Oil is the most important energy source in every developed economy and is a vital ingredient in the emergence of the developing countries. No commodity has a greater impact on the economy and on world politics than oil.
Yet, oil is largely taken for granted. For decades, production of crude has risen in unison with the growing demand for gasoline, diesel, plastics and the many other products derived from crude. Complacency about oil exists in spite of three warnings that the supply of that vital energy source is limited. Two oil shocks in the 1970s resulted from artificial constraints on supply. The most recent market disruption was entirely different.
In 2008, we had a sneak preview of the future of oil, with the price spiking above $140. Speculators were blamed for pushing crude to 2 ½ times the level at the start of the prior year. Speculators certainly participated in the markets. However, the bulk of oil was purchased by companies that process the crude to make products for consumers.
While speculators were a contributor, the reality is that the massive economic growth in Asia boosted demand at the same time that production growth hit a brick wall. Every component of the crude supply system was working flat out to take advantage of the windfall of higher prices. Yet, demand outpaced the best efforts of the oil industry to pump crude at a faster pace.
Fair enough, it takes time to find and develop new oil fields. Perhaps in time the oil industry would have caught up to demand if the Global Financial Crisis had not slashed demand across every industry and around the world. Or, the industry might not have caught up, as we will see in the next article. In any event, a showdown was averted in 2008. Even as the Western World struggles out of recession, the oil price is bouncing back.
It’s not hard to understand the revival of the oil price. Last year, China became the world’s largest automobile market. Auto sales in that fast-growing country are expected to rise a further 20% this year over last.
A vitally important note about the Chinese auto market is that every unit sold represents another auto on the road. In the developed world, new car sales each year more or less offset older vehicles that are retired. In China—and India and Brazil and all the rest of the developing world—auto sales each year represent an expansion of the number of vehicles in operation. The world’s fleet of cars, trucks, buses and SUVs is growing at a staggering pace. Clearly, demand for gasoline and diesel will continue to expand with the growing fleet of autos. At the same time, the myriad other uses for crude will grow in tandem with economic growth.
Even with further initiatives to improve fuel efficiency in the West, there is no doubt that global demand for crude will continue to rise.
There is much less assurance that the supply of crude will keep pace with the growth in demand. At the very least, the cost of extracting crude will increase as new supplies become deeper, more remote and more difficult to extract. Add to those rising costs the inevitability that governments will cut subsidies for oil production and impose levies to acknowledge the environmental cost of oil production and consumption. The near term outlook is unclear, but it is certain that the price of crude will trend higher in the coming years.
Why is the oil market important to GreenTech Opportunities?
There are a couple of very important reasons. The first is that the value of alternative energy forms will increase as the cost of conventional energy rises. As the price of crude increases, so too will the value of energy derived from wind, solar, geothermal and other sources. Conversely, the sharp drop in the oil price since its peak in 2008 brought down the near term value of alternative energy companies.
Further, with the growing awareness of the potential for oil shortages and rising energy prices, government policies will swing more solidly in favour of energy from other sources—any other sources. Rising energy prices will also mean that energy conservation will also become more important.
There is a great deal of controversy surrounding the energy market. This issue cuts through the emotion and rhetoric to present some basic information about the long term outlook for the crude oil market.
What Future For Oil?
When people complain about high gasoline prices, they don’t realize what a bargain they are getting. To obtain the same energy from human labour would cost a multiple of the cost of oil. In fact, the energy content in a $75 barrel of oil is equivalent to an adult working 40 hours a week in a labour-intensive job for 12 years! At the U.S. minimum wage, that human labour to replace a barrel of oil would cost $200,000.
Little wonder that the industrial world has developed a strong addiction for oil. Being so cheap, energy using devices, and in fact our whole economy, is incredibly inefficient in terms of energy usage. For example, as we’ve pointed out before, less than 1% of the energy in a gallon of gasoline actually goes towards moving the human down the road.
Two years ago, record high prices kept oil front and center in the financial and the popular press. Now, the environmental consequence of a catastrophic failure at a deepwater oil drilling rig has put oil once more in the headlines.
Since April 20th, oil has been spewing into the Gulf of Mexico at an estimated rate of up to 19,000 barrels a day from an out-of-control oil well a mile below the sea. An explosion and fire on the Deepwater Horizon drill platform left the well spewing oil. So far, the best minds in the oil industry have not been able to control the oil flowing from the well. It took six weeks to get a cap over the top of the well and capture a portion of the oil.
By June 10, at a spill rate of 19,000 barrels a day, the oil released into the ocean equated to four Exxon Valdez spills. A portion of the crude is now being captured, but it is unlikely that the leak will be fully contained until a relief well intercepts the out-of-control well. The earliest estimate for that to occur is mid-August.
The Exxon Valdez spill occurred near shore, so that the full effect was felt almost at once. This well is 50 miles offshore. It took weeks for the oil to begin to come ashore. Sea life in a large portion of the Gulf of Mexico is now swimming in water contaminated with oil. Over the coming weeks, oil will be fouling beaches and marshes from Texas to Florida and then beyond.
More people will be directly affected by the current spill than the Alaska spill. As more of the oil washes ashore, it will become a stark reminder of the consequences of having the American economy so intimately tied to petroleum. This disaster just might begin to have a meaningful impact on American energy policy.
