What's Up With Oil? July Hiatus

When the equity market tries to convince itself that the second quarter gain of 15% in the S&P 500 is real, it occasionally frets about oil prices. We recently heard a presentation by John Hess, the CEO of Hess Corporation, at Harvard's Belfer Center. Here are some things we took away.

Oil represents 35% of the global energy supply today. Separately, Ian Bremmer of McKinsey notes that the world's 13 largest oil companies, measured by reserves, are controlled by governments. They are : Aramco (Saudi Arabia), Gazprom (Russia), CNPC (China), NIOC (Iran), PDVSA (Venezuela), Petrobras (Brazil), and Petrona (Malaysia). Hess, as the CEO of a multinational producer himself, makes the point that the future energy policy of the world's major producers will become their foreign policy. To put this into perspective, multinational corporations today produce only 10% of the world's oil and gas and hold only 3% of the world's reserves. U.S. policy makers need to keep this in mind in the future. No amount of political wind about wind will take away the global dependence on hydrocarbons, particularly oil and gas, for the intermediate term future.

From 1986-1996, oil was $15-20 per barrel. Demand growth led prices upward from there. 86 million barrels per day (mbd) is the current worldwide demand. The recession has shaved about 2 mbd off that total, but in the near future, demand will outstrip supply, and prices should start moving up once more. Hess said that we are nearing a crisis in productive capacity, and not a crisis in reserves, or oil in the ground.

He cites a total reserve number of 2-3 trillion barrels of oil worldwide. The problem is that existing fields are being depleted by about 6% per year, and continuing production from these mature fields will require increasing pressures for extraction, which is more expensive. Hess says that we need to add 5 mbd to replace the depletion from producing fields and to provide for demand growth. However, industry exploration hasn't replaced reserves at this level since 1984.
The top 6 multinationals, including companies like Exxon and Conoco, produce about 11 mbd, or about 13% of world demand, and their depletion is about 6% per year. OPEC's swing capacity is about 3 mbd, a little bit more than the current recession-driven decline in demand. Aramco is producing at about 8 mbd today, but OPEC is reinvesting only about 10% of its proceeds in exploration and development to maintain production and provide for future growth. The rest is being fed into their domestic economies for current consumption and diversification through sovereign investment funds.

The industry cycle is five years from prospecting to the drilling of exploration wells. Hess says the average is another five years to the drilling of production wells. So we need a ten year lead time to offset depletion and provide for growth. He characterizes the industry's $400 billion per year exploration budget as inadequate.

Iraq's production is 2 mbd versus 5mbd before the onset of the Iraqi conflicts. However, Iraq's reserve potential is said to be #2 behind that of Saudi Arabia. The problem is going to be an economic and political one. There will clearly be a resource-based nationalism that seeks to control the development of the oil resources by a state-owned company, and yet they cannot achieve that goal without the technology and resources of the multinationals. How can these companies, some of which are public, assess not only the political risks of force majeure but the relatively new security risks to the lives of their international personnel on the ground? They can do this by placing exceptionally low bids for their licenses. However, this will not be acceptable to the national oil company. Again, the outlook for prices is not good.

Investment in equipment has lagged. Rig rates have gone from $100,000/day to $500,000/day because of the shortage.

It was interesting to hear Hess, speaking at Harvard, say that the worldwide shortage of geologists, geophysicists, drilling and reservoir engineers is one of the biggest constraints that the industry, and his company, faces today. Fewer finance MBA's and more P.E.'s!

Worldwide, he said, the transportation sector accounts for about 50% of oil demand, primarily through automotive, commercial, and jet fuels. He cites the 20% total efficiency of the current gasoline auto engine as something that should be addressed post-haste. He favors putting out a challenge CAFE level of 35 mpg by 2020. We know one major auto company, currently in bankruptcy, that would be gonzo under that regime.

China's oil demand is about 7 mbd, or a little less than 10% of world demand, and non-OPEC demand is growing at 1 mbd currently, and could accelerate if worldwide growth resumes.

It was a sobering, but realistic scenario, and one that computes. No amount of talk about ethanol, wind, residential solar, or fuel from algae will address the near-term and intermediate term futures without demand reduction/efficiency strategies and strategies to increase the development of reserves.

Before going on a July hiatus, we wanted to give our loyal readers some food for thought. Talk to me and let me know your thoughts, even off line. Happy Fourth of July!