that new production sources, such as offshore, tar sands and other unconventional sources are amongst the highest cost producers today. These oil sources now make up a significant and growing percentage of global production. As a result, it is becoming clear to many industry analysts that current oil production cannot be sustained under $75 a barrel and the price required to sustain production seems destined to continually rise.
Middle East Exports are Increasing in Cost and Risk
There have also been significant political developments of late which have permanently altered the dynamics of the oil markets. The so-called “Arab Spring” uprisings in countries such as Egypt and Libya are forcing these and other major oil producing nations to spend more of their oil revenue on social assistance programs. For example, as a result of newly announced social spending in Saudi Arabia, it is forecasted by The Institute of International Finance, Inc. that the budget balancing price of Saudi oil will jump from $68 per barrel in 2010 to $85 per barrel in 2011 and then continue to rise, but at a slower pace, to $110 per barrel by 2015.4
In general, it can also be said that political instability and social unrest are very detrimental for oil investment and production. Recently, as Libya collapsed into civil war, production went to near zero causing extreme volatility in the Brent Crude price. As the Middle East region continues to experience riots and protests, we can only assume that there will continue to be heightened risk of disorderly political change which could dramatically increase prices in the future.
Regardless, it now appears that even if, politically speaking, the status quo is maintained, the majority of the Middle East exporting nations are now producing at or near capacity while domestic consumption is increasing. Their economies and populations are continuing to grow and mature and, as a result, their exporting capacity will in turn be limited and possibly begin to terminally decline.
Major Oil Companies’ Production in Decline
The struggle to grow oil production, especially non-OPEC production, was highlighted in a recent report by Deutsche Bank’s Paul Sankey that measured the dramatic oil declines for major oil companies in Q2 2011.5 Despite $120 per barrel Brent pricing during Q2 2011, the results of more than 20 major oil companies showed a 1 million barrels per day year-over-year decline. The sample group in the report accounted for over 1/3 of global production, so it would be difficult to expect smaller companies to make up their shortfall.
Supply Constrained and Prices to Remain High
In summary, even though the oil price has been averaging 4-5 times higher than the most knowledgeable industry watchers would have expected just eight years ago, global production has remained relatively stagnant. Government agency production estimates have been overly optimistic and a review of the oil market environment suggests production will continue to disappoint. High prices are now required just to maintain current global production. Even with robust pricing, it is beginning to appear that a tremendous amount of our existing production is at risk due to rising rates of decline and political instability. These factors may soon push global production into an irreversible decline. (more)
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