Peak Oil News: Complacency and the Threat of Diminishing Oil Reserves

Tuesday, February 22, 2005

Complacency and the Threat of Diminishing Oil Reserves

noticias.info

Oil Price outlook: OVER A BARREL

Charles Whall
Global Oil & Gas Analyst at Newton

Summary: Oil companies continue to report, year by year, that they have found more reserves than they have produced, implying that exploration and the discovery of new reserves will satisfy increasing demand for oil for many years to come. This has led consumers and governments to believe that no immediate action is needed to reduce the dependency on oil. Fueling this complacency about the future availability of oil at a reasonable price is the notion that current high prices are merely the result of supply disruptions and political tensions and that, when these tensions subside, the price of oil will correct downward to its historic mean - as it has following past energy crises. The reality is much more shocking. The rapid increase in the price per barrel of oil experienced during the second half of 2004 is not a simple, temporary price spike that will soon abate; rather, it is the new baseline for oil prices, signaling the very real potential for upwardly spiraling real energy prices going forward. Should this potential not be recognized and acted upon…sooner rather than later…increasing energy costs could lead to substantial economic disruptions in the years ahead.


Global demand for oil is increasing alarmingly…

The International Energy Agency (IEA) estimates that “World primary energy demand…is projected to expand by 60% between 2002 and 2030.” It is predicted that oil demand will grow in-line with total energy demand, and that much of this new demand will come from the expanding economies of developing nations, notably China (from 5.2 million barrels a day in 2002 to 13.3 million in 2030) and India (from 2.5 million barrels a day in 2002 to 5.6 million in 2030) .

To meet this demand, OPEC would need to double its current production, which is unlikely given that presently it is producing oil at or near maximum capacity and reinvestment rates, as measured in terms of active drilling rigs, have not accelerated sufficiently to grow production .

Yet, year by year, oil companies continue to report that oil reserves are being replenished faster than they are being consumed, implying that we have a long way to go before dramatic, corrective measures must be implemented . This has led to complacency amongst the world’s oil consumers and, in turn, has failed to stimulate the required emphasis on conservation and the development of alternative energy resources.

Whilst these projections, like other such long-range forecasts, likely will be proven wrong, the materiality of the increase in demand for oil, driven by the growing prosperity of the world’s most populated countries, is very real. Most worrisome is that these healthy supply projections are likely to be proven to be overly ambitious, meaning that supplies could fall well short of the world’s future demand for oil.

Many of the commentators on the oil industry have backgrounds in economics, rather than in earth sciences. As such, their projections are framed around economic theory (supported by history), which suggests that current price spikes will correct to a historic mean as either demand wanes or further supply gains are achieved.

Whilst supply and demand dynamics are important elements of the short-term oil market, simple extrapolation of historic observations misses two key factors that differentiate the oil market from the broader market.

Firstly, oil is a finite commodity that is depleting, so much so that oil reserves are now increasingly concentrated in the OPEC countries. Secondly, with mobility increasing globally, the substitution of oil by other fuels becomes increasingly more difficult. This is due not only to the lack of progress with realistic energy alternatives, but also the huge investment in the supply and vehicle infrastructure that would be required to facilitate switching to other fuels.


While supplies are gradually running out…

We believe that the market has failed to recognize the decreasing quality of oil reserve replacement as reported by the oil companies. Instead of replacing reserves with new discoveries, reserve replacement has instead come from counting, today, exploration barrels discovered decades ago. In addition to the historic exploration component, the technology element is also important, as we have been able to recover more barrels from these existing fields. This, also, has in turn led to increasing reserves – reserve additions that will not be sustained, as recovery expectations for new fields are already higher. We consider both the Exploration and the Technology elements in what follows.

Exploration
Consider. Oil companies have not replaced production with exploration-related barrels since the early 1980s . In fact, the peak performance in discovering new fields was in the early 1960s . Of the world’s top 20 fields, only one, the Kashagan Field in Kazakhstan, was discovered in the last ten years.

The oil industry has always tended to find the largest fields first, simply because these structures are more visible on seismic surveys. Oil companies found more than they could produce from the 1950s to the early 1980s. The oil companies sat on these exploration finds, only moving them forward to development when they were needed. In between, they waited for extraction technologies to improve and for the oil consumption demand to develop.

The reserve booking process only allows exploration finds to be recognized when a field is deemed commercial (usually when the decision is taken to develop that field), so oil companies have been able to live off their inventories of past exploration successes. Unfortunately, much of the remaining inventory of exploration finds is composed of heavier or sour crudes, a lower quality feedstock that the industry cannot adequately process without complex refining capacity, which is already fully utilized.

