Really, Really Cheap Oil

Forbes.com ^ | Christopher Helman

[BenLurkin]

Oil, at a recent $66.50 a barrel, will fall to $45 by mid-2007 and could dip briefly into the 20s in 2008. Sometime next year you are going to see a $1.95 price on a gas pump.

So says Michael C. Lynch, 51, president of Strategic Energy & Economic Research in Amherst, Mass. He swears he hasn't been inhaling fumes. His reasoning: New supply, coming online from all corners of the world, is more than ample to satisfy growth in demand and sufficient even to withstand an embargo against Iran, which produces 3.75 million barrels of oil a day. Lynch argues that the threat of disruptions--nuclear brinkmanship, war, terrorism, hurricanes, pipeline corrosion--has larded oil prices with a $20-a-barrel risk premium. As these perils recede, oil prices will fall.

A refreshing but distinctly minority view. Over the last two years, as prices have soared, proponents of the Peak Oil theory--which argues that we will soon pass the point of being able to replace reserves as fast as they are consumed--have resurfaced in force. Of course, folks have been predicting the end for 50 years. In fact, there's still plenty of fuel to be sucked out. Consider that over the past 100 years the U.S. has drilled 3.5 million wells into most of its oil basins yet still produces 5 million barrels a day. In the Middle East only 50,000 wells have been drilled into far more prolific basins, yielding 15 million bpd. While the world has consumed maybe 1 trillion barrels of oil in the last century, there are at least 1 trillion barrels waiting to be exploited, reports the U.S. Geological Survey. Add to that an estimated 1 trillion barrels of oil sands resources and another 2.8 trillion barrels of oil shale, and we can all afford to put down our "End Is Nigh" placards. "The oil price spike was caused by geopolitical issues that can be fixed or overcome," says Lynch. The real issue is geology. Recent discoveries--and the prospect of new ones--sketch a bright future.

One of the industry's most enduring optimists, Lynch spent 20 years working on energy policy at the Massachusetts Institute of Technology's Center for International Studies, his alma mater. Four years ago he opened his own shop to advise oil companies, governments and investment banks. While a student at MIT during the Cold War, he studied national defense. He became frustrated because "no matter how much we knew about the Soviets, we would never be able to fully predict whether a madman might launch a nuclear first strike. Psychology is not inherently knowable," he says. "Geology is." His abiding faith in technology's ability to wring oil from the most tucked-away places have put him on the outer margins of conventional thinking. He says, "I've been a gadfly since I started."

A gutsy one, too. In 1981, while living in Boston, Lynch got into a 3 a.m. tangle with two burglars in his apartment. Stabbed in the chest, knocked unconscious with a bottle of triple sec from his liquor cabinet, Lynch woke to find one of the culprits still on the scene. So he grabbed a sword he kept behind his bedroom door and--still wrapped in his plaid bathrobe--whacked the guy. In the hospital, he identified the assailant by the tattoos on his arms. The incident triggered a mild form of posttraumatic stress that he keeps in check with low doses of antidepressants. The pills, he insists, do not affect his outlook on the long-term health of the world oil supply.

The recent doubling of prices, Lynch argues, was set in motion four years ago; the 2002 strike by Venezuelan oil workers has kept 1 million or so barrels per day off that country's output of 3.25 million bpd. The subsequent application of socialist economics to the Venezuelan fields has done little to bring that volume back.

The trouble in Venezuela was followed by the U.S. invasion of Iraq, resulting in another 1 million bpd reduction to an average 2 million. In 2004 China sent out petroripples by pushing up its consumption by nearly 1 million bpd to 7.4 million. Add in the unrest in Nigeria, which knocked another 500,000 bpd off-line, and the world suddenly had 4% less oil than it expected. By mid-2005 every producer except Saudi Arabia was pumping flat out. The Saudis had 1.5 million bpd of spare production capacity--oil spigots on standby--and it was less desirable heavy crude. The spot markets reflected the unease as traders braced for the next disaster. They got it in hurricanes Katrina and Rita, which knocked 700,000 bpd or so off-line. Still, says Lynch, "These were all one-time transient events that can be fixed or adjusted to." There's reassuring evidence of adjustment from both supply and demand.

