Oil and the Great Deception - Part Three

"Oil Production in the United States is in a permanent decline."

This is one of the loudest of all claims by oil bulls, and the one stated with the most smug self satisfaction, a seemingly impregnable statement that no one with even half a brain could possibly refute. This claim is usually made in conjunction with some comment about M. King Hubbert, and his prescient statement about the aforementioned peak, complete with the required head bowing and reverence for the so called "messiah" of the peak oil movement.

How can anyone deny this after all?

According to the Department of Energy web site, domestic oil production peaked in 1970, at 9.6 million barrels per day. On a Monthly basis, it peaked in November 1970, at 10.4 million barrels per day. However, this doesn’t tell the entire story.

1) Production in the U.S has stopped declining and was flat in 2007 vs. 2006. While there is some noise in the numbers due to recent hurricanes, it is estimated that in 2008, production will again be flat before a large 4.1% increase in 2009. The chart below shows the reversal in this decline.



2) During a four-year period, from 1982 to 1985, domestic production grew every year, a legacy of increased oil exploration while prices were high in the late 1970’s and early 1980’s. The total percent increase in domestic production was 4.65%.

Here is a chart from Google Docs. Although hard to see in the chart due to the scale and my technical incompetence in trying to remove the lower numbers, production did increase before tailing off once prices collapsed.



3) Domestic oil production also increased in 1977 and 1978, including a whopping 5% in 1978.

4) Domestic oil production increased 10.3% from 1976 to 1985, from 8.1 million to 8.9 million barrels per day.



5) Recently, sequential production has increased for four straight months (December 2007 to March 2008), although still down on a year over year basis. And yes, I understand that four months does not a trend make, just thought I would mention it.

Why am I wasting time writing this?

To demolish cherished beliefs held by millions of investors who rely on others to do their homework for them. Stop regurgitating what you hear on TV, and do your own god damn research.

What you should really be thinking about is that if production can actually increase in a mature basin like the United States, then imagine what could happen in areas of the world that are at the cutting edge of exploration.

Now before you your make your comments about how stupid I am or how I just don't understand, please read the following about things I am specifically not saying, so please don't accuse me of this:

1) I did not say that U.S production will ever reach its previous peak of 10.4 million barrels reached in 1970, just that production could head up again due to increased exploration.

2) I did not say that it is easier to find oil in the United States.

3) I did not say that the possibility of a small increase in production in the United States will solve all of our supply problems.

Oil and the Great Deception - Part Two

"It is getting much more expensive to find Oil these days."

While it is true that it is getting more expensive to find oil, one has to examine whether that increase is of a permanent nature as many argue. The reason that it is getting more expensive to find oil is mainly because service, drilling and other costs are sharply increasing. While this may seem like a circular argument at first, my intention is to demonstrate that the cost of finding oil is rising to a cyclical peak, and that it is not secular in nature.

All the data shows that the cost of finding Oil is rising sharply. Why? Very simply because of a self reinforcing boom in exploration and production, which led to a capacity shortage in oil services and drilling as demand for rigs and services increased faster than supply. Other costs, such as for steel, or the acquisition of existing producing properties has also increased for the same reason, a shortfall in capacity in various sectors, or an imbalance between supply and demand.

It is therefore, a cyclical increase in the cost of finding oil, not a secular or systemic one. If the exploration and production sector cuts drilling significantly, say 30-40%, then extra capacity will flood the oil services and drilling market leading to a plunge in prices and then the cost of finding and developing oil will decrease.

This argument is supported by data from many sources.

The Energy Information Administration (EIA) study entitled Oil and Gas Lease Equipment and Operating Costs, which has data from 1976 to 2006. The chart below demonstrates the cyclical nature of oil services.



Look at the green line back in the early 1980's when the cost index fell from 123.3 to 82.6 in just five years. This study does not include drilling and completion costs. If you included these, the cyclicality would be even more pronounced. Also, this data is only through 2006. The green line currently is significantly higher.

The same trend can be seen in the HS/Cambridge Energy Research Associates (CERA) Upstream Capital Costs Index. The latest monthly release from May 2008, shows that "the latest increase raised the index to 210 points from its previous high of 198. The values for the UCCI are indexed to the year 2000, meaning that a piece of equipment that cost $100 in 2000 would cost $210 today."



This index tracks "the construction of a geographically diversified portfolio of twenty eight onshore, offshore, pipeline and LNG projects."

As an example, five years ago, it may have cost $ 250,000 per day to lease a rig to explore deep offshore. Today, if you can find one it may cost you $800,000 per day. According to Cambridge Energy Research Associates (CERA), dayrates can be 30-40% of the cost of an offshore well.

So in a sense, it is getting more expensive to find oil, but people who say this are either ignorant of the reason why or being disingenuous to further their investment case. Bullish investors use this as an excuse to justify that oil prices have to stay higher because the cost to find oil is higher.

Please understand that I am not predicting that this these various cost indices will turn down soon, only stating for the record that they can turn down, and have turned down precipitously in the past once capacity catches up to demand.

If you argue that the cost of finding Oil is permanently higher, then you are accepting the argument that industries that have been intensely or even pathologically cyclical for 100 years are no longer subject to those conditions. This is a bold statement to make and you better be damn sure you are right.

Please read my earlier post of the fallacy of demand growth in emerging markets.

Oil and the Great Deception

"What matters is growth from the emerging markets, not the United States or other mature markets."

