Running Dry

Where does the oil price go from here? After a 100 per cent rise in 24 months, a correction might seem well overdue '” unless, of course, higher prices are more correct than lower ones. A fall would work like an interest rate cut. It would give relief to the global economy and temper rising geopolitical tensions; whereas further rises would fuel inflation, add billions to the US deficit, make squillions for the oil companies and fray nerves everywhere.

The spectrum of opinion on oil prices is broad. To Morgan Stanley, the oil price is a speculative bubble about to burst. It believes China's 35 per cent surge in demand last year distorted the market. Merrill Lynch goes for supply tightness and firm pricing in light oil, but thinks $60 a barrel is unsustainable in the longer term. UBS envisages a slow correction, its oil models predicting $48 for 2006 and $35 by 2008.

On the other hand, a clutch of oil pessimists see supply risks and new levels of demand. In May this year, the US investment bank Goldman Sachs received worldwide attention when it released a benchmark report that predicted spikes, triggered by supply bottlenecks, as high as $105 over the next two or three years.

Canadian bank CIBC expects a grinding tussle between demand and inadequate supply, spreading suburbs, new world affluence, just-in-time logistics, budget airlines all making stronger calls on oil. The IMF, with an even gloomier view, fears that new supply will be totally inadequate and calls for massive, urgent exploration spending. French investment bank Casse D'Epargne/Ixis expects severe supply shortfalls, thinks depletion is running high and predicts $340.

So far, the pessimists have been on the money. Their predictions five and six years ago that oil would start an inexorable rise by 2005 or 2006 were not far out. They also said the US natural gas price would surge a year or two later. With hindsight, this was optimistic because it has already risen 20 per cent this year. The price of natural gas, at US$8.50-US$9 per 1000 cubic feet, is four times higher than in 2002 and causing pain to US power utilities. Economists may console Americans that "demand destruction" will reduce the price of gas, but already there has been industry destruction. As dramatically higher gas prices have hit producers, 21 fertiliser plants (20 per cent of US production) have closed. Imports based on cheaper Asian gas will muscle out the local product and US food prices, already pressured by oil, will rise.

Until recently, commentators dismissed the oil pessimists as myopic retirees and cranks. The said they were ignoring normal market behaviour, whereby supply would obviously increase as prices rose; swelling cash balances would set drills going full bore; much of the world was still lightly explored; there were new extraction techniques that would mean work-overs and access to deep oil not yet exploited.

The doomsters didn't see it that way. They focused on geology, arithmetic and the physics of oil reservoirs. They were not saying that oil would run out, but they did believe that targets would tend to be higher risk, offshore, more remote, deeper and more costly to drill. In their experience as former senior geologists, they believed the big oil companies were risk averse, and that the more the risks rose, the more averse they would become.

This has been borne out by the behaviour of Big Oil (the world's largest oil companies). It ought to be drilling like mad, but over the past two years as much money has been allocated to buybacks and takeovers as exploration and drilling. Many also have a mindset that oil should be US$25-$US30 a barrel, so they are damned if they will risk royalty arrangements that leave slim pickings when oil returns to normal levels.

One obvious argument for price moderation is spare capacity in the Middle East. Even conceding that conventional light oil may grow scarce in 20 or 30 years, at present OPEC has two million barrels of shut-in capacity. The world's biggest oil company, Saudi-Aramco (the Saudi national oil company), said it could lift production by 50 per cent to 15 million barrels a day and, at a pinch, to 20 million. Recently it has reduced this figure to 12 million, but that is still 20 per cent more than present production.

These two million spare barrels are often talked about, even if they are sometimes described as only one million. The precise figure perhaps doesn't matter because the conventional attitude has been that normal market forces will reassert themselves once temporary problems, Iraq for example, have been resolved.

However, some problems are more than just temporary: Bin Laden remains at large; Iraq could slip into civil war over the division of its oil fields; and further attacks on oil infrastructure are likely.

