What is happening with the future of oil prices ?

Posted on July 8, 2008. Filed under: Uncategorized |

The hard facts on Oil Prices

  • The world price of oil in US dollars has doubled in the last year (June 2007 to June 2008) from US$67/barrel to over US$135/barrel
  • The world price has gone up by 6 times in 6 years, from US$20/barrel in 2002 to over US$135/barrel by mid 2008
  • With hindsight we can see that the great cheap oil era lasted 16 years from 1986 to 2002 when the price was mostly in the range $15 – 25/barrel, coming off a $39 peak during the “oil shock” of 1980 (equivalent to about US$95/barrel in 2008 money). The short sharp spike seen at the end of 1990 was due to the first Gulf War.

Due to the growth in oil supply not keeping up with steadily growing demand around the world.

Oil is getting more expensive because surplus production capacity has diminished and continues to diminish, as shown in the chart on the next page. Oil industry volumes are of enormous scale (86 million barrels per day – a barrel is 159 litres), and the costs of supply infrastructure are in the billions and trillions of dollars.

Lead times for new industry infrastructure are typically 3 to 10 years. All new mega-projects on the production side are well known out as far as 2012, and few seem likely to boost global supply by enough to overcome declines in old oil fields. See the comprehensive listing of oil megaprojects at http://en.wikipedia.org/wiki/Oil_Megaprojects/2008.

The balance between growing capacity from new infrastructure investments and declining output from old infrastructure has seen global production capacity climb at a slower rate than consumption for the past 25 years, as shown in the following chart. 

The analysis by Goldman Sachs in the next chart below suggests that price rises to date have already destroyed demand amounting to about 5 million barrels/day or 6% of current world consumption. Any further price rises may be expected to cause further demand destruction and consequent hardship for those being priced out of the fuel market. 
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Why shouldn’t we get back to the $20/barrel we enjoyed in the 1990’s?

It’s simple – the world has used up practically all the easy “light sweet” crude oil that used to pour out of desert sands for $3 – 4/barrel and be easily refined into saleable products. Discovery of oil peaked more than 40 years ago – see the chart below.   

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Not only is it costing much, much more to find and extract each new barrel of oil (typically $60/barrel for new deep offshore wells) but most of the oil we can now get is shifting towards “heavy” and/or “sour” grades that require billions of dollars of new investment in refineries to process them.

“The oil is getting harder to extract. Most oil comes from ageing, waning giant fields discovered long ago. There are no more giant fields to find, only lots of small ones, difficult ones or fields deep under the ocean. The remaining crude oil is heavier, thicker, dirtier, quite simply cruder! It’s difficult to get out, expensive to get out, slower to get out. So, the rate of oil extraction will decrease.” Michael Lardelli on Perspective, ABC Radio National, 26 June 2008

There is no going back to $20/barrel short of a world recession that shuts down demand for oil, and for everything else. 

This year many refineries have been finding it harder to buy oil of a grade they can economically refine, especially the 50% of US refineries located in the Gulf of Mexico who are suffering steep declines in overseas supply from their

The table below shows, for oil exporting nations, net export declines accelerating from 2006 to 2007. Monthly data for 2008 shows that the overall downward trend is continuing. It is the declining volume of tradeable oil on global markets that is causing steep price rises this year when we are seeing only moderate abatement of growth in global demand.

If declines in the supply of tradeable oil were not enough to create a tight market, buyers are reacting nervously to talk of attacks on Iran by Israel or the USA, and it only takes a rumour to send oil prices on another upward jump.

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Critically, Saudi Arabia appears now unable to perform the role of market stabiliser that it played from the 1980’s until the 2000’s on the basis of its known ability to pump up to 20% extra volume at short notice. Depletion of Saudi Arabia’s giant oil fields appears to have taken away its ability to help the world in this way, though the Saudis will not directly admit they no longer have this power.

It seems likely that since 2007 OPEC has lost effective cartel power because few of its members have the ability to pump more oil. This means the cartel as a whole can do practically nothing to bring down prices even though key members like Saudi Arabia have much of their wealth tied up in Western economies and are clearly concerned about damage to their own interests if oil prices go any higher – thus the Saudi conference held on the 22nd of June 2008. 


So what happens next?

Price rises did indeed pause in mid-June after an astonishing $11 run-up on Friday 6th June. Traders may have been waiting for an outcome from the Saudi conference on 22nd June, which was soon seen to have provided little new knowledge or cause for optimism.

Game on. Futures topped $140 for the first time on 26th June. 

So what will next week, next month and next year bring?

“Predictions are always difficult, especially about the future.” Niels Bohr 

There are essentially two patterns of oil price prediction being made by informed pundits:

  1. Ongoing steady price rises driven by the continuing supply-demand squeeze
  2. A big discontinuity caused by demand destruction of a major sort, followed by a short period of lower prices then a resumption of ongoing steady price rises driven by the continuing supply-demand squeeze.

We are compelled to once again raise our target prices for oil. We are lifting our target for West Texas Intermediate by $20 per barrel to an average price of $150 next year and by $50 per barrel to an average price of $200 per barrel by 2010.” 


Pattern B – Price moves down then up on a rising trend

The other school of oil price projections makes the common-sense point that serious demand reduction and perhaps economic recession in some countries will be triggered when oil prices reach a critical level – when “demand destruction” becomes really destructive. Proponents suggest that such a free-fall in demand from one or more larger consuming countries such as the USA will be dramatic enough to drop price back to, say, US$100/barrel for a period of time.

Some writers guess that the critical price point to cause such sudden and significant demand destruction may be US$200 – 300/barrel, based on percentages of world GDP, but the accompanying analysis is weak and the arguments published to date do not convincingly pinpoint a critical price for oil above which it cannot go. 


Conclusion: Stay awake, expect oil prices to be in dynamic movement.

Conservatively, plan for US$200/barrel by 2010, but don’t be surprised if a recession somewhere drops price back to US$100, for a short while, or sudden war in the Middle East sends prices skyrocketing.

Expect the fundamentals of fading supply growth and growing demand to push prices ever higher in the 5 year horizon, perhaps well beyond US$300/barrel.  


Finally, let’s look on the bright side.

There is plenty to like about moderately higher oil prices, if communities, businesses and economies take heed and get time and help to adjust.

Less traffic, less congestion and less pollution would be a big plus for most of us.

New business opportunities should spring up in areas such as energy conservation, Natural Gas conversions, cleantech industries, electric vehicles and freight optimisation.

Having the world place a higher value on energy from oil will change a lot of business decisions, improving our resource efficiency and enhancing sustainability.


Read full guest post from anawhata at The oil drum


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