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Why Are Oil Prices Rising? “The Answer” Comes

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rossi   Tuesday, 07/08/08 01:30:54 AM
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Why Are Oil Prices Rising? “The Answer” Comes into Focus

Recent information and analysis has clarified the dimensions of the energy Tsunami - what is causing the price to rise and how future prices and supplies will behave. The distinguishing characteristic of the picture is complexity. People want simple answers which is why so few of them understand oil. The oil world is huge and its behavior is multifaceted. Understanding it takes more than a simple minded idea like “blame the speculators.”

The reality is that the oil market is undergoing a sort of “perfect storm” of many different factors, including:

1. A group of countries that together produce 13% of the world’s oil are mismanaged or infested with political violence causing them to produce far less oil than they could if they had a stable government and market economy. The underproduction could be as much as 5 to even 10 mb/d (million barrels a day).

2. Russian oil production is declining. That fact has dire implications for the amount of oil available to future export markets, as discussed in the link. When you combine declines in Russia with those of Mexico and the North Sea, the extent to which non-OPEC supply could decline in coming periods becomes significant.

3. Within OPEC it is uncertain as to whether Iran and Nigeria will increase or decrease their oil exports in future years. Saudi Arabia, Angola, and Libya are the only OPEC countries likely to increase oil production near term. Iraq is a potential bright spot starting in a few years at best.

4. Old oil fields produce less oil each year, which is called the decline rate and the amount by which they decline must be made up by production from new fields. Global decline is estimated to be about 3.5 - 4 mb/d per year, a much greater number than additional oil demand that is estimated to range from 1 - 2 mb/d per year.

Decline rates for existing fields have been rising and will probably continue to rise as more extreme methods of recovery are applied to old wells. The geological rule is that as efforts to increase the output of a field by extraordinary pressurization and drilling efforts becomes greater, the field will decline much more rapidly once the decline starts. For that reason, there is a risk that the largest Saudi fields - and others such as Russian fields - may decline more rapidly than currently is projected and such increased declines could start to happen fairly soon.

An additional important fact regarding decline is that newer fields tend to be offshore and offshore fields exhibit much higher decline rates than land based fields. Offshore fields often decline by 8% - 15% per year compared with 5% - 8% for land fields.

5. Megaproject analysis indicates oil supplies coming from new oil fields will substantially drop after 2010 and will drop even more steeply after 2013. Some projects scheduled for the next few years could face substantial delays. If so, some of the projects now projected to start up in 2008 - 20010 will be delayed into the 2011 - 2015 time frame. That will add to price pressures in the near term. The megaprojects work is the most tangible evidence of a coming oil supply crisis.

6. New oil fields are located in increasingly difficult environments such as deep offshore or difficult fields like Kashagan. Costs of oil recovery in these fields are much higher. Higher costs are partly due to the fact that it takes more energy to recover the oil from these fields, so the Energy Return on Investment is declining.

This means the amount of net oil recovered after oil expended in the process of recovery is lower in these new, more expensive fields. If you project this trend into the future, at some point there would be no net gain at all from the process of extracting oil from new fields. At that point, which is well out into the future, there could be no more oil available at all.

7. In addition to the real historical phenomena discussed above, oil prices reflect to some degree whatever fears there may be that future political events may reduce oil supplies. The most important risk today is clearly the possibility that military action will be undertaken to keep Iran from having nuclear weapons. There are clearly no good choices for the West. An Iranian bomb would be a very clear and present danger to the security of the developed world but a military attack would clearly bring immediate instability and the risk of even greater future conflicts.

8. At the same time that all the above factors are influencing oil prices, higher oil prices are moderating demand somewhat, particularly in OECD countries. But while demand is declining in developed countries it is continuing to increase from developing countries, particularly in oil-exporting countries where fuel prices are subsidized and therefore market mechanisms do not impact consumer oil demand. The enormous - almost unimaginable - new wealth of oil exporting countries is being used by many of them to develop new industrial bases, which growth adds to their enhanced consumer demand to yield huge increases in their own use of their oil and thus decreases in their ability to export it.

It is not clear that the reduction in subsidies in developing countries that do not export oil such as China will reduce demand. In fact it could have the perverse impact of increasing usage in developing countries if higher prices cause an increase in the supply of fuel available to their consumers.

9. One way to sum up the outlook for the oil supply available to importing countries is to look at all the countries which produce more than one million barrels per day and which together supply 88.4% of world oil. An analysis of these countries that accounts for the projected internal use of their own oil production projects that their exports (which is not the same thing as production) are likely to decline going forward from today. If true, that would account for an increasing price of oil.

I’m sorry this discussion was so long. Unfortunately, there are simply a great many influences on the price of oil. It is quite wonderful that all this complexity gets boiled down into a single price that changes minute-to-minute. Oh well, blame the speculator.

Meanwhile, if all this is just too much, you might enjoy a more general perspective and one better expressed by Peter Lynch that I recently came across. Happy Independence weekend, and may we some day become independent from oil.

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