The fact that the industry has found the majority of the large, higher quality fields means that, even with technology increasing the find rates, the volumes of useable oil found per well and in total each year are decreasing, just as demand is increasing. As such, and unlike some have suggested, increasing investment in exploration will not result in appreciable new supplies.


Technology

The annual reserve bookings made by oil companies have two main components. One is the movement of exploration barrels into the development category. The second component is generally captured under the heading of “revisions”; this covers the change in the expected ultimate recovery from a field through time, as technology allows improved recovery.

Indeed, this latter category historically has been the largest component, but is now decreasing with time. The reason for this is simply that the huge leaps forward in technology that emerged in the late 1970s through the 1990s are not currently being replicated. The industry has in fact so optimized recovery factors that there is not the pore space left in the reservoir to support further step changes in recovery.


The key step changes in technology have been:

· The growth in extended, directional well drilling. This allowed both greater reach and more oil well productivity enabling increased recovery, particularly with offshore fields.
· The many leaps forward in computing power have allowed more efficient data collection and ever-larger datasets to be manipulated, the major beneficiary being more complex seismic surveys. As well as improving exploration success rates, this, in turn, allowed for better definition of oil fields and more complex reservoir modeling, leading to improved field management and recovery mechanisms.

There have been, and continue to be, many incremental technology initiatives, but nothing that is likely to have the same step change impact, which has increased the recovery rates for the best fields, from 30% of oil in place just a few years ago, to upwards of 65%, currently. Perceived wisdom in the oil industry is that “Good fields become better; poor fields become worse”. There is a significant element of truth to this. Firstly, it is the larger fields that allow extended life reservoir optimization. Secondly, the “poor fields” often tend to refer to the more recent development of more marginally economic or smaller fields. These fields have been developed with the benefit of modern technologies, so optimized recovery factors are assumed. This leaves less room for positive reserve ‘revisions’; indeed as recovery expectations grow, we have noticed a growing number of field disappointments, yielding negative reserve revisions, a situation that is likely to be exaggerated in the short term as the SEC ensures more rigorous enforcement of reserve booking guidelines.

The improvements in oil well productivity, combined with smaller developments where production is unconstrained by surface facilities, means that depletion (the production rate at which oil is removed from a field) has been increasing. This is good news initially, but it creates an ever-higher reserve replacement threshold, meaning that the industry needs to run faster simply to stay in place, as a greater proportion of reserves are produced each year.

Replacing reserves is becoming more difficult, at a time when reserve growth is needed to satisfy demand. So, as North American and North Sea reserves continue to mature, we will grow increasingly dependent on the five Persian Gulf countries that control approximately two-thirds of the world’s oil reserves: Iran, Iraq, Saudi Arabia, Kuwait and the United Arab Emirates.


Conclusion

Normally, when dealing with natural resources, the more history we have, the more confidence we have in predicting the future. Certainly, the history is there, with more than 100 years of oil exploration and production data. The problem is that some have used this data to extrapolate a continuing “bottomless” energy resource. The oil companies have continued to support this view as it suites their purposes in their illustrations of sustainable business models.

This extrapolation is naïve; instead, we need to appreciate this data for what it is, an illustration of the dislocation between what we have experienced in the past and what we will most likely experience in the future. This increasing concentration of the remaining reserves in OPEC countries increases OPEC’s ability to manage the oil price downside. What has been evident in 2004 is that, as demand surprises to the upside, it is increasingly difficult for the production system to respond.

Rather that returning to a historical mean, the price spike we experienced during the latter half of 2004 is now the new baseline for the price of oil; the $35/barrel environment has, in effect, replaced the $20/barrel oil world of the past, with the potential for the price to spiral inevitably upward as the years progress.

What does this mean for investors in oil companies? It is clear that the competitive landscape for new development opportunities will become tighter as China, India and other energy-short economies seek to address their national energy security by tying up oil reserves abroad. Those oil companies that have already made aggressive moves to access reserves will likely prove to be the winners; but, as importantly, companies that have developed the skills to embrace the globalization of natural gas as a commodity have the potential for exceptional earnings growth in a higher energy price environment.

With technology unable to solve the problem of diminishing oil supplies, we must seek realistic alternatives to balance energy supply with consumer demand. Weaning global consumers from their false sense of security will require bold action, most probably in the form of much more restrictive conservation measures (i.e. ever stricter fuel efficiency standards), and fiscal stimuli needed to accelerate the implementation of alternate energy technologies.

Otherwise, in the not too distant future, energy consumers will face an unprecedented “Super Price Spike”, with potentially devastating economic disruptions.

We believe this is an environment that is wholly positive for the more commercially creative oil and gas companies, and one that also provides exceptional opportunities for businesses that address the shortfall in the fossil-fueled energy supply.


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