The search for crude is driving oil companies further and further offshore, leading them to drill in ever deeper water and to greater depths into the earth. While drilling technology has made tremendous improvements, the reality is that such deep drilling comes with huge risks. We have now seen how dangerous deep-sea drilling really is and how difficult it is to fix a problem once it arises.
The oil industry is increasingly relying on sources that are deeper, more remote, and in general more expensive to find, develop and extract. That is the reality of the oil industry for the simple reason that there is no alternative. The easy to get oil is long gone.
Can Oil Production Continue to Increase?
Everyone has heard of "Peak Oil." Plenty has been written about the topic. In fact, there has been such a torrent of information, opinions and mis-information that few people have a clear understanding of the concept and its implications.
Some people are spreading the myth that the oil supply will suddenly dry up. Others are convinced that the industry will be able to continue to boost production for decades to come. Both of those extreme views are false.
The term Peak Oil implies that it will become harder to continue to boost production. The amount of oil pumped will not suddenly drop, but it will become increasingly difficult to expand production and even to maintain the current level. At the very least, the cost of new production will become more expensive, perhaps much more expensive.
Crude production has increased for decades along with expanding demand. The rapid industrialization of half of the world’s population is now accelerating the growth in demand for oil. As demand ramps up at an unprecedented pace, we are already seeing signs that further growth in output is becoming more difficult. Some highly credible experts believe that oil production has already peaked. Oil will continue to be pumped for many more decades. But, with supply growth constrained and demand rising, the available oil will go to the highest bidder.
We have already seen the impact of a shortage of supply. Just think back to July 2008, when the oil price hit $145, seven times the level at the start of this decade. Many commentators and even some policy makers naively attributed the unprecedented rise to speculators. Just remember, those speculators bid the oil price to that level on the belief that market fundamentals would push the price even higher. The Global Financial Crisis reversed the speculative binge and simultaneously cut real demand for crude.
The rapid rise in the oil price coincides with the emergence of China and other developing nations. After the wild gyrations of 2008, crude is back where it was in 2006. Then, the whole world was growing at the same time. At this time, the strong growth in the emerging economies is the driving force, as the developed countries are just emerging from recession.
Oil Production Has Already Stalled
Oil production rose along with the rising demand until 2005. Then, even as the price continued to climb, the oil flow rate remained pretty much constant, dropping with the recession in 2009. The growth in production after 2002 came largely from turning on shut-in capacity. Once the wells were flowing flat-out, there was nothing more that could be done.
There is a popular misconception that OPEC controls the majority of oil production and can simply open the valves as needed. In reality, 60% of oil production comes from outside of OPEC. Every oil producer, OPEC or otherwise, did everything they could to participate in the rapidly rising prices after 2005.
Of course it takes time to find and develop new oil fields. Without getting into a lot of detail here, there have not been many new discoveries over the past decade, certainly not of a size that would have an impact on world production. There will certainly be many new discoveries. At the same time, the established fields are declining.
The last big oil discovery was 195 kilometers off the coast of Brazil. The field is operated by Petrobras, the Brazilian state-owned oil company. The water depth of 2,000 meters is more than twice the depth of the out-of-control well in the Gulf of Mexico. The oil is located 5,000 meters beneath the seafloor – a deep well even for an onshore operator.
The environmental disaster presently unfolding in the Gulf of Mexico is a stark reminder about the risks and the real costs of exploiting oil from increasingly more remote locations.
It is now a race between the oil finders and the oil producers. For many years, production has outpaced new discoveries, so that global reserves are falling.
While we aren’t about to run out of oil, it is abundantly clear that oil will become more and more expensive to find, develop and extract. At sufficiently high prices, oil production could continue to increase for some time yet. Recent history has shown us that much higher prices may be required to balance supply with ever rising demand.
Security of Supply
Nearly 60% of U.S. oil is imported, with the leading suppliers being Canada, Saudi Arabia, Mexico, Venezuela and Nigeria. Growth in Canadian production relies heavily on expanding tar sands output. There is mounting opposition from the environmental movement against expanding what has been branded “dirty oil”. Production in Mexico is dropping rapidly, with output from the biggest field down 50% in 18 months. Some industry analysts are forecasting that Mexico will become a net oil importer within the decade. The other three major suppliers to the U.S. all carry substantial political risk.
In fact, much of the oil produced in the world comes from jurisdictions that do not provide a great deal of comfort regarding security of supply. The world has already experienced two episodes of oil supply disruptions for political reasons.
Implications for Energy Policy
We are not in any way intending this to be an oil market commentary. In the near term, it is just as likely that the oil price might decline as increase. Our intent here is to look at the trends in the longer term and the implications for alternative energy policy.
It is highly likely that the environmental mess unfolding in the Gulf of Mexico will lead citizens and policy makers alike to look closely at the oil industry, including long term costs and security of supply. That scrutiny will undoubtedly impact public opinion and government policy regarding energy.
People around the world, and Americans in particular, will become more open to government policies that lead to a move away from oil, even if that action may cause some near-term discomfort.
Alternative energy sources have already started to gain momentum. Rising public and policy support will accelerate the movement toward alternative energy.
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GreenTech Opportunities provides investment commentary and specific company recommendations to subscribers on the developments that are happening in the alternative energy field.