Oil quality also matters. If it is sour or heavy (lower grade oil), then most refineries are not equipped to handle it. And there is an even deeper problem with those one or two million barrels: they seem to have disappeared.

The latest figures by the world's largest energy statistical bureau, the US Department of Energy's EIA (Energy Intelligence Administration), show there is now no spare capacity. It lists world demand in the first quarter of 2005 at 84.38 million barrels a day and supply at 84.12 million, a 260,000-barrel shortfall. This may simply be because of the usual difficulty of accumulating timely and accurate oil data, but it does roughly fit with what the price is telling us.

More interesting are the revisions to demand forecasts. In five of the past seven years, the EIA's figure was, in retrospect, quite low. The IEA (International Energy Agency), the Paris-based European equivalent, and Australia's ABARE have, to varying degrees, also undershot. The EIA explains this bias towards lesser demand as an assumption that rising prices reduce demand. This is a fair assumption when supply is not an issue.

This year, the EIA has changed its tune and now says demand will be up 2.1 per cent, which is stronger than the trend. OPEC opts for a more modest 1.8 per cent (an extra 1.57 million barraels a day). That may not sound like a lot of oil, but it is almost exactly the same as Algeria's 2004 exports.

This is not to say that supply cannot rise, and so far it has, the oil industry and OPEC apparently doing their best to meet the market. The issue is knowing when the big new fields will come on stream and at what cost. One study of pending supply suggests eight million barrels a day of new supply will arrive by 2007, but the same study is more pessimistic about the following five or six years.

But supply itself is not the whole story. It is not just that a new Algeria or Mexico has to be added for new consumers each year; an Algeria goes missing each year as well. This is what US Vice President Dick Cheney described as oil's "pesky" problem: it depletes. When Cheney was CEO of Halliburton in 1999, he thought an additional 50 billion barrels per annum was required by 2010; three years later, Harry Longwell, an Exxon Mobil vice president, said 80 billion.

In other words, many industry leaders know full well we are past normality in the oil market. David O'Reilly, the CEO of Chevron, calls it a "new oil equation". This suggests that the greatest worry about oil is not terrorism or supply bottlenecks; rather, it's end-game. The North Sea is depleting at 5 per cent per annum; Alaska's giant Prudhoe Bay is depleting at 8 per cent per annum.

Meanwhile, Ghawar, the greatest oil field in Saudi Arabia, which has been producing more than half of all Saudi oil, has a depletion rate of 5 per cent and 18 years of life remaining. It seems highly unlikely that Saudi-Aramco officials would recklessly drive Saudi oil production over a cliff, but a field 55 years old and bringing up around 35 per cent brine with the oil is much more likely to be closer to hydrocarbon senility than youthful vitality. Saudi-Aramco says at least 50 years remain, but physics is a better guide than corporate PR.

Deletion would be a less pressing issue if demand moderated. Certainly, Asia is baulking at the present prices, but the US is the market that counts. The US consumes 25 per cent of world production and imports about 12 millions barrels a day, which is almost what US cars use. So, substantial price relief might emerge if US drivers suddenly cut back on trips to work, shopping malls, school and church.

Because state taxes on gasoline are low, pump prices may be irritating for most, but not excruciating. Wages are firm, housing prices are up and, besides, economists keep telling consumers that the oil price will drop soon enough '” because it always has.

In any event, there is precious little households can do about it. Catching the train or bus is not an option because most US cities did away with trains, trolley cars and buses years ago. Only a dozen have light rail. China will cut back, but for how long? Beijing has pinned its hopes on the auto market to provide employment, spin-off industries and exports. Cars are also very fashionable in China '” sales rose 50 per cent in June '” and the mayors of a dozen cities have banned bicycles in their central city precincts.

As Exxon's Harry Longwell suggests, the situation is "challenging". Uncertainties and loose ends abound, but most of those loose ends are pointing the oil price upwards.

Richard Campbell is a securities adviser with stockbroking firm, Bell Potter.