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Death of the Oil Industry, Part Two

January 27th, 2009
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Oil and gas
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Last week’s blog discussed the rush of rhetoric to bury the oil industry from a demand perspective. This week we look at this purported premature burial from an equally strong supply perspective.

Bottom line, if you think the world’s major exporters of oil will sit idly by while the “green” wave washes over them, think again. For years OPEC, led by Saudi Arabia, has had to endure being cast in the role of villain for supplying the very commodity its customers have been voraciously consuming for decades. A key reason that global oil demand growth had been outstripping world oil supply growth has been the woeful performance of non-OPEC oil producers. From 1990 to 2004, global demand for oil increased by 16 million barrels per day, while non-OPEC oil supply rose by only 6 million barrels per day. That lack of non-OPEC contribution to increasing the world’s oil supply had as much, if not more, to do with global spare oil production capacity shrinking to a sliver in recent years. And the prospect of that skinny cushion in a volatile world was the main impetus in speculators driving the futures price of oil to stratospheric heights last year. OPEC’s efforts—really Saudi Arabia’s—to restrain production in support of oil prices in recent years was misguided only in its inability to foresee, as we all did, the extent of the collapse in the global economy and consequent plunge in oil demand.

Had non-OPEC oil producers been able to bolster their own output in the past 15 years, oil prices never would have topped $100/barrel.

About 40% of non-OPEC oil output today comes from countries whose production is in secular decline, according to a new analysis by Raymond James & Associates. RJA contends that non-OPEC oil production likely will reach a permanent peak within the next 3-5 years. The major cuts in E&P capital spending being announced every day will only worsen that scenario.

So will non-OPEC oil supply decline be a non-issue as OPEC stands by and wistfully watches its market shrivel and disappear in the wake of a biofuels boom and new fuel efficiency standards?

Think back to the oil boom of the late 1970s and early 1980s. The order-of-magnitude increases in oil prices at the time certainly inspired the development of alternate fuels and the push for better fuel mileage. Those developments contributed somewhat to decreased demand for oil, which at the time had peaked in 1979. But OPEC mainly lost market share to non-OPEC producers that took advantage of higher prices to develop new reserves and production in high-cost areas such as Alaska’s North Slope, the North Sea, and Canada’s oil sands—not to mention Mexico and the Soviet Union. From 1980 to 1986, non-OPEC producers added 10 million barrels per day of production capacity. OPEC’s share of world oil production dropped from more than 50% in 1974 to 30% in the early 1980s; OPEC—mainly Saudi Arabia—had cut its output by a third in support of prices. At the same time, looming on the horizon was the threat of more market share loss to a surge of new alternative supply from synthetic fuels.

It fell to Saudi Arabia to right the ship. The kingdom had been acting as swing supplier to help support oil prices, only to see its own fellow OPEC members cheat on their quotas and cause the Saudis to lose the most market share of all. Through a netback pricing scheme, Saudi Arabia quickly ramped up its production to recapture lost market share, resulting in a price collapse that endured for 3 years. But the resulting lower price spurred increases in consumption and halted production growth in most of the rest of the world.

Today, OPEC is showing some solidarity in throttling back production. In early January, the data show that OPEC has already sliced 1.5 million barrels per day from its output, a commendable effort relative to their target of a 2.2 million barrel per day cut for the month.

Calibrating oil supply to match expected demand is a tricky business, especially in today’s economy. OPEC certainly has a vested interest in pushing prices back up to minimally acceptable levels for the long run. How successful it will be in the short term depends on how bad the demand collapse will be this year. But there is little doubt that the group will ultimately succeed, because the very survival of these countries depends upon it. And before some scofflaws chuckle at the thought of OPEC disintegrating and sheikhs being impoverished, just think for a moment of jihadists in the Persian Gulf taking control of more than half of the world’s oil reserves from these weakened governments.

So the question becomes: At what level will OPEC keep production to support oil prices in the long run? The answer is simple: A level that ensures the highest prices possible without encouraging more competition for OPEC or major conservation measures.  (OK, maybe not so simple—the devil is in the details.)

Some analysts put OPEC’s target price level at $75 per barrel to support their collective budgets. Even without guessing how bad the demand decline could get this year, that seems a bit out of reach, barring some major supply cutoff. It will be largely up to Saudi Arabia to make the kind of cuts needed to support that price level, and that could leave the kingdom’s surplus capacity—and therefore lost market share—at an uncomfortable level, especially if it remains there for a long time.  Perhaps a more comfortable price level would be $50-60 per barrel. That could choke off some of the costlier non-OPEC supply initiatives and keep fuel costs low enough to spur demand again significantly. (A corollary benefit would be to rein in Iran’s and Venezuela’s shenanigans—something to comfort Saudi Arabia and its key customer, the US.)

But what if a massive effort ensues to develop alternative transportation fuels? That seems doubtful. A huge turnover of the global vehicle fleet to electricity or hydrogen is a generation away. Only biofuels have the potential to make an immediate large-scale dent in petroleum-based transportation fuels’ markets. Yet the best estimates are that biofuels will account for less than 3% of the market by 2030, up from less than 2% today.

Sure, it’s conceivable that a combination of heavy taxes on petroleum-based transportation fuels and tax credits for biofueled cars could make an even bigger dent in oil’s market share in the years to come. And then it might occur to the Saudis to revisit 1986. Just as the prospect of $150-200/barrel oil invigorated prospects for renewable energy and biofuels in particular, the threat of $25/barrel ($10/barrel?) oil will have the opposite effect. And all the Kyoto agreements and green energy initiatives by the new Congress and new administration won’t change that. That’s especially the case when new economic powerhouses such as China and India, exempt from Kyoto’s strictures, continue to flout the treaty’s ultimate intent in order to sustain their recently booming economies after the current downturn has run its course.

Does anyone really believe that the American public would stand for a policy that pours billions of taxpayer dollars into an uneconomic commodity while also keeping fuel costs high, forcing them into vehicles they don’t really want, and enabling the country’s main new economic rival to become even more competitive—especially in these perilous economic times?

So don’t dust off those funeral togs just yet. The oil industry will be alive and kicking for decades to come.

A smart US energy policy would recognize that certainty and do everything possible to support domestic oil producers by helping to keep the playing field level, not making it tougher.

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