Oil Bulls love to trot out China, and to a lesser extent, India, when discussing the unbelievable growth from emerging markets. I heard a money manager call such growth "massive." Well let's see just how massive this growth is. In 2006, China consumed 7.2 million barrels a day, and in 2007 it consumed 7.58 million barrels a day. This is "astounding" growth of 380 thousand barrels a day. In 2008, the barrel per day growth is estimated to be 420 thousand barrels. While the growth rate is fairly impressive on a percent basis, the absolute increase is hardly more than a rounding error in an 87 million barrel a day market.

Now let's look at the "mature" markets that don't matter. Demand from the 30 countries countries belonging to the Organization for Economic Cooperation and Development (OECD), was 48.96 million barrels per day in 2007. This demand has been flat for several years and is roughly the same as it was in 2003. This demand will begin to fall, as it has done in the past when oil prices reach very high levels. We have already seen evidence of this in reports on miles driven on U.S. highways which fell 4.3% in March 2008.

Let's look at what that impact will be:

OECD Demand declines one percent - 490,000 barrel per day decline.
OECD Demand declines two percent - 880,000 barrel per day decline.

As you can see, a one percent decline in demand from "mature" economies would wipe out all China's absolute growth last year. A two percent decline would be equal to twice China's barrel per day growth. So emerging markets don't really matter except in the context of the entire market. Are the OECD demand declines I listed above realistic? Yes, demand has fallen in previous years when prices were high.

Is Oil the New Globe.com?

Here is why Oil shouldn't go to $200 a barrel. Notice I didn't say won't go to $200, as betting against a commodity in this market is tantamount to financial suicide.

1) The fundamentals don't support an accelerating price for Oil. While the U.S is not officially in a recession, growth has slowed down here as well as in the rest of the world. Less economic growth means less demand for Energy. Has supply changed in the last month? Only in the minds of those bulls who believe any time a gun is fired in an oil exporting nation, supply is threatened.

2) The elasticity of demand for Oil may not be linear - that is to say that each 1% increase in the price reduces demand to a different extent. Is it possible that the higher the price, the more demand impact occurs? It is not inconceivable that demand for oil worldwide could flatten out for several years - it has happened before.

3) Many countries subsidize the price of refined products to its citizens to promote social stability. As the price of Oil moves up, the cost of these subsidies increases to the point where it is no longer economically feasible to do so. Once these subsidies are reduced or eliminated, the impact on demand may be tangible. Turkmenistan recently ended subsidized gasoline for its citizens, and others will follow suit as the price of Oil goes higher. While demand from Turkmenistan is negligible in the world market, many countries use subsidies, including China. China, is in effect, hurting itself by shielding its people from increasing prices. Since demand doesn't fall internally as prices rise, this leads to even higher prices.

4) Although demand for Oil is inelastic in the short term due to a lack of substitution, there is a "crowding out effect" as consumers pay up more for gasoline, they will cut back on purchases of consumer items and other discretionary purchases. This will cause a further decrease in demand for Oil since many products use Oil in the manufacturing process. Many of these products and items are made in China, which still relies heavily on exports. So won't this "crowding out effect" eventually reach the end of the supply chain, and cut demand for Oil?

5) The price of Oil is firmly in the hands of speculators and financial players as everyone knows. This is difficult to prove, but it is clear that technical reasons and momentum are keeping the price elevated. As a trader on the floor said this morning on Bloomberg, the market wants to go up. And we all know that what the market wants, the market gets, at least in the short term. When this momentum ends, the impact will be staggering.

6) Much is made of the growth in demand for Energy from emerging economies, but the United States still uses 30% of the world's oil, and lack of growth here will eventually have an important effect on the market. In other words, a 5% growth in demand in the U.S. is worth 1.1 million barrels a day, while China's much hyped up growth of 7% was only worth 600,000 barrels a day. What if demand in the U.S declined 5%? Could China make that up?

7) Another important reason is less analytical - take a look at the people that are telling you that everything will be OK with Oil in particular, but also with Commodities in general. That prices will stay high. Do they look familiar? They should, as they are the same ones who told you that everything would be OK in the housing market and the Homebuilders. Remember that crap? They didn't buy land any more, they "optioned" the land. They had access to capital, etc. None of these reasons stopped Homebuilders from going down 75% from the peak. Consider your source.

8) Another non analytical reason is this - eventually someone in OPEC will stand up at a closed door meeting and say this: is it really wise for us to have oil so high for so long? Won't this eventually lead to permanent long term changes to demand as countries adjust their economies? Won't it stimulate the growth of alternative fuel sources? Or might it cause so much inflation that it will crash the world economy?

What could end the momentum play? Here are a few scenarios:

1) A Democrat in the White House releases oil from the Strategic Petroleum Reserve to bring prices down. The government has twice as much Oil in its inventory as the entire commercial market does. Sure, OPEC might cut production to balance the market, but then there goes the spare capacity argument.

2) A Democrat in the White House pushes a Windfall profit tax through during the first 100 days. This tax is not on Oil companies but on commodity traders and speculators. Or they could push up margin requirements for futures trading on certain commodities.

For those of you who don't remember, the Globe.com, was the poster child for the start of the Internet boom in the late 1990's. It soared way above its true value as money piled into a speculative play. The company is now long gone, and I am not saying that Oil will one day be "long gone," but might there be some lessons we can learn from our past mistakes.