August 27, 2011
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№ 3 (March 2011)

Russian Minister: No More Cheap Oil

   Russian Finance Minister Alexei Kudrin said recently that over the next three years, oil prices will linger below $60/bbl.

By Alexandr Khurshudov

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   Russian Finance Minister Alexei Kudrin said recently that over the next three years, oil prices will linger below $60/bbl. JPMorgan  experts predict that next year oil price will reach $120. Venezuelan Minister Rafael Ramirez insists that if the Suez is closed, the price of a barrel could rocket to $200.
This is certainly a nice collection of opinions, is it not? For over 10 years, I have closely monitored oil prices and marvel at ease of price forecasts. Often, both during the war in Iraq and in the midst of the global crisis, have I had to use figures in hand to cool hotheads predicting slumping and stagnation in Russia.

   Oil is the scarcest of all major natural resources. In developed countries, Europe and North America, its stock has been steadily declining. The dynamics of oil prices depend on many factors, which can be separated into two groups: fundamental and speculative.

Market Speculation Runs are Short-lived

   It is no secret that the global exchanges trade oil price expectations rather than oil itself.

   Less than 2% of futures contracts result in real delivery. Meanwhile, stock exchanges regularly trade some 300 million tons of oil in issued contracts, 7.8% of global production. This is virtual oil, it is neither produced nor sold, but it creates tremendous speculation opportunities. In the second half of 2008 a large bear speculation backed by the developing crisis has brought the players the income of approximately $210 billion. About half of this sum has been earned earlier on bullish speculations.

   However, opportunities and capital from punters are not limitless. Even a well-organized oil price speculation cannot become a long-term profitable investment due to opposition from consumers and producers. During the last plunge of oil prices OPEC needed two months to reach a decision and just as much for its implementation, and within half-year the speculative line ended.
Yet, the true long-term (fundamental) trends must be monitored in annual average prices. Since 2003, the oil market has formed a growth trend, a steady pattern based on long-term factors of the global economy. Let’s take a closer look. Hereafter I use data from the BP annual energy reports.

Proved Stocks Climb on the Wave of Price Hikes

   The world's oil reserves are the first of the basic factors. Over the past five years they have grown 10.1% and have now reached 181.7 billion tons. This looks good but the question is, what contributed to this growth? More than half of new stock is “paper oil” – as a result of oil price hike, previously uneconomic deposits are now profitable. For example in the US, out of a total of 215 million tons reserves increment (7) only 13% are new discoveries, the rest is the result of revaluation. In 2006, Canada's reserves jumped 1.3 billion tons, almost 60%, because production from well-known deposits of heavy oil became profitable.

   New fields are being opened mainly offshore, where everything costs about 10 times as much as onshore. The development of Kashagan, the largest Kazakh field in the Caspian, is being delayed precisely because the deposit needs $136 billion investments, which is about $18.6 on each barrel of oil to be produced. However, even the close shelf is already well-studied, large unexplored areas remain only in northern Russia and Canada. It is true that the deep shelf exists, but the BP accident in the Gulf of Mexico showed that such deposits will require several times more investments. The growth of profitable reserves is tightly associated with the growth of oil prices, and price stabilization will quickly result in reduced reserves over several years.

Economic Growth of Developing Countries is Impossible Without Growth in Energy Consumption

   Global oil consumption is the second most important factor. In the last crisis year, 5-15% manufacturing production decrease resulted in only 1.7% fall of energy consumption. Historically, energy consumption is hugely imbalanced: while developed countries consume 1.8 tons of oil annually per capita, the largest developing countries (China, India, Indonesia) consume eight times less. In 2009, China increased oil consumption by 6.7% and last year increased it by another 12%. If in the next 15-20 years growing APR economies at least double their consumption, global production will have to rise by 20-25%.
However, the development of the global economy is not a straight forward process – any strong trend is modified by other process. In developed countries, growing oil prices put downwards pressure on oil consumption by 9% over the past four years. Of course, a significant role was played by the global crisis, but even the rich nations must find ways to economize. Oil demand in APR countries will be hampered by their populations' low incomes. In China and India, prices on petroleum products are regulated by the state – in fact, they are even subsidized – but the growth of expensive oil imports will compound this. With an average salary of $300 per month, gasoline at $1 per litre will become a luxury. To me, this is the embryo of a looming crisis (though one unlikely to happen within the coming decade). And there is a way to postpone the next recession – by increasing oil production in OPEC countries, mainly in the Middle East.

