Wednesday, July 06, 2005

But They Won’t Drill With It...Not For Now, Anyway


A few months back, the Goldman Sachs so-called research department upped their oil price forecast from a $28 a barrel number to a headline-grabbing “super-spike” range of “$50 to $105 per barrel.”

I wrote about it—see “The Goldman Gurus: Two Years Too Late” from April 1—in my “rambling and sarcastic” way, and my point was this: for one thing, Goldman was coming very late to the energy shortage party that had been more accurately and more profitably predicted by Marc Faber in the pages of Baron’s; and for another, the price range itself was ridiculous—being large enough to drive a Hummer through.

Naturally enough, oil prices spiked to $58 on the Goldman excitement and reversed the next day—and the reversal did not stop for seven weeks before bottoming at $47.

But you can’t keep a good raw material in shortage down, and oil is back above the Goldman-giddy levels. And will likely go higher over the next year or two or three, if the spending plans of the major oil companies are any indicator.

I have pointed out before how the U.S. majors, including Exxon Mobil Corp, remain cautious about the long term price of oil—because they do not want to get caught up in another boom-bust cycle. So they are returning much of their cash flow to shareholders rather than to the drilling companies.

Exxon Mobil, for example, generated $40 billion in cash flow last year, and spent $12 billion drilling—but paid $7 billion in dividends and spent $10 billion on share repurchases.

Now, over the July 4th weekend, comes a report from the British press that the two largest foreign oil companies, British Petroleum and Royal Dutch Shell, will “hand back $60 billion” to shareholders over the next two years in the form of share buybacks and dividends.


This amount is, according to the reports, “equivalent to Bulgaria’s gross domestic product,” which, while interesting, is a less-than-meaningful way of thinking about the money.

The meaningful way to think about that $60 billion is that it represents 6 to 12 billion barrels of crude oil that will not be found over the next two years by BP and Royal Dutch. And that is because oil exploration costs as much as $5 to $10 a barrel of reserves in large (usually deepwater) fields.

6 to 12 billion barrels of new oil that could (assuming the exploration is successful) be added to the world's supply in a two year period are nothing to sneeze at when you consider that every two years the world consumes 60 billion barrels of oil.

Meanwhile, it’s summer here in Rhode Island and the driving is heavy. The big headline in today’s Providence Journal reads: Gas prices hit record high in R.I. The sub-heading reads: But soaring prices so far have failed to reduce demand.

Seems that a gallon of regular unleaded hit $2.289 a gallon yesterday, beating the previous record set in May—just after that Goldman Sachs report and its $50 to $105 a barrel “super-spike” forecast.

The Providence Journal reports that $2.289 is not so horrible in relation to years past: adjusted for inflation, that same regular unleaded went for $2.89 a gallon 25 years ago. Which, the paper notes, explains the strong demand in the face of rising prices.

After all, the Journal says, quoting a Hofstra professor, gasoline demand is "inelastic" and requires a more sustained and dramatic price increase to influence demand.

But so long as British Petroleum and Royal Dutch, not to mention Exxon Mobil and the rest of the world’s major oil exploration companies, prefer to give surplus cash flow back to shareholders rather than spend it in the ground, we may just see oil at $100 after all.

And then we’ll see how "inelastic" the demand for gasoline becomes.



Jeff Matthews
I Am Not Making This Up



The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.

13 comments:

RDS said...

I'm an engineer and I do alot of conceptual study work with big oil. It's becoming very clear that the easy crude has been produced. Future production requires complex or even unproven technology in less than hospitable places. It's alot easier to return money then take risks in oil rich countries that don't like the presence of Exxon and BP.

Ideally, a BBL of produced crude should result in refined products such as gasoline and jet fuel and natural gas and nuclear power plants should provide the lions share of global power. Let's quit burning crude to produce electricity. Both the Saudis and Dubya recoginize this situation.

JoeC said...

So with the price of oil and its derivatives climbing with demand unchanged (at least according to the Providence Journal Bulletin) then I guess we can have added confidence that credit card lenders and other retail-oriented financial institutions can hit their loan-growth targets. This is tongue-in-cheek but I do want to make the point that consumers tolerate inflation in a manner that suggests price inelasticity in periods when interest rates are low and credit is easy (hmmm like now). If/when rates rise and credit becomes more restrictive, then we may see tangible impact on consumption patterns. Thanks for a great blog.

RichL said...

There is a confluence of events to keep in mind before getting too bullish about oil.

Short term, the SPR is close to being filled, which releases some demand.

Beyond this, every year, CapEx is being spent to reduce the usage of oil. CAL put winglets on all of their fleet to save ~9% of their annual fuel use. In a world of cheap capital and low returns, don’t underestimate the potential reduction from energy-saving investment. On the supply side, there is constant improvement in the efficiency of drilling technology, such that each dollar spent is more effective in finding oil.

Offsetting this is the simple fact that it’s really hard to find oil-drilling workers, especially when a home construction job is so much more pleasant. That's allegedly why PPP decided to hold off on drilling in 2005. Perhaps it just makes sense to spend less if the bodies aren't there to use more money efficiently, but the technology is?

