NEWGATE PERSPECTIVES – Global Resources: Oil
December 1, 2011
 f all commodities, oil is the one we are most familiar
with. We know essentially where it comes from,
how it is used and its price. We buy it once a week
or so in the form of gasoline or diesel; some of us heat our
homes with it. Yet for all the apparent simplicity of oil, its
extraction, refinement and subsequent usage are extremely
complex. The United States imported oil from over 20 countries
in 2010, in addition to its domestic production. Grades
and quality of crude vary widely. So do its uses, from familiar
ones like gasoline and diesel to lesser known such as asphalt,
kerosene and a host of other petrochemicals.
This report is focused on the production and consumption
of oil. The details regarding the various aspects of the
oil market have significant impact on investors. Just as the
oil industry is multifaceted, the investment opportunities
inherent in oil’s production process are equally complex. Use of Oil. The United States remains the single largest
consumer of oil, though emerging Asian economies collectively
now use more oil than the US. The annual increase in
US oil consumption is remarkably steady, more so than one
might think given the extreme volatility in oil prices. US oil
consumption has grown at a compounded annual rate of
1.1% since 1965, with a 3.5% standard deviation. By contrast,
during the same period Chinese consumption grew at an
annual rate of 8.7%, but with a standard deviation of 9.8%.
As one would expect, consumption declines when prices are
high and when the economy is slow or in recession. Both
countries saw oil consumption decline in the early 1980s.
US consumption had also declined in 2008 and 2009 but
rebounded in 2010, while Chinese consumption increased
steadily during that period.
The annualized standard deviation of the price of oil is
over 20% (varying only slightly by grade of crude). Given
the fairly stable demand and the high level of price volatility,
it would appear that actual US demand is only a small factor
in oil pricing1. As demand from other parts of the world
(notably emerging Asia) grows in absolute terms and as a
percentage of total demand, it is reasonable to expect that US
demand will have a declining importance in the price of oil.
Sources of Oil. The news media and politicians frequently
refer to American dependence on foreign oil, with
particular attention paid to oil imported from countries
considered unfriendly to Western interests generally and
US interests in particular. Chart 1 below shows the source
of oil consumed in the US. Despite common perceptions,
the US remains a significant producer of its own oil, though
production has clearly declined in absolute and relative
terms from its highs. The US imports less oil (as a percentage
of total consumption) than it did in 2005, due to
both increased domestic production and overall declining demand. Most US oil imports come from countries with
which we have good relations, such as Canada, Mexico
and Northern Europe.
Chart 2 shows where oil is located and produced globally.
Again, there are important distinctions. For example,
Iraq has a lot of oil but has seen production curtailed by
the military conflict and internal strife. Conversely, the
US and China are “overproducing” oil relative to the size
of their reserves. A closer look at the chart reveals several political/economic fault lines. More than 75% of the world’s oil
reserves (the source of future production) are located
in just 8 countries. Most are in the Middle East and are
highly vulnerable to political unrest. Libya has already
gone through a revolution. Venezuela, a country currently
dominated by a leftist government, has a large
portion of the remaining oil. Furthermore, much of Venezuela’s
oil is low quality, requiring more processing than
traditional grades of crude to become usable products.
Russia has shown a willingness to use its energy resources
as a tool in an aggressive foreign policy. Canada has
large amounts of oil, but mostly in the form of tar sands.
Although abundant, they are challenging to extract
from an environmental perspective and expensive to
fully exploit.
Saudi Arabia remains the dominant force in the
oil markets. Thus far, it has been immune to the “Arab
Spring” revolutions and other forms of political unrest.
It is naïve to assume that the country can remain isolated
from these events. The recent death of Crown Prince Sultan
bin Abdel Aziz Al Saud, the heir to the Saudi throne,
has thrust to the forefront the question of who will
succeed King Abdullah. For the first time, the Allegiance
Council will determine the next Crown Prince. The two
most likely successors to ailing King Abdullah are each in
their mid to late 70s. The future beyond these two men
is increasingly muddled, with a large number of family
members as potential claimants to the throne.
There is considerable disagreement as to the reliability
of the estimates of Saudi oil reserves. In his book,
Twilight in the Desert, noted oil researcher Matthew Simmons
accused the Saudi government of vastly overstating
the size of its reserves and its ability to increase production.
Published in 2005, it created an uproar and leant support to Peak Oil Theory (discussed below). However,
Simmons was not specific with respect to the timing of his
predictions. It now appears that Simmons was too pessimistic
regarding the forecasts of Saudi oil production.
Saudi Arabia has been able to maintain a high level of oil
production. While it has not matched its peak production
of 2005, demand growth has been lackluster due to
economic conditions. Simmons’ supporters in the Peak
Oil community continue to promote his and other pessimistic
viewpoints2. Regardless of the short term accuracy
of his predictions, the true productive capacity of what is
purported to be the largest source of oil remains a closely
guarded state secret. Saudi Arabia will become a more
important source of hydrocarbons than it is today provided
that its resource base is accurately stated and it can
increase production. Should either of these assumptions
be wrong, as Simmons suggests, oil prices would likely
move much higher.
US Production. Table 1 lists the largest domestic
oil reserves. This list contains conventional oil and oil
shale. However, it only includes “proved reserves” of oil,
numbers far lower than the larger numbers frequently
reported in the media. “Proved reserves” are estimates of
the amount of oil recoverable using existing technology
and where the extraction is economically feasible. The
concept of “resources” allows for additional technology
and can be defined by a range of oil prices and extraction
costs. So the amount of oil considered a “resource”
is greater, though with less certain probability regarding
whether that oil will ever be extracted.
