Is there fraud in the house of Saud?
By Jim Jubak
On April 22, Saudi Arabia made what appeared, on the surface at least, to be a dramatic announcement. Forget quotas, the Saudis proclaimed. They would pump all the oil consumers wanted up to its current capacity of 11 million barrels a day. And, to make sure that the world would have enough supply in the long term, Saudi Arabia would spend $50 billion over five years to increase oil production capacity to 12.5 million barrels a day by the end of 2009.
In the short term, the announcement isn't anywhere nearly as dramatic as it seems. The Saudis are already producing more than 9.5 million barrels a day. By long-standing policy, the country has kept a cushion of 1.5 million to 2 million barrels a day in idle excess capacity as a buffer against unexpected demand spikes. All the Saudis have really promised to do is to produce to full capacity.
But what about the long-term promise of increased capacity? Here, too, not everything is as it seems. To understand why, you've got a take a closer look at the structure of the Saudi oil fields and at the truly abysmal state of global energy-demand prediction.
New oil fields add to capacity
Saudi Arabia produces oil and gas from more than 80 fields, but 50% of its current reserves are locked up in just eight fields. Those include the Ghawar field, the world's largest, with remaining reserves of 70 billion barrels by official Saudi oil-industry count.
In 2004, the Saudis started production from two new fields yielding about 800,000 barrels of oil a day. That brought daily oil production capacity to around 10.8 million barrels. And in March, the Saudis announced contracts to foreign firms for $8 billion to develop new fields that would start production between 2006 and 2009. Those fields would add 2.7 to 3.1 million barrels a day to production. Add it all together and the goal of reaching 12.5 million in production by 2009 seems an easy reach. (For more on the Saudi oil industry, read this study from the Center for Strategic and International Studies.)
But, as I said, everything is not what it seems. Some of the Saudi fields, Ghawar, for example, are old and while reserves remain huge, production rates are declining as it gets harder and harder to extract the oil. Everyone agrees that happens as natural pressure declines, bigger pools are exhausted, and easily accessible deposits are tapped.
Saudi's rate of depletion in dispute
What the Saudi state oil company, Aramco, and outside oil critics don't agree on is the rate of depletion.
Matthew Simmons, a member of Vice President Richard Cheney's 2001 energy task force, and organizations such as the Association for the Study of Peak Oil and Gas (ASPO) contend that the Saudis are hiding the rate at which they are depleting their current oil fields and that the country will have a hard time keeping oil production at current levels, let alone increasing it.
In his book, "Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy," Simmons argues that once 50% of the reserves have been withdrawn from a field, production begins to decline. The common approach, and one that Aramco readily admits it has applied to older fields such as Ghawar, is to pump water into the rock where the oil is trapped to increase the pressure on the oil and get more of it to the well.
According to Simmons, the more water you pump into a field, the less oil you can pump out. This is especially true, he writes, when water has been pumped in rapidly in an effort to get more oil out fast. Eventually, the field has to be abandoned with much of the oil still in the ground.
This, Simmons claims, is exactly what happened in several huge Saudi fields to push depletion rates up to a point where all the extra production will do no more than balance the shortfall from existing fields. Saudi Arabia, he concludes, may have already reached peak sustainable production. (You can read more of his work at the Simmons & Co. Web site.)
Simmons' work builds on that of M. King Hubbert, a true iconoclast in the U.S. oil industry. In 1956, while working for the Shell Development Co., Hubbert predicted that U.S. oil production would peak in 1970. That idea seemed laughable to his audience at a 1956 Texas meeting of the American Petroleum Institute, but his model turned out to be remarkably accurate.
Global peak in 2008?
Now other geologists and geophysicists updating his work find that the model shows global oil production hitting a peak -- now called Hubbert's peak -- around 2008. (For more on this model and the evidence for a peak in global production as well as links to sites giving you a packing list for surviving the coming collapse of our oil-based civilization, check out ASOP's site.
You'll notice that while U.S. oil production may have peaked in 1970, the U.S. oil industry is still pumping oil today. Hubbert's work predicted a quick and steep run to the peak and then, not a quick collapse in production, but a very gradual but inexorable decline. Even after Hubbert's peak, new oil fields will be discovered and new technology will extract more oil. But the rate of new production will be insufficient to cover the depletion of existing reserves, and production will slide. The downward slope may indeed be so gentle that no one notices it at the time. The age of oil, according to Hubbert, is more likely to end with a whimper than a bang.
Higher oil prices as production gradually declines are one factor that makes the slope so gentle. At $50 a barrel, it pays to put more expensive technology to work extracting oil from fields that were regarded as played out. That makes oil companies such as Apache (APA, news, msgs) that specialize in "exhausted" fields a good buy now if you believe Hubbert's peak is near.
Higher oil prices, of course, also encourage consumers to turn to alternative sources of energy, such as coal or wind, and work to increase the supply of those alternatives as companies find investing in non-oil energy projects more attractive. That's why I've recommended Peabody Energy (BTU, news, msgs), a coal company recently.
After all of this I'd like to be able to tell you what the price of oil will be in 2009 or how many years the world has to get ready for the descent from Hubbert's peak, but I can't. That's because the art of predicting the growth in global oil demand has been completely outstripped by events. Oh, it's not that there aren't lots and lots of projections. It's just that all of them are based on oil prices that have been left in the dust by the current market. And that's important because at some point for some consumers higher oil prices cut into consumption. For example, the top price that the Energy Information Agency uses in projecting the global demand for oil out to 2025 is $37 a barrel. All we know about economics says that demand is likely to be lower if oil sells for $50 a barrel than for $37. But not only don't we know how much lower, we haven't even put the higher price into the models yet.
From the investor's point of view
So where does that leave you as an investor? Caught between Saudi optimism and peak oil pessimism, I'm inclined toward the darker end of the scale. I know the Saudi's have motivation for painting an optimistic picture, since any forecast of steady or lower oil prices in the future due to extra capacity inhibits others from developing some source of non-oil energy. The longer the world believes that the Saudis can provide the oil it needs, the longer the Saudis remain at the center of the world's geopolitical stage. And we do have enough anecdotal evidence -- reserves in Oman, for example, are showing damage from the use of water to extract oil -- to believe that Saudi depletion estimates might be on the low side.
But if we take Hubbert's peak seriously as a model, as investors we should also realize that the oil-based global economy still has decades of life and that, on average, rising oil prices, and, until extraction costs get really out of hand, rising oil company profits, will be with us for a while. Investors don't have to make a killing on oil stocks this month or even this year.
That's not bad to remember at a time like this when oil shares are taking their lumps.