Kevin H. Stecyk said...

My guess is that we'll see plenty of elasticity at $100 per barrel. BP has an excellent primer on energy called Statistical Review of Energy 2005. In their review, they show the consumption by various countries. In 2004, the OECD countries plus Former Soviet Union (their term) consumed 65% of the oil. The remaining 35% was consumed by emerging market economies.

While Rhode Islanders might be able to easily afford $100 per barrel, many who live in the EME countries cannot. And thus, should the price actually reach $100 per barrel I expect we'll see plenty of elasticity.

Jeff Matthews said...

Thanks to Kevin for highlighting the BP Statistical Review--this is the bible of the industry, and I used it back in the early 1980's to help put together supply/demand forecasts for my boss at Merrill Lynch.

Back then, world oil consumption was roughly 55 million barrels a day. Twenty three years later world oil demand is running about 84 million barrels a day.

On top of this staggering growth in demand is the fact that countries are gradually dropping from the "net exporter" side of the ledger to the "net importer" side, as they industrialize.

That, in two paragraphs, is why I think we face an energy crisis, sooner rather than later.

DaleW said...

Back then, world oil consumption was roughly 55 million barrels a day. Twenty three years later world oil demand is running about 84 million barrels a day...On top of this staggering growth in demand...

I don't know what global gross product growth has been since the early 1980s, but I wouldn't believe it's lower than the 2.1% CAGR in oil demand. Why is this staggering? Hasn't oil exploration become cheaper during this time and hasn't the real price of crude declined over this time? This to me says, especially after a big runup in price, the market is responding fairly well to incentives and disincentives.

Excellent point on the foregone oil discoveries.

Kevin H. Stecyk said...

Why is this staggering?

It is staggering for at least two reasons. One, industries should be able to do more with less. Energy intensity (barrel of oil per unit of industrial output) should go down as industries become more efficient. So global growth has likely exceeded 2.1%. But oil demand has still grown at an astonishing rate of 2.1%. Two, at some point the world will be unable to produce more oil per day. Do we really think that we can pump 150 million barrel of oil per day? Not only would the environmental costs be horrendous, but so would be the physical costs of finding and developing sufficient amounts of oil reserves to meet 150 million barrels per day. At some point, we will reach a plateau. Considering that there have not been any "elephant" fields discovered in the last 30 years or so, the growth of demand should give us pause.

Hasn't oil exploration become cheaper during this time and hasn't the real price of crude declined over this time?

I don't believe so and no. The finds are becoming smaller (meaning costs are spread over fewer barrels), more science is needed to find those smaller finds, and companies are having to go further offshore and into more inhospitable regions of the world to find oil. If oil were easy, cheap and inexpensive to find and develop, you wouldn't see companies selling their conventional portfolios to focus on high priced Canadian oilsands development. With regard to price being cheaper in real terms, I urge you to look the graph titled "Crude Oil Prices since 1861" on page 14 of Statistical Review. Prices are equal to or greater than they were in the early 1980s. What I find interesting is that prices have generally hovered around $20 in 2004 dollars for the last 100 years or so. That isn't the case any longer.

DaleW said...

It is staggering for at least two reasons. One, industries should be able to do more with less. Energy intensity (barrel of oil per unit of industrial output) should go down as industries become more efficient.

The baseline isn't just industrial usage. Breaking it down on two basic axes, there is industrial consumption and personal consumption. Industrial usage has migrated to less energy-efficient countries while personal consumption modalties have become more efficient . Higher personal consumption efficiency is offset by the marginal energy consumption rate as incomes climb, e.g., the Southwest Airlines/Polaris/BayLiner effect. US industry has become more energy efficient and less energy-intensive while emerging countries have taken up the slack on that.

Two, at some point the world will be unable to produce more oil per day. Do we really think that we can pump 150 million barrel of oil per day?

I assume this is rhetorical. My post had nothing to do with this.

I don't believe so and no.

Oil prices have gone sideways or declined over the entire course of the commercial history of the substance, as we see in the BP review. But I was referring to the time period encompassing Jeff's remarks, during which oil prices have certainly declined in real terms.

As for finding costs, I'm not the expert, but I know the answer to the Canadian oil sands question. The answer is price. It's not ease of finding or whatever other reason. Price is the great equalizer. How many producers are electing this strategy? Just because a few firms are going with this strategy doesn't mean all of them are. This is like looking at a $30 million hedge or mutual fund and extrpolating that to all mutual funds and hedge funds. I don't imagine it's refective of much of the industry.

Kevin H. Stecyk said...

Regarding the baseline, your earlier comment referenced "global gross product growth." I have merely indicated that energy intensity per unit of GDP has gone down. Thus, you'd expect global GDP growth to exceed that oil demand growth. Personal and industrial usage are all part of GDP growth. And besides, even manufacturing in Mexico and China and other places still benefit from the gains made over the last decades in technology.

