Oil's Wakeup Call
By Martin T. Sosnoff
If you want to dream about oil prices long term, the go-to guy is Matt Simmons, chairman of Simmons and Company International. Simmons' thesis called "the Peak Oil Thesis" is awesomely simplistic: The elephantine oil fields of Saudi Arabia peak out in a few years. Unfortunately, this is only a working hypothesis.
Saudi Aramco technocrats won't let Simmons near their reservoirs or seismic research data. They claim a reserve margin of several million barrels a day. Simmons' competition, Cambridge Energy Research Associates in Massachusetts takes the Saudi side of the argument, but the market these days is siding with the bears on net worldwide incremental production possibilities.
The next five years will tell the story. I'm leaving out the demand side of the U.S. equation. If you believe our next president and the Congress will draft a cohesive energy policy that curbs demand and successfully encourages new energy sources, you don't want to play in this game. Just be mindful that we have over 100 million cars on the road, gas guzzlers, and they're going to hold the road over the next 10 years.
Oil now accounts for 95% of transportation energy, and Simmons and others believe future growth in oil demand is inexhaustible. I never knew anyone who could predict the price of oil accurately for more than six months. The consensus historically runs wide of the mark, expecting demand to peak and prices to collapse from supply sources. The classic magazine cover story in The Economist in March 1999 projected $5 a barrel oil, that the Saudis would flood the world with cheap oil and demand would peak. How wrong can you get it?
Actually, oil demand the past 10 years grew 1.5 million barrels per day, and the cost to find new oil keeps rising. The problem for many oil producers is that they fail to replace reserves. Exxon keeps its exploration budget flattish. If they didn't, profit margins would drop meaningfully. For most oil operators, costs are rising 10% to 15% annually.
The analyst consensus for oil hangs in the mid-$80 range. If oil stays above $100, earnings estimates are 15% too low for 2008. This could be one of just a few upside surprises for a major sector of the market this year. Long-term forecasts range much lower--$70 to $85 a barrel. Commodity traders taking the long side on far out futures contracts took home fortunes the past few years.
The demand side for oil is compelling when you look at incremental increases for China, India and other emerging economies. Demand could grow by 1.5 million barrels a day for the next 10 years. Considering the decline rate in existing oil fields, the world needs some 37 million barrels of new capacity to keep pace. This is a big number. To the extent it's unfulfilled, oil prices will rise until they trigger demand destruction. So far, demand destruction remains a vague, iffy concept.
Meanwhile, the North Sea oil fields are in rapid decline. Output from Mexico's Cantarell Field, second largest in the world, has already fallen 41%. Oil discoveries peaked in the 1970 to 1980 decade. Very little production comes from fields discovered since 2000. Only 15% of production is from fields discovered in the 1990s.
The decline rate for the world's oil fields remains a debatable issue. Cambridge Energy Research Associates charts it at 4.5% per annum. It may be much higher, but the Mideast situation remains unfathomable. If Middle East oil production flattens out within a few years, world production could easily decline 5% over the next 20 years. Maybe the Saudi claim of production enhancement is true, but they will make the world pay if they are the sole major swing producer.
Alternative energy supplies don't cover the transportation sector. Nuclear power, solar energy and wind create electricity. Who knows when we'll see a viable battery-driven car that's acceptable in terms of power, range and price point. Railroads are more efficient than trucks. I own Union Pacific (nyse: UNP - news - people ) as a play on rising grain and coal shipments worldwide.
The deep basic is the world's oil supply probably won't ever exceed 100 million barrels a day, but demand could reach 100 million barrels by 2015. If oil prices for the U.S. go to $150 a barrel, oil costs would move from 8% of gross domestic product (GDP) to the 10% level.
Rising oil prices could reduce GDP by half a point, annually. This condition, hopefully would precipitate a new consensus that the demand side for oil must be dealt with even if the states and federal government tax auto producers, car buyers and car owners, forcing conversion to 40 miles per gallon automobiles. GDP in China and India would come in a couple of percentage points lower on $150 oil, crimping the case for commodity plays of all kinds.
The law of unintended consequences applies here.