The markets are rejoicing as the “great oil bubble” loses air and rapidly heads back to its proper double-digit price. The rejoicing may be a bit premature as the underlying supply and demand fundamentals do not appear to support “proper” prices for oil.
Between 2004 and 2007, global oil consumption grew by 3.9%, driven by emerging giants China and India (40% of the world’s population) and other rapidly growing emerging economies. While consumption has exploded, production has not kept pace. Non-OPEC production growth has slowed well below historical averages. And the only country with significant spare production capacity is Saudi Arabia. Unfortunately, Saudi spare capacity is not independently verified, and the vast majority of their current production is from the giant Ghawar oil field, a dowager now 57 years old which still produces nearly 5 million barrels a day.
“Saudi Aramco is injecting a staggering 7 million barrels of sea water per day back into Ghawar, the world's largest oilfield, in order to prop up pressure. It accounts for 30% of Saudi oil reserves and up to 70% of daily output. Doubts grow about Saudi as Global Swing Producer," Aberdeen Press & Journal Energy
It is interesting to note that the above article appeared in April 2004. Time is not on the side of Saudi Arabian spare productive capacity.
Surplus Capacity Remains Low
World surplus production capacity remains low. The estimated 1.35 million barrels per day in June 2008 is equivalent to less than 2 percent of consumption, an amount well below the 1996-2003 annual average of 3.9 million barrels per day. This puts upward pressure on prices and leaves world oil markets vulnerable to supply disruptions.
Even if world GDP were to slow significantly, oil consumption may not fall off the table. Per capita oil consumption is growing in the Middle East, China and India. If these areas continue to subsidize the price of gasoline, then demand may stay strong, even in a slowing global economy.
Disturbing Findings
The historically conservative International Energy Agency (IEA) has issued some disturbing findings in its latest report. It notes that global production cannot keep up with demand, and the trend is getting worse. It predicts global oil depletion at 5.2% this year, versus 4% last year. Over 3.5 million barrels per day of new production will be needed each year just to hold global production steady. With Ghawar, the world’s largest and one of the oldest fields now producing less than 5 million barrels per day (approximately 6% of global daily production), where will this new production come from this year, and in every succeeding year? What if the global depletion rate is over 6% next year, equivalent to Ghawar? This is the crux of the issue. Finite supplies will never be able to meet infinite future demand.
Increasing Reliance on OPEC Production
Call on OPEC to Fill Growing Demand
According to the Interagency Task Force on Commodity Markets (ITF), spare capacity is shrinking. Since 2003, OPEC oil production has grown by 2.4 million barrels per day, while the “call on OPEC,” the difference between world consumption and non-OPEC production, increased by 4.4 million barrels per day. The world oil market balance has tightened. If speculation was the reason for higher prices, then inventory levels should be rising. However, inventories have been falling. According to the ITF, global demand is expected to grow at approximately 1.6% annually, lead by China, India, the Middle East and Latin America.
Non-OPEC Supply Growth
It’s 1915 in China
The year was 1915 and a young and growing America was just beginning to fall in love with the automobile. That year there were 9 privately owned vehicles per 1,000 Americans. That is precisely where we find China today as it begins its own love affair with the automobile. The difference of course is rate of change and scale. China recently passed Japan as the second largest automobile market after the US. Astoundingly, China did not begin encouraging private car ownership until 1994. Even more amazing, 37% of people driving in China today did not know how to drive 3 years ago! (The death rate from accidents per 100,000 cars is 4.5 times the US rate.)
With a middle class already estimated at nearly 300 million people (21% of total population), it is only a matter of time before China will have more cars than any country on the planet. On the luxury side, China is already the #1 Rolls Royce market in the world, with the most popular model selling for a cool 7,000.
As the financial system grows and gains acceptance in China, it will open up more opportunities for Chinese citizens to buy cars on credit. In a Chinese car ownership survey, 96% of respondents said they paid cash for their cars. As this nation of hardworking people begins to taste the convenience and freedom of automobile ownership, there is no turning back, even at higher fuel prices. The global demand for gasoline will grow rapidly as car ownership becomes more commonplace in China.
China now imports over 4 million barrels of oil a day, roughly the same as Japan. Despite a major production effort, China’s crude oil output is forecast to rise only 1.1% in 2008 to 189 million metric tons. This is down from a 1.6% increase in 2007, according to the Chinese Petroleum and Chemical Association. The implication is for continued growth in imported oil, even if the economy slows from its current double digit growth.
Per Capita Consumption Likely to Rise
China, India, and the Middle East use substantially more oil to produce a dollar’s worth of real output than the United States. These economies are among the fastest growing in the world. They have accounted for nearly two-thirds of the rise in world oil consumption since 2004. However, these economies still consume a relatively small amount of oil on a per capita basis. As these economies continue to develop and incomes rise, per capita energy use is likely to increase dramatically.
Geopolitical Uncertainty
“There is currently a high degree of uncertainty in world oil markets due to fears about the adequacy of oil supplies in the future. Current world oil supplies are highly concentrated, and much of those supplies are held by nations that limit access to private investment, thereby preventing full development of production through enhanced expertise and technology. In 2007, the top 10 oil producers represented about half of total world production. In addition, geopolitical risk surrounds many of these top producers, either because of current supply disruptions (Iraq, Nigeria) or the perceived threat of a disruption (Iran, Venezuela). Finally, as noted previously, there is little surplus production capacity available to offset any disruption.” ITF Interim Report on Crude Oil, July 2008
Dollar Rally Pushing Down Commodity Prices
The dollar is enjoying a nice run after a long period of dreary performance. This is affecting all things priced in dollars, particularly commodities. The fundamentals for the dollar have not improved, only sentiment against other currencies such as the euro. While a dollar rally could last into the fall, it is very likely that it cannot be sustained without improved fundamentals. Look for reality to reenter the markets after the November elections. The alchemists at the Fed cannot create prosperity through the printing of more dollars, though they will surely try to stave off a severe recession in this manner.
Lower gas prices at the pump have been a welcome sight to all consumers, and especially politicians running for election. Given long term supply and demand fundamentals however, those looking at the “great oil bubble” as just a passing bad dream may be in for future nightmares in the years ahead. However, those investors who understand the future trends should be able to sleep much more soundly.
Today’s Markets
Stocks fell sharply Monday as the financial sector deepened its slide amid reports of more losses at Lehman Brothers and of a bail-out for mortgage giants Fannie Mae and Freddie Mac.
The Dow Jones Industrial Average finished down 180.51 at 11,479.39. The S&P 500 Index was down 19.60 to close at 1,278.60. The Nasdaq also ended lower, losing 35.54 to close at 2,416.98.
Gold futures closed higher Monday, rebounding from last week's drop of more than 8% as weakness in the U.S. dollar helped increase demand for the precious metal, lifting prices by nearly $14 per ounce for the trading session.
Crude-oil futures closed below $113 a barrel Monday with traders' nerves rattled by signs of sluggish demand for oil worldwide just as concerns started to wane over the potential for energy supply disruptions in the Gulf of Mexico. Crude found some level of support as the U.S. dollar fell against some of its major currency rivals and as tensions in both Georgia and Iran continued to worry traders. Traders are always nervous because they deal with day-to-day swings, not long term fundamentals.
Wishing you a good evening,
Tony Allison
Registered Representative