Supply Outlook

Consider supply. Since 2003, industry spending on exploration and production has exploded from $169 billion to $277 billion last year, according to consultancy John S. Herold. Rental rates for some drilling rigs have quadrupled to more than $300,000 a day. New oil is coming from almost everywhere, a mix of big and small, OPEC and non-OPEC. In the U.K.'s North Sea fields, for example, Apache Energy is using new recovery techniques to revive production in a basin thought to be in terminal decline. Oil from a 1-million-bpd field in Azerbaijan recently hit the world markets, flowing through the new $10 billion Baku-to-Ceyhan pipeline. In Angola offshore fields could start pumping 500,000 bpd next year, and deepwater fields off Brazil will add hundreds of thousands more, as will onshore fields in Algeria. On the horizon: In the Gulf of Mexico, Chevron, Devon Energy and Statoil recently discovered fields in an area thought to hold from 3 billion to 15 billion barrels (equivalent) of oil and gas reserves. Lynch calculates that global production capacity will expand by a net 2 million bpd this year and 3 million bpd in 2007.

On the demand side, growth has moderated worldwide. Lynch expects growth to increase less than 1 million bpd this year and 1.4 million bpd in 2007. What accounts for the dip? High oil prices and a slowdown in some industrialized economies. Both European and U.S. demand will be flat this year. The rate of growth will slow even in China: 500,000 bpd this year, compared with 900,000 bpd of growth in 2004.

All this will give producers time to catch up. Lynch points out that global oil production held on standby has climbed to 2.7 million bpd now. The Saudis account for 2 million of that; Kuwait and Abu Dhabi the rest. Lynch sees the cushion climbing to 4.5 million bpd in 2007 as the Saudis bring the Khursaniya field into service but cut back elsewhere to make a place in the market for non-OPEC growth. If elections in Nigeria next April ease political tensions between groups in the Niger River delta, 500,000 bpd more could hit the market almost immediately. To make room on the market for Nigeria's high-quality crude, other OPEC nations would likely cut back, pushing the cushion up to 5 million bpd. That capacity should cover a supply disruption from virtually anywhere in the world, helping to push down the price of oil, Lynch believes, to $45 a barrel by the second quarter of 2007.

Can you say 'contango?'

What about the contango effect (when the price of a barrel of oil for delivery in six months is higher than an identical barrel bought on the spot market today)? Contango pricing encourages hoarding: Why sell your barrel of oil at today's spot price of $66.50 when you can make $2 more by promising to deliver it in six months, more than enough to cover the cost of storing it? The result is that oil inventories in the developed world--2.7 billion barrels--are now at their highest levels since 1999, enough to offset 12 months of, say, blocked Iranian exports.

But, as Lynch points out, oil futures don't usually trade in contango. Producers need to reduce their financial risks. They do so by being sellers in the futures market, depressing futures prices. Lynch thinks that it won't take long for savvy oil traders to notice the gradual building of the capacity cushion and to decide that there is no real threat of supply disruption. When speculators start unwinding their oil futures positions, the rush for the exits will begin, pushing down oil prices.

Even Saudi Arabia, once the world's leading producer, may not be able to halt the price slide. The kingdom has for years taken it upon itself to hold most of the world's spare production capacity. In April Saudi Aramco cut its output by 350,000 bpd to 9.1 million bpd because there wasn't enough demand for the oil. As new production comes online from OPEC and non-OPEC nations alike, the Saudis will likely need to trim back again, to 8.5 million.