The Bakkan formation illustrates these technical
issues. Table 1 shows proved reserves for North Dakota3
at just over one billion barrels. The US Geological Survey
lists the resources at approximately four billion barrels.
Yet unofficial estimates of oil in the field can approach
500 billion barrels. To some extent, all those estimates
are correct. What changes is the underlying assumptions regarding price of oil, cost of extraction and the willingness
to sacrifice all other interests – agricultural, residential
and environmental – to extract the oil.
The possible extraction methods for unconventional
oil (including oil shale and tar sands) also highlight the
complexities of the oil market. Historically, oil shale has
been mined in a process similar to coal mining, then
processed offsite. This process is referred to as ex situ (off site), though the actual distillation of the shale into
oil is known as retorting. However, major oil companies
have been expanding the research and development
programs to increase in situ (at site) methods of extraction.
In situ methods include breaking down shale while
underground (“fracking”) and the heating of the shale
underground to release oil, which is then pumped out
using conventional techniques.
The economic viability of unconventional oil (and
the determination of extraction methodology) will hinge
on a number of economic and technical factors. The
most important is likely to be Energy Returned on Energy
Invested (EROEI). The name itself, while unwieldy, is
fairly self-explanatory. Do we get sufficient energy out of
the project to justify the energy put in? Current unconventional
oil projects in Canada are profitable as Canada
has large amounts of natural gas nearby, and often
associated with, the oil fields being developed. This would
likely be true for the Bakkan field, at least initially.
Assuming that the geology behind the 500 billion
estimate is technically correct, to extract that oil would
require almost unlimited resources – energy to run
equipment, water to inject underground and bring oil to
the surface, the ability to dispose of waste water, and most
importantly, large amounts of money.
One may reasonably expect that as technology
develops and the price of oil rises, more and more of the
oil in the Bakkan formation (and in similar fields) will be
recategorized, first as resources then as reserves. But even
the man who discovered the Bakkan field and dedicated
most of his life to it thought that only 50% of the oil
would be recoverable4.
Understanding these distinctions is key when evaluating
energy policy and investment opportunities. In addition
to impacting US environmental regulations, securing
access to oil is a significant component in foreign policy.
Increasing domestic production of oil is frequently an
issue in national elections, with significant debate regarding
environmental regulation. For example, the 2010 failure
of the Deepwater Horizon rig focused public debate
on offshore oil drilling. However, the bulk of domestic oil
reserves are onshore.
Also important is our sense of what oil (and therefore
the products that we buy directly) should cost. The
price of oil typically referenced is West Texas Intermediate
(WTI), a very high quality grade of oil. But as
Chart 1 suggests, not much oil is actually produced (or
shipped) through that region, and therefore purchased
at that price. Oil on the East coast is imported largely
from Northern Europe and it is priced as a function of
Brent Crude prices. Recently, the price of Brent Crude
has far exceeded WTI. Consumers are often confused
by this, as they may see gasoline prices stable when WTI
prices decline.
Are We Running Out? What About Peak Oil? Peak Oil Theory was conceptualized in 1956 by M.
King Hubbert, a geologist for Shell Oil. More formally,
Hubbert theorized that once 50% of a reserve base was
consumed, production from that field would decline
regardless of investment or field management techniques5.
Reduced to its simplest formulation, Peak Oil
Theory points out the tautology that any finite resource
is, in fact, finite.
The world is much more complex than that. It is
not enough to say that eventually the world will run out
of oil. The timing matters on both a micro and macro
level. The micro level involves companies deciding
when to continue to extract oil from a field and when
to completely abandon it. Typically less than half the
oil is extracted from a given field. Given higher prices
and advanced technology, companies are going back to
fields abandoned decades ago to extract oil previously
considered non-economical.
On a macro level, countries must create energy
policy based on assumptions regarding their domestic
oil reserves and the costs of exploiting those reserves
compared to importing oil. When the oil will run out;
whether with respect to a particular field, country or
globally, is a matter of great importance.
Critics of Peak Oil Theory note that oil continues
to be discovered, frequently in large quantities. They
also point out that new technologies are allowing for
increased production. Peak Oil Theorists (and others)
often note that these new discoveries, however vast, are
often difficult to access and contain oil in non-liquid
forms such as shale or tar sands. The continued development
of oil in a variety of new fields and forms had
led one prominent Peak Oil Theorist to comment:
“Let’s all loudly agree: we are not running
out of oil! But we are rapidly depleting the
high quality relatively easy-to-extract-and-refine oil that has fueled a tremendous
expansion of the world economy since the
dawn of the petroleum age. Yes, petroleum
companies may continue to make money
developing new resources, especially if
rising global demand helps drive high
fuel prices. But overall “energy profits” for
society – the energy returned from invested
resources – are shrinking rapidly, even as oil
prices and corporate profits may rise6.”
Conclusion. The oil market is unique in that it is
the one (outside of agriculture) that almost everyone
participates in directly. The oil market is highly fragmented
by geography and geology. It is also impacted by
the economic and technological resources necessary to
refine oil to its usable forms and transport it to the major
sources of consumption. The promise of vast quantities
of domestic petroleum is appealing. The reality is that
most of the oil that we will consume for the foreseeable
future will come from conventional sources in countries
with which the United States has a strained relationship.
There are two investment implications for these facts. We
should assume there will be a high degree of oil price
volatility driven by geopolitics. We should also assume
that the drive to convert resources into reserves will continue
regardless of the current price of oil. Understanding
the complexities of this market should help investors
better modify their portfolios in order to capture the
opportunities these markets present. |
