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Confusion in the Oil Patch

Dave Cohen
dave.aspo@gmail.com
February 11th, 2009

The only difference between a rut and a grave are the dimensions
—Ellen Glasgow

A standard story is making the rounds which goes like this: low prices and lack of investment will impair future oil production capacity. When the global economy rebounds, which could happen as early as 2010, oil prices will shoot up again as demand once again outstrips available supply. The AP's John Porretto writes don't get used to cheap oil—

The oil industry is scaling back on exploration and production because some projects don't make economic sense when energy prices are low. And crude is already harder to find because more nations that own oil companies are blocking outside access to their oil fields.

When the world emerges from the recession and starts to burn more fuel again, and higher demand meets lower supply, prices will almost certainly shoot higher....

Some analysts say oil could eventually eclipse $150 a barrel, maybe even on its way to $200... No one knows for sure, but some analysts say the spike could happen as soon as next year [in 2010], perhaps in 2011 or 2012.

This line of reasoning is certainly consistent with the "peak oil" narrative, but the situation in the oil markets is not so straightforward. What will the demand for oil be over the medium-term? In order for oil prices to spike over $100 again in 2010 or 2011, demand must once again bump up against available supply, excluding some (spare) capacity that will be held back.

Last week I said that I was going to defend the proposition that it is unlikely that the world oil production would ever exceed its July, 2008 peak. I realize now that I was getting ahead of myself. Instead I will use a simple model for the available oil supply and examine each term in it this week and next.

1. S(t) = PE(t)(1 - DI) + PN(t) + PSC(t)
where S = available supply over the time interval t, PE = the existing production base, PN = new production, PSC = spare capacity and DI = the net decline rate

Let's examine new oil projects (the term PN in equation (1)) in light of the current oil market.

Future oil demand depends on a successful reflation of the U.S. and global economy, a process that could take 2 years or more. A lot of uncertainty exists about the timing of the recovery, but considering the very deep hole we're in now and the low price of oil, it would seem to make sense to keep some new oil in the ground until economic conditions stabilize and indicators reveal some light at the end of the tunnel.

The problem for new conventional oil now is not so much that companies are delaying production of oil which is in the hopper—that would actually make sense. The problem is that they will produce this new oil at a time when OPEC is cutting output and there's a glut on the world market! This behavior is shortsighted and self-defeating.

Contrary to reasonable expectations, oil producers (mostly) outside OPEC are pressing forward with new oil projects everywhere you look, to wit—

• The head of Brazil's state-run energy company Petrobras said there would be no project delays in 2009, bucking a wider trend, and that production was about 2.4 million barrels per day.
• BP recently announced that it has successfully started production from the third and fourth wells at the Thunder Horse field with production now in excess of 200,000 barrels of oil equivalent per day (boed), signaling the completion of commissioning and commencement of full operation. BP plans to start-up additional production from the Thunder Horse North field in the first half of 2009.
• Start-ups of major [Chevron] projects in 2009 are expected to include a discovery in the Gulf of Mexico known as Tahiti as well as Tombua-Landana located off the coast of Angola and Frade, a deepwater field well off the coast of Brazil. In addition, Chevron anticipates "significant production increases" from recent start-ups at Agbami in offshore Nigeria, and Blind Faith in the Gulf of Mexico as well as from expansion activity at Tengiz in Kazakhstan.
• Oil production on the Norwegian continental shelf may fall 9.7 percent this year, declining for a ninth year, the country’s Petroleum Directorate said... [but nevertheless] There’s “uncertainty” about what effect the drop in oil prices and the global slowdown will have on investments after 2009, the agency said. Norwegian fields “have a robust economy at $50 to $70 a barrel of oil,” Nyland said in an interview. “Should prices fall below $50, without production costs going down, projects may be postponed.” [Note — Thus Norway is not cutting back their falling output]

Russia's oil companies are not making cuts to support OPEC although low oil prices and "lack of new greenfield projects" will take a toll on their now falling output. Among the major non-OPEC producers, only Azerbaijan appears ready to actually cut production by as much as 300,000 barrels per day. We shall see.

The New York Times reported that OPEC's compliance with announced cuts was running at about 75%, an unusual display of discipline. But Bloomberg reports that compliance is currently closer to 68%, which is still pretty good.

OPEC members with output quotas, all except Iraq, pumped 26.2 million barrels a day, 1.36 million more than their target of 24.85 million barrels a day, according to data compiled by Bloomberg.