But Lynch sees a limit, and he believes the Saudis could push for a quota cut of 1 million bpd by mid-2007, bringing official cartel output to 29 million bpd. Persuading all OPEC nations to go along would establish a floor under oil prices. But cheating has always occurred in such circumstances; with lower prices, cash-strapped nations like Venezuela might even refuse to decrease output to keep revenues steady and social entitlements coming. Already Libya and Algeria are overproducing their current quotas. Russia, the world's biggest producer but not an OPEC member, sets its own agenda. When Russia resisted the Saudis' call for a quota cut in 2001, opec nations kept production steady, oversupplying the market and sending oil plunging to $21 a barrel. Lynch imagines a similar scenario by the end of next year.

Longer term, Lynch says, there are even better prospects for cheap oil. Near-civil war in Iraq, a dangerous standoff with Iran, Arab- Israeli tensions, ethnic and religious strife in Nigeria, anti-American nationalism in Venezuela: Rarely have so many volatile events converged. This, too, shall pass, Lynch believes. "Ten years ago the world was pretty much at peace," he recalls. "Right now it seems like there's unrest in every corner of the globe. But that doesn't mean it will continue forever."

A return of 2.5 million bpd worth of production in the trouble spots would satisfy six years of growing demand from both China and India. Even better, India should be able to supply more of its own oil, considering the estimated 3.5 billion barrels of recent discoveries in once unexplored basins in Rajasthan.

One last piece of hopeful evidence. Despite his rejection of psychology, Lynch does try to read the minds of large oil companies. Even after two years of high prices, he notes, they won't invest in a project unless it promises solid returns at less than $40 a barrel. That tells him that if the petrol giants thought oil prices were going to stay high they would hold on to more of their profits to invest in more exploration acreage and megaprojects. But they're not. This year ExxonMobil and BP will return to shareholders more than $40 billion in dividends and stock buybacks.

In Texas these days you still see bumper stickers on the backs of old pickup trucks that read, "Lord, just give me one more oil boom and I promise not to piss it away this time." Lynch says, "Now's the time to go long on bumper stickers and short on oil."

[William Tell]

Stat-boy said: "The market for oil takes time to adjust, but the fact is that the market will adjust."

Traveling through the southwest last year my wife and I were entertained by the small wells pumping merrily along almost everywhere we went.

Low yielding wells require a storage tank at the wellhead and trucks to keep the tanks empty. Pipelines are far too expensive for such wells.

These low-yielding wells are all over the place and we never saw one that was not pumping. At $10 per barrel, it probably doesn't pay to send the trucks, so such wells would stop operating. As soon as the price recovers sufficiently, the wells start up again. Every well probably has its own critical price based on storage tank size and cost to transport the oil.

[wouldntbprudent]

Also new technologies will open or re-open wells that otherwise were not profitable---

WEST BERLIN, N.J., Sept. 28 /PRNewswire-FirstCall/ -- Mobilestream Oil and Global Resource jointly announce a meeting between the companies to be held on October 11, 2006, to discuss the acquisition by Global of all technologies owned by Mobilestream Oil.

Mobilestream Oil, Inc., (OTC Pink Sheets: MSRM - News) owns a family of microwave technologies which not only allow for the complete recycling of an automobile tire (recovering all of the component parts for resale), but also permit the economic recovery of oil from sources such as shale, tar sands, oil resid and existing oil wells.

http://biz.yahoo.com/prnews/060928/clth009.html?.v=65

[William Tell]

ukie55 said: "Thanks, and I was happy with $2.49 till I read your post. Some places around here are still at $2.65. I wonder why? /s"

There is a factor keeping gasoline prices high that will kick in hard real soon, I think.

Less than five years ago, I paid $1.09 per gallon in Los Angeles. Perhaps the wholesale price was as low as $.40 per gallon. I don't really know.

But today, I have to pay about $2.65 per gallon here and the wholesale price nationwide is $1.45 per gallon.

That's a markup of $1.20 to get wholesale gasoline into my tank. That's far more than it cost five years ago.