150 million barrels per day was a rhetorical comment meant to draw out that there is a limit as to how far production can increase. As we edge ever higher in daily consumption, it becomes increasingly difficult to maintain that production level, let alone grow production. Exxon has kept its recent production flat (see their annual report). If F&D were becoming cheaper, we'd expect Exxon to grow production. Instead, Exxon is cautious about getting caught up in a boom bust cycle and paying higher prices to add production. Exxon has decided to return cash to shareholders through share repurchases, as Jeff indicated in his article.

But I was referring to the time period encompassing Jeff's remarks, during which oil prices have certainly declined in real terms.

In your earlier comments, I believe you referenced the early 1980s? So yes, if you take 1980 to 1983 as your timeframe, then you are correct. As we can see from the chart, it was a spike. What caused the spike? As reported on June 28 in the Wall Street Journal article Pursuit of New Oil Supplies Runs Into a Bottleneck (subscription required) Second quarter of 1979: Amid price increase free-for-all among OPEC members, Saudi Arabia cuts production. Sept. 22, 1980: Iran-Iraq war begins. Jan. 28, 1981: President Reagan lifts U.S. oil price and allocation controls. Now if we shift the timeframe forward to 1985 onwards, then no, prices now are higher in real terms. And unlike then when OPEC was deliberately reducing production, we now have OPEC trying its best to increase production.

With regard to the Canadian oilsands, the reason more aren't following the same strategy is because all the economic leases are taken. Oilsands development remained inactive for decades. Costs were high and conventional oil was plentiful and cheap. Then the Alberta and Canadian governments realigned the fiscal terms, making oilsands more attractive. Then came along higher oil prices. And now there is a boom in that sector. Just look at the stock prices of those companies and royalty trusts that have oilsands production.

In summary, I am not sure that the 1980-83 period supports your earlier thesis that, This to me says, especially after a big runup in price, the market is responding fairly well to incentives and disincentives. The 1980-83 period was an aberration. The key difference then compared to now is that then producers were artificially restricting output and today they are trying to increase output but are unable to do so in order to bring the prices down. Prices might retreat if forecasters are correct in predicting a worldwide economic slowdown. But I still doubt we'll return the long-run historical average of $20 per barrel in real terms. I think the long-run forward price of oil will be considerably higher than $20. How high? I have absolutely no idea. It might be lower than it is today or it might be higher yet. We'll have to wait and see.

DaleW said...

egarding the baseline, your earlier comment referenced "global gross product growth." I have merely indicated that energy intensity per unit of GDP has gone down. Thus, you'd expect global GDP growth to exceed that oil demand growth.

You referenced only industrial demand, not consumer. I pointed out that there were more components to the equation than just industrial demand and asserted consumer demand would be the offset to that. I maintain my belief that the growth rate in energy consumption over the time span under discussion is hardly stagging.

If F&D were becoming cheaper, we'd expect Exxon to grow production.

It has become cheaper -- in terms of the market price of the commodity they're trying to find.

n summary, I am not sure that the 1980-83 period supports your earlier thesis that, This to me says, especially after a big runup in price, the market is responding fairly well to incentives and disincentives

Ask any Houstonian this question and they'll tell you what the response was. Prices run up, investments follow. It's a pretty simple equation. The only questions are how much of a lag there is, how much incremental capacity comes on, and what will the interim and post-boom response be. I'm not saying oil is going to $20 tomorrow and we have a lot of Canadian oil sands exposure, thanks, but I think this sequence is pretty predictable.

Kevin H. Stecyk said...

I think we're coming to an end here DaleW.

Prices run up, investments follow. It's a pretty simple equation.

If it were so simple, then why have we deviated so much from the long-term historical price of $20? And why hasn't Exxon been spending to increase its production? And why have BP and Royal Dutch Shell been returning money to their shareholders if they can do better on their own by investing it?

In any event DaleW, I am no longer interested in debating this topic with you. I am comfortable with my knowledge and the facts.

You can have the last word.

Peace.

DaleW said...

If it were so simple, then why have we deviated so much from the long-term historical price of $20?

I find the recent deviation from the real $20-30 level less remarkable than a 100+ year maintenance of that range.

And why hasn't Exxon been spending to increase its production?

I don't know. Why has Magellan failed to outperform for years and years despite its track record? Not everyone's a .350 hitter, not every PM, not every company's board, and not every batter despite their track records.

And why have BP and Royal Dutch Shell been returning money to their shareholders if they can do better on their own by investing it?

I have met more CEOs than I care to know who have no idea how to connect those two concepts.

In any event DaleW, I am no longer interested in debating this topic with you. I am comfortable with my knowledge and the facts.

You can have the last word.

Peace.


I'm not debating. Simple conversation. Peace.

Jeff Matthews said...

The reason the majors are not spending more on drilling is very simple: they had been using, until 2004, $18 to $20 a barrel as a long term oil price for dcf purposes, rendering many large offshore projects uneconomic.

This caution derives from two facts: major oil companies are now run by finance guys, not oil guys, and they stick to dcf models and not the lure of the big elephant field; and oil companies are tired of getting caught up in past boom/bust cycles, so they'd rather undershoot than overshoot the price of oil.

Which is precisely why there is an energy crisis coming. So long as these guys don't believe $40, then $50, then $60 a barrel oil is sustainable, they will not invest enough to prevent prices from going higher.