Archive for April, 2009

PREDICTING THE PRICE OF OIL

Posted by Blacky on Thursday, April 30th, 2009

Two important parts of the equation are absent from the discussion of where oil prices are heading. This missing components are the decline in the now aging super giant oil fields of the world. These fields account for a significant part of world supply.  The second component is the long term sustainability of oil production from the unconventional shale plays.

This story actually begins in 1986 when the price of oil crashed and an industry was largely put into a severe tail spin. As a result, the largest companies began to restructure their companies to survive a long period of surplus capacity. At the same time, they began to sell their U.S. production assets to smaller independent companies that could operate cheaper than the majors. The restructuring of major oil companies shifted profit centers to countries that have more favorable tax and regulation policies. During this same time half the work forces of the largest companies were replaced by outsourcing. This has continued and has spread to even the smallest companies. Today many prominent companies have a surprisingly small number of full time employees.  This evolution of company structure has led to great flexibility for these companies to shift resources to projects that are seen as having superior profit potential in a changing oil price scenario.

As the price of oil changes, as it always does, the flexibility to shift resources and focus to alternate projects is molding the real value of future oil. This is because both National and private oil companies have the ability to halt projects in a very short time. This is what happened at the last big drop in 2009. It is unprecedented how drilling rigs and projects were silenced worldwide, and virtually overnight. Projects around the world were put in the “suspended indefinitely” category. This leads me to my point. Worldwide oil production declines at about 5% per year. Normally, rigs are running around the world to replace oil deliverability lost to natural decline.

There are so many factors that will significantly influence oil prices in the future that predicting the future price of oil may not be impossible.

I expect the largest decline to come from OPEC producers. Since the 1980s, OPEC members were assigned daily production quotas based on reserve studies that determined each member’s total in the ground reserves. The larger the reserves, the more a member country could produce every day. This led to creative accounting in the reserve reports that the Western world mostly took at face value.  Many super giant oil fields were included in these reserve reporting.  In 2008, with increased demand, it became apparent that most OPEC nations could not produce 100% of their assigned quotas. This woke us up to the fact that when the global economy begins to grow, supply pressure will greatly influence the price of oil.

In the short term, the natural decline of aging major oil fields will play a bigger role in the price of oil than is commonly reported. Stark realization of the effects of unrealistic reserve reporting will come when Saudi oil production begins its decline decades before it is commonly expected. I predict we will see this depending on several other factors, such as the degree of transitioning to alternative fuels and global economic activity.

With regard to large, long term recoverable oil from unconventional reservoirs, all I can say is, we’ll see.  Producing oil from shale reservoirs has only been possible for a few years, and made possible for the first time because of advances in horizontal drilling and multistage fracing.  When I see wells in North Dakota that produced oil initially at a rate of 2,000 BOPD that are down to producing at 100 BOPD after one year, it gives cause to doubt some of the glowing engineering reports seen on public company financials. What will these wells be making 3 or 10 years from now. Is the huge increase in domestic oil production sustainable? Remember this; nobody can answer that question with certainty.

One thing has been consistent over my 30 years of observation that is, the consensus of experts cannot be relied upon. It is a little like 7 day weather forecast that cannot anticipate a change in the wind direction on the 2nd day.

Jim (Blacky) Pryor