So, what changed?

One change is inventories. At today's wholesale and retail prices, inventories are growing. As the article points out, it is possible to purchase oil and contracts which will pay one to simply store oil.

When every bucket and teacup in the US and the rest of the world is full, then things will start to change rapidly.

Locally, the discount station that I frequented for years has its pumps turned off. They haven't sold a gallon of gas in perhaps as long as a year. (Just after what was obviously a very expensive upgrade of their tanks and equipment.)

The reason that my local discount station is closed is that they can't buy gasoline at prices attractive enough to do business with their intended customer base; that is, the "super frugal" such as myself.

When the teacups start overflowing, gasoline will begin to be available to the independents again. Then stations will have to trim their margins and compete for customers.

[mysterio]

There was a glut. It was a short one, and prices have been skyrocketing ever since.

[Former Proud Canadian]

bump

[litehaus]

this will TANK chavez BIG TIME!!!

---

Citgo stations USED to have slightly Higher prices roun gere, Now, they are the lowest! Ha Ha Ha Hugo!

[shield]

Yep, after seven eleven thing and his awful visit to the USA...those stations dropped 15 cents below all others. I don't care....I'm buying my gas at the same place I've always brought it.

[thackney]

There was a glut.

It was caused by faltering Asian economy and OPEC's short sided greed that prevented them from agreeing to the larger production cuts as they had in the past. And you are right, it created a glut.

My point is they actually had more of a monopoly then as compared to now. It will happen again, maybe in a few years or will take a couple decades. But if you follow this market long enough you will realize boom/bust is fairly normal.

and prices have been skyrocketing ever since.

At least you are learning some. Back in July you said we would never see $30-35 without competition. At least now you are claiming $20.

[pabianice]

Just wait until the dilithium chamber enters the market. Oil will crash!

[BenLurkin]

I want my next car to be powered by Mr. Fusion....

[mysterio]

No, I said it will never drop to $20 until the market produces a competitor. Could it? Sure, I guess. Will it? Probably not.

[Tolerance Sucks Rocks]

If true...and I believe it could very well be true...this will TANK chavez BIG TIME!!!

Maybe some thoughtful, considerate Venezuelan will do us a favor and kill him before then.

[Jet Jaguar]

What was that? LOL!

[thackney]

Do you still believe it will not hit $30-35 without a competitor? And how much market share does that competitor need to have? (or any other way you want to measure it)

[mysterio]

It might hit $40 again, but I doubt it. The competitor would need 10%+ market share to have any impact at all. And oil will have to stay $60+ for a while before the market produces a competitor that anyone is interested in.

[thackney]

Thanks for the input. I see it hitting $30 again fairly easily but if that is in 3 years or 10 years, I wouldn't put any money on it. Oil was in the 'teens less than 5 years ago. The market and players just have not made in major changes to think that it will not happen again, in my opinion.

Oil Prices
http://tonto.eia.doe.gov/dnav/pet/hist/rwtcd.htm

[shield]

They've been trying....everytime you hear this thug blaming Bush...you know his people have tried and failed. [Per several reliable sources]

[SunkenCiv]

Oil prices poised to drop sharply, energy consultant says-(1.15/gal)
contracostatimes | Wed, Sep. 13, 2006 | Kevin G. Hall
Posted on 09/13/2006 9:56:52 PM EDT by Flavius
http://www.freerepublic.com/focus/f-news/1701085/posts

[Paul Ross]

Yeah. It is like mold!

It just won't go away...what, 5 years running now!? Nice if it ever came true...but this wishful thinking obviously has SPIN written all over it. And who benefits thereby? I can only think that this is really Kool-Aid intended for the electorate...to placate the dawning realization of immense inflation now bursting through...keeping people's wage demands static with false hopes.

Some of the finger-prints on this kind of spin point squarely right to the top of the administration...US Fed to Discontinue Publishing M3 Numbers