How long will countries desperate for revenue adhere to their quotas? Iran, Venezuela and Nigeria are in this boat. Among these, Nigeria is especially prone to fall off the wagon because they've got large oil developments coming on-stream in 2009. This West Africa producer has apparently cut production to 1.76 million barrels per day (their quota) in January, down 265,000 barrels compared with December. The cut conflicts with Nigeria's need for revenue.

Nigeria, the world's eighth biggest oil exporter, is hoping its new offshore oilfields will help boost its production as funding shortfalls and insecurity in the Niger Delta keep a cap on output from onshore and shallow water ventures...

Experts expect Nigerian will struggle to meet the 2.29 million bpd oil production assumption on which its 2009 budget is based, particularly as it complies with OPEC quota cuts meant to help support world oil prices.

Agbami, which is operated by Chevron and Statoil in adjacent offshore blocks, is ramping up to 250,000 barrels per day by the end of the year. Akpo, which is operated by Total, will start production in April and is expected to reach 175,000 barrels per day by year's end. Will Nigeria maintain quota discipline in the face of all that potential new revenue coming on-stream? I don't think so.

My doubts are confirmed by recent statements by Mohammed Barkindo, group managing director of Nigeria National Petroleum Corp. (NNPC), who believes that these and future deepwater projects are viable at only $40/barrel, which conveniently for them is also the current oil price (Oil & Gas Journal, January 28, 2009). And I'm quite sure Chevron, Total and Statoil will not object to producing the oil.

Outside of OPEC, the need for immediate returns for shareholders conflicts with shrinking demand and low prices. Consider the way Chevron and ConocoPhillips have responded to a deteriorating world economy.

Chevron thinks the future looks bright.

Unlike some large oil companies, the company said "an excellent queue" of projects had formed, and there was no reason to change spending from the record levels of 2008.

“Much of our 2009 spending continues to be on large, multiyear projects aimed at increasing energy supplies to meet global demand and also improving operating efficiency and reliability,” chief exec Dave O’Reilly said in a statement...

ConocoPhillips, sensibly, is worried about the future.

The recession and global financial crisis are taking a toll on energy companies after several years of rising oil and natural-gas prices, and is the first of the world's major publicly traded oil companies to respond with big cutbacks...

ConocoPhillips set its 2009 capital budget at $12.5 billion, an 18.3% reduction from 2008. "We are positioning ourselves in the current business environment to live within our means in order to maintain financial strength," said Chairman and Chief Executive James J. Mulva in a statement.

Do Chevron (and British Petroleum, Petrobras, etc.) know what they're doing? Sure they do—they're making money for their shareholders. They will probably accomplish some other things as well—

• With demand continuing to fall, and lots of oil being stockpiled on tankers, they will further drive down the oil price and thus increase risks to future projects.
• They will produce oil now that we'll need later when demand finally does come roaring back sometime after 2010. This will cause another oil price shock like the one in 2008 Quarters I & II.
• They will further weaken faltering non-OPEC production capacity over the medium-term and accelerate OECD dependence on OPEC.

Declines in deepwater oil fields come on relatively quickly and these declines are steep and rapid once they occur. Where's the next generation of Gulf of Mexico projects (Figure 1) that will replace relatively large producers like Thunder Horse, Atlantis and Tahiti?

Figure 1 — Declining well spuds and discoveries in the Gulf of Mexico. From Offshore Magazine

Yet again we see the triumph of short-term thinking and profits over longer-term survival strategies. On this view it is not so much project delays that are impairing the future as it is full implementation of current projects outside of OPEC that were begun 4 or 5 years ago when demand and prices were rising. Persian Gulf countries are not delaying planned capacity expansions, but they're obviously not going to produce this new oil anytime soon. Unlike Chevron, Saudi Arabia, Kuwait, Qatar and the United Arab Emirates take the long view.

One could argue that the international oil companies (IOCs) need whatever profits they can generate to support costly exploration & production (E&P) down the road. That's nonsense. IOC revenues have been extraordinary over the last few years and E&P costs are going down along with costs for everything else during the global recession. Falling costs are not stimulating activity now but should partially offset lower prices over the next few years. The IOCs can afford new E&P. Their real problem is insufficient oil to find in the places they have access to (Figure 1).

The gung-ho production policies of oil companies are counterproductive in those cases where IOCs have the ability to control output. Keeping some oil off the market right now would help stabilize prices at $70-80/barrel, the range required to support investment in longer-term oil field maintenance, future conventional projects and production from unconventional sources. Profligate oil production during the global recession will not pay dividends in the end.

Contact the author at dave.aspo@gmail.com

dave.aspo@gmail.com
February 11th, 2009