Sunday, June 8, 2008

Oil Price Poker

The current feverish state of the international oil market could be due to many factors. How you would bet on future prices depends on how you read the hands of the various players, and in particular on whether you think OPEC is bluffing.

The market was reminded on Friday of the (hopefully small) possibility that either Israel or the US could attack Iran before the US presidential elections later this year. This is bound to lead to a short term leap in oil prices.

Until Friday The Hive was canvassing the notion that the current price is a bubble created by speculators. There are very good reasons to believe this may be the contributing to current prices, including lax regulation of US energy futures markets.

Speculation was however the fourth reason George Soros gave in Senate testimony on oil prices last week. In listing major factors he said "First, the increasing cost of discovering and developing new reserves, and the accelerating depletion of existing oilfields as they age. This goes under the rather misleading name of peak oil."

Now everyone seems to agree that there are currently serious constraints on supply. The International Energy Agency's monthly Oil Market Report says of the month of April that "Effective OPEC spare capacity stands at 2.3 mb/d on paper, although refinery outages, crude quality and high prices mean much of this oil would be difficult to market under current conditions". It also lists several issues in Nigeria and the North Sea that have contributed to reduced supply. (Figures for May are not free so I do not have them.)

Many people hope that these constraints are largely caused by temporary political instability and temporary shortfalls in drilling infrastructure, refinery capacity and so on.

A more pessimistic view is that these difficulties will increase over time due to "the increasing cost of discovering and developing new reserves, and the accelerating depletion of existing oilfields as they age".

A rule of thumb, based on on the historical development of very many mineral resources, suggests this would be expected to be a factor if Middle East countries have already mined a large fraction, say roughly half, of their total crude oil resource. Don't consign yourself to the internet debates on "peak oil", read this considered piece by David Goodstein a physicist at the California Institute of Technology. Goodstein has been urging scientists, engineers, politicians and the general public to prepare for the end of cheap crude oil for several years now.

Goodstein is not a crazed millenairian, his expectations are based on the historical trajectory of a large number of mineral resources. If you look at the historical production from, to name a few, anthracite coal in Pennsylvania, British coal, North Sea oil, French uranium, US oil, there comes a time when the quality of ore declines, the location of remaining ore becomes inconvenient, production costs rise and production slows. I'd also recommend you take a look at the public lecture by Goodstein's Caltech colleague, engineer David Rutledge. He has also collected data on most of the resources I have mentioned here into an Excel spreadsheet that you can play with for yourself. (Full disclosure: I used to work at Caltech and Goodstein was the Ph.D supervisor of a good friend so maybe I am biased.)

There are many people, including Goodstein and Rutledge, who believe that Middle East oil supplies are near the point at which they will not be able to sustain current daily production. Based on the stated Middle East oil reserves you will usually see this does not seem very likely. However lets take a look at those reserves

Over the 25 years shown world oil consumption has exceeded announced oil discoveries by about 200 billion barrels of oil and non-OPEC reserves have remained roughly constant. Yet the OPEC reserves look remarkably constant year to year except for very sharp increases adding up to about 400 billion barrels of oil in the late 80s. (This plot is from Rutledge's talk.)

This jump coincides with an OPEC rule change that associated the amount of oil a country was allowed to sell each year with the size of its reserves. As Goodstein puts it "politicians discovered 400 billion barrels of oil without ever drilling a hole in the ground!" It seems to me likely that OPEC reserves are hugely exagerated, possibly by a factor of a few.

One other piece of simple available evidence. If you subtract Kuwaiti production since 1980 from reserves in 1980 you get about 50 billion barrels rather than 100 billion barrels of official reserves. This strangely enough is about what a recent leak from the Kuwaitis suggests they think they have.

The US Geological Survey, the US Energy Information Agency and the International Energy Agency all take these stated reserves at face value but on the face of it this does not seem credible.

So, finally, lets have a look at recent Saudi oil production (taken from the International energy agency.)

During the Iraq war in 2003 the Saudis were able to very rapidly increase production about 1.5 million barrels of oil a day to about 9.5 million barrels of oil. At this point they were certainly still operating as a cartel artificially restricting supply. Around April 2004 they were able to do the same again in response to oil prices rising out of the price bracket OPEC was attempting to protect (about $40US I believe). At this time Saudi Arabia's production quotas were increased to "legalize" this increased production and it was maintained at roughly this level for several years. Prices however continued to increase. At this point either the Saudis are unable to fulfill their stated goal of keeping prices low by increasing supply or they realise that the value of their oil assets is increasing with rapidly rising demand and are quite happy to sit tight at a comfortable production rate. This possibility is another of Soros's four factors affecting world oil prices. Alternatively they are simply unable to convince the rest of OPEC to further increase quotas despite both wishing to and being able to increase production.

Saudi production dropped significantly after April 2006 to as low as 8.5 million barrels of oil a day, this figure was significantly below their quotas at the time which is consistent with suspicions that some of their older fields are getting tired. However, this year production has been increased again to 9 million barrels of oil a day, presumably in response to increased prices. Production is once again roughly the same as the OPEC quota. Once again, either the Saudis and OPEC are quite happy with the current trajectory of oil prices or they are unable to increase production significantly. In recent weeks the Wall Street Journal has reported that the US has asked the Saudis to increase production and that the US was dissapointed with a Saudi response that they would supply only an extra three hundred thousand barrels a day. (The comparisons to quota come from here)

It is tempting to look at this plot and ask yourself if you feel lucky, how would you place a bet on future Saudi oil production/

Can the Saudis still increase production to 9.5 million barrels of oil a day?

I suspect not but I have to concede the evidence I have given is not compelling. I am just expressing an overall distrust of the Saudis and the feeling I get from reading around the issue. Ideally one would carry out a detailed study of everything that is publicly known about the various Saudi oil fields. Matthew Simmons has been arguing for this pessimistic view of Saudi oil reserves for years on the basis of just such a study, he seems well informed and has been a consultant on energy issues since the first oil shock. On the other hand I have not read his book and lots of people just think he is plain wrong.

Will the Saudis ever be able to increase production above 10 million barrels of oil a day?

Despite many official predictions to the contrary I would be willing to bet a large sum against this.

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