OPEC May Counteract the Rapid Price Growth but is Unlikely to Try Very Hard

   Coordinated OPEC actions in 1998 and 2008 showed that this organization has the means to effectively leverage the oil market and to suppress bearish speculation. The question is, will OPEC resist the bull market just as fiercely?
Consumer countries will insist on such a policy. I think the sad experience of the war in Iraq will deter these states from direct military intervention, but they have enough economic and political instruments anyway. OPEC countries do not have a developed industry and essentially depend on consumer goods imports. Their authoritarian regimes need to be supported and they are unlikely to withstand the joint actions of the US and the EU, which will soon be joined by China and India. That is why OPEC has already been declaring its intention to regulate not only bottom, but also the top margin of oil prices for several years.

   Still, it is easy to cut production, but growth in production requires certain conditions. Almost half of OPEC's oil reserves (59.2 billion tons) are in Iraq, Iran and Venezuela, where the political situation discourages investment. The decline (13% over four years) in production in Saudi Arabia, the main OPEC exporter, looks alarming. In 2009, the reduction was motivated by quotas, but there was no apparent reason for the production slump in 2006-2007. OPEC's 2008 actions indicate that even given the general mood on price stability, exporters do not mind earning extra money on the stock exchange panic of buyers. In other words, raising OPEC production capacity will be a complex process and is likely to lag behind the consumption dynamics.

   There are other major global factors that support a growing trend in the oil market. Such as dollar inflation, deterioration of the remaining reserves, over-exploitation of deposits, especially offshore fields. High prices led to higher investment, and in my opinion, many oil managers contracted the “quick payback” syndrome. For forced withdrawal, reservoir pressure is lowered to unacceptable values, with induced water breakthrough fill the producing wells; as result, the remaining reserves incur much higher production costs than would have been required otherwise. Notably, the unreasonable use of horizontal drilling and hydraulic fracturing, though they lead to higher oil production, also come with huge amounts of produced water which increases expenses. But rather than delving into the technological details, I am better off focusing on the factors that contribute to reduction of oil prices. First of all, this concerns alternative fuels.

The Use of Alternative Fuels will Grow, but Only Gas and Coal can Significantly Offset Oil Consumption Levels.

   The biofuels concept is supported by many, but its actual production lingers at mere 1.3% of global oil production, while requiring significant quantities of energy and large acreage. However, oil prices above $100/bbl., will significantly increase the biofuel profitability and its production will gradually grow. I think the next 10-15 years will see the growth in recycling of all organic substances: natural bitumen, peat, sludge, litter, timber manufacturing waste. Yet this industry is unlikely to compensate the future hundreds-millions-tons growth in oil consumption. The same applies to the growing use of the transport of electricity.

   Coal processing is more promising option. It is much cheaper than oil and at current production rates it can feed global economy for 119 years. Technology for producing liquid fuels from coal is well known. The problems of coal processing concern environmental sector: mines, air pollution and industry waste are costly things. In my opinion, production of motor fuels from coal requires 10-15 years to reach mainstream industrial levels.

   Eventually, natural gas could become a key competitor to oil. Natural gas has already taken the “place of honor” in power generation, while the automobile industry is actively engaged in switching motor vehicles to LPG. The gas calorific value is clearly lower than that of gasoline and it is more difficult to transport and store, but its low price has (so far!) compensated for these faults. Global propane-butane resources stand at about 8-10 billion tons, and annual production is 150-200 million tons (which could offset oil consumption by 3-4%).
Lasting peace in the Middle East could significantly reduce the oil prices growth. However, now we are farther away from the peace than 10 years ago, and the abundance of weapons and mutually opposing vectors in the region do not contribute to the production of oil.

Oil Prices Growth will Start to Slow Down After Initial Rise for 3-4 Years

   History and forecast oil prices in the coming years are shown in Figure 1. There are no current reasons for growing trend to stop, so I expect the average Brent price this year at $95/bbl. The current jump of oil prices over $100 happened due to political instability in the Arab countries and is speculative; when ended, the prices should go down to the region of ​​$80, so they can rebound back in time for the winter season. Price growth at the rate of $8-10 per year is likely to continue for 3-4 years, starting to slow down after this due to a number of reasons: fuel saving policies, expanding fuel production range, growing gas usage.

   Generally speaking, a sudden flare of hostilities in Arab countries can lead to short-term jumps in oil prices up to $150-200/bbl. But I think such the chances of this are highly unlikely. The threat of oil shortages will force leading countries to join the forces and quickly extinguish a dangerous development.

   The depletion of cheap reserves and the resulting growth in oil prices is the first sign that global resources are finite. Similar processes have been observed in the nonferrous and rare metals industries; the time is near when a shortage of forest, land and clean water will also become apparent. Humankind can no longer carelessly take from nature; we have only 20-30 years to change from a consumer approach to one of balanced development. I have no doubt that this problem will be solved, but the path to the solution will not be easy.

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