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Markets: Oil Prices- Up, Up and Away ?
New York: June 06, 2005
By John R. Stephenson

"We believe oil markets may have entered the early stages of a "super spike" period, which we now think can drive oil prices toward $105/bbl."

--Goldman Sachs analyst Arjun N. Murti in his March 30, 2005 research report.

"Over the next five years, crude prices will almost double, averaging close to $77/bbl and reaching as much as $100/bbl by 2010."

--CIBC World Markets analyst Jeffrey Rubin in his April 5, 2005 research report.

 

It's hard to imagine oil going any higher, but if the analysts are to be believed, that is exactly what we might be in store for. The reason? The usual culprits of declining supply and surging demand.

Like all commodities, oil is now in a classic bull market and while the price might dip on occasion, the trajectory for the foreseeable future is towards higher prices. For me and you that means higher prices at the pump.

While it may seem strange now, it wasn't all that long ago that oil was hovering around the $10 per barrel mark. That's when Exxon decided to acquire Mobil and Conoco acquired Phillips Petroleum in an effort to drive greater economic efficiencies in their operations. And who could blame them with oil trading so low? But today, with oil prices up more than five-fold, the talk has turned back towards the production side of the equation and what needs to be done to keep the oil flowing in sufficient quantities. Welcome to the classic boom and bust cycle of commodities.

All commodities, oil included, are driven in the long-run by the forces of supply and demand. In the short-term, all matter of speculative activity can be a driver for price change, but once you look long-term, it becomes a matter of simple supply and demand. Where we sit today is that world oil demand has surged to some 84 million barrels a day and rising while supply is stuck at 83.5 million barrels a day and struggling. But how did it get this way?

For starters, we went through about a twenty-year period of underinvestment in energy. Back in 1982, there were some 321 refineries active in the United States - today there are 149. Twenty years ago there were 4,530 oil rigs exploring for oil and gas in the U.S. - today there are 1,200. Compounding the problem is the fact that oil is getting harder and harder to find and extract throughout the globe. As Matt Simmons an energy investment banker says, "The entire world assumes Saudi Arabia can carry everyone's energy needs on its back cheaply" he told an audience in Washington D.C. and "If this turns out not to work, there is no Plan B." The sad fact of the matter is that there hasn't been a discovery of a giant oil field (one million barrels a day or more) in at least thirty-five years. Not only that, but some of the existing giant fields are going on 50 to 70 years of production.

Around the world, major oil fields seem to be in decline. The North Sea and the Gulf of Mexico have both peaked and started declining. U.S. oil production peaked in 1973, and by 1981, the nation's oil companies were pumping almost a third less oil in the lower 48 states. According to a study by Deustche Bank (published in the Financial Times - Sept. 22, 2004) only 6 percent of the world's 15 major oil companies (between 2001 to 2003) have been able to replace all of the oil that they have pumped. In fact, Deustche Bank estimates leading oil companies during the 2001-2003 period have actually cut exploration by some 27 percent. According to geologists, the average oilfield declines by about 4.8 percent a year. Today, the U.S. imports some 13 million barrels a day, more than 60 percent of their demand, making the U.S. a hostage to foreign oil.

While the situation in Canada is better, the search for oil and gas continues to be met with frustration. The western sedimentary basin isn't what it used to be with most of the easy oil having been pumped. Natural gas supply is in an even more precarious position within North America with new supply coming from coal seams and super cooled gas (liquefied natural gas) transported on container ships, from abroad.

But what about technology? No doubt a technological breakthrough is possible, but I wouldn't hold my breath. Back in the 1960's, the Hughes diamond drill bit was invented which touched off an explosion of technological innovations in the oil industry. In the following years, wells were being drilled to 25,000 feet, once an unfathomable depth. But in spite of these advances, oil prices increased by 1,000 percent during the 15-year period between 1965 and 1980. The lesson is clear - when supply and demand are out-of-whack it doesn't matter what happens with technology.

Oil isn't about to disappear from the planet in the next few years, but it is probably fair to say that the easy oil is declining. The unconventional oil, such as that from the tar sands, is much harder to find and more expensive to turn into usable energy. The so-called technological revolution in oil hasn't resulted in any major energy discoveries and may, in fact, have just advanced the decline in the existing reserve base.

On the supply side of the equation, the economies of Asia and the U.S. have been growing at a steady clip. During the period between 1980 and 2001, U.S. oil consumption grew by some 20 percent while Asian demand exploded. With a population of 3.6 billion people, Asia has seen oil demand surge by two million barrels a day to 20 million barrels a day in the last year alone. China is by far the biggest consumer of oil in Asia and is now the second largest consuming nation after the U.S.

But what is driving Chinese demand? The love affair with the automobile for starters. Currently, China is home to some 20 million cars with analysts predicting that China could see between 120 and 145 million cars on their roads within the next fifteen years. As well, China has experienced a tremendous increase in the country's manufacturing base over the last few years. This has placed huge demands on the country's electric grid which is overtaxed at best. Enterprising businesses have solved the power shortage problem by buying diesel generators to power their factories, further driving up the demand for oil. With both a surge in car ownership and a rapid industrialization underway, China is redefining the worldwide supply/demand balance for oil. Not only is China an engine of growth, but India and other Asian nations are also experiencing rapid levels of economic growth which further increases the region's reliance on oil. By some estimates, Asia's demand for oil will double within the next 6 to 12 years.

Figure 1: Surging Oil Demand

Source: M. Murenbeeld and Associates

 

The Chinese save upwards of 40 percent of what they make. Contrast this with the average person in North America who saves less than 2 percent. Yet only 4 percent of the Chinese population owns a car. With rising levels of affluence and some 300 million Chinese twenty years or under, look for car ownership to increase sharply rather than decrease in the years to come. The Chinese are not about to go back to riding bicycles soon and their rising demand for oil will only serve to upset further the tight geopolitical balance that currently exists.

When you ask the pundits where all the oil is going to come from to keep prices from rising, there is no response. Some analysts have pointed to Russia as a potential bright spot. But does this give you comfort? For starters, recent history seems to show that the state is more than willing to expropriate private property when it serves a political purpose. While the recent Yukos affair might have been a one off, it remains to be seen whether the industry as a whole will be motivated to make the necessary investments in infrastructure to deliver on the Russian promise for oil and gas. And while the Russians claim that they are pumping some 9 million barrels a day of oil, they only have pipeline capacity for five million barrels per day.

All of this trouble, at least in the short-run, could be good news for the Canadian oil sands. With reserves second only behind Saudi Arabia, investors and producers are flocking to the oil sands. While costs to produce a barrel of oil are considerably higher in the oil sands, the supply is long lived. Investors might consider purchasing Canadian Oil Sands Trust (COS.UN - a buy at under $80.00)

Declining or stagnant supply and increasing demand is the story of oil at the start of the twenty-first century. Who amongst the current lot of "bright spots" in the oil supply universe is going to rush to North America's aid when demand outstrips supply or Saudi Arabia calls it quits? Will it be Russia, Algeria, Iraq, Kuwait, Libya, Venezuela or Iran? Hard to say, but it might be time to start taking the train to work.

 

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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