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Surprised in October? A New World of Oil By Marshall Auerback
"The Saudis are out of capacity. That's my opinion… They have no infrastructure or extra pipes or gas, oil, and water separators [very expensive large globes used to separate what comes out of a water injection well]. They have very heavy oil which, through a conventional refinery, produces asphalt. We don't need asphalt. We need gasoline. It takes a complex refinery to make gasoline and it only takes 7-10 years to build one." -- Matt Simmons, Simmons & Co., a leading independent oil analyst
As July began, Saudi Arabian officials announced that they were satisfied with the current level of world oil prices, around $35 a barrel -- the clearest indication yet that the kingdom has abandoned support for the old OPEC price range of $22-$28 per barrel. Saudi Arabia's oil minister Ali al-Naimi indicated that, at current levels, oil prices were "fair." Two implications flow from this:
*The Saudis have now lined up with the rest of the OPEC cartel in implicitly suggesting that the old reference benchmark of $22-$28 was less than fair. From this flows a simple but dramatic conclusion: It is highly unlikely that we shall see an "October surprise" in which the Saudis flood the crude oil market in order to bring prices down sharply and thereby help ensure a Bush re-election. Faced with rising welfare costs and escalating political tensions, the kingdom has a corresponding need for additional capital expenditure for increased oil capacity. Goldman Sachs estimates that the Saudis require an average price of at least $30 a barrel over the next 5 years just to maintain real per capita expenditure.
*Perhaps more significant, the Saudi statement speaks volumes about the true state of supply/demand in the oil market. The kingdom's actions may in fact constitute an implicit fait accompli, an acceptance of their inability to increase production substantially beyond current levels, bringing the days of peak oil production ominously closer.
The latter point is especially germane to those who continue to harbor thoughts of a return to cheap oil. It remains the consensus among investors on Wall Street and among a number of policymakers in the West that current high prices are a temporary aberration. Such misplaced optimism mirrors the stated (inflated) production targets of oil companies and oil-producing nations. Oil companies themselves appear to be consistently overly optimistic because of their desire to convey to investors that they still have attractive growth prospects. This was certainly the case with Shell, which only recently sacked its CEO and director of exploration for persistently overstating the company's reserves.
The oil-producing nations of OPEC also continue to set forth ambitious production targets in an attempt to negotiate more favorable OPEC quotas. So far, careful analysis of these optimistic forecasts has revealed that they are based on questionable assumptions regarding investment and technology as well as unrealistic timetables. They all assume quite low depletion rates on existing output. Lastly, the historical record shows that this sort of optimistic bias has prevailed for some time, while actual production growth has consistently fallen short of optimistic forecasts.
It is striking that the vast majority of Wall Street oil analysts, indeed, the oil companies themselves, have continued to base their forecasts on the old OPEC targeted price range of $22-$28 per barrel in spite of increasing evidence of looming supply shortages. But the comments by Saudi Arabia last week, coupled with concerns raised by Nigeria, Iran, and Venezuela, all suggest that OPEC may finally be acknowledging the new reality: Depletion dynamics -- a technical term which simply refers to declines in production of existing fields regardless of demand or increased capital expenditure to improve them -- have now come to the fore. Investment aimed at newer, smaller reservoirs and improving existing fields will not be enough to overcome these depletion dynamics. Therefore even with higher prices and higher levels of investment, growth in global oil output will slow.
Which does call into question the efficacy of the planned production increase OPEC announced with some fanfare last month in Beirut. OPEC officials assured the world that the organization would increase production by 2m barrels per day to 25.3 million barrels per day in an attempt to cool down global oil prices. There is some question, however, about the sustainability of such production hikes, given that the cartel has not pumped out such volumes of crude since the second oil shock produced by the Iranian revolution over a quarter-century ago.
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