[+ Font] :: [- Font] :: Printable

Crude Awakening!

Puru Saxena
June 20th, 2005

The majority of analysts, politicians and OPEC wise guys have been calling for a top in the oil price. This has been happening for the past 2 years now and they’ve been consistently wrong. As this propaganda (fear management) continues, oil continues to surge higher. The problem for the establishment is that the oil price is dictated not by officials in fancy boardrooms but by the two most basic economic factors – supply and demand. And, this dynamic is now working for a significantly higher oil price.

Like it or not, the era for cheap oil is over and expensive oil is here to stay. In the end, the oil price will kill your desire to own a big and hefty SUV. So, why will oil continue to rise and how high can it go? For this, let’s turn to a bit of history.

In late 1973, Egyptian and Syrian bombers attacked Israeli troops on the banks of the Suez Canal. A few days later, Israel turned to America in an act of desperation and requested for immediate help. President Nixon obliged by sending supplies to Israel who managed to hold off the offensive. As a result of this American “interference”, the Organisation of Petroleum Exporting Countries (OPEC) decided to retaliate, announcing production cutbacks and an embargo on oil exports to America. Gasoline prices in the US soared, from $2 a barrel earlier in the year to over $10 a barrel in December 1973 – a massive 500% surge in a few months! The oil crisis stunned the world and especially America was caught totally off-guard.

The 1973-74 “Oil Crisis” did make things worse but in reality, however, oil supplies were already very tight. In the early 70’s, American oil production was peaking - a fact, which was largely unknown at that time. A legendary scientist by the name of King Hubbert had warned in 1956 that the US would peak as an oil producer in the early 1970’s. The wise guys thought he was a lunatic. After all, America had been the largest oil producer for the past 100 years. In 1970, American oil production hit a record-high of 9.6 million barrels of oil per day. At the time, academics and intelligencia dismissed Hubbert as a whacky scientist not realising that 1970 was in fact the year when oil production peaked in the US!

Hubbert was spot on; the wise guys were dead wrong as American oil production declined throughout the 1970’s. America’s oil peak was only recognised a few years later when people realised that America (for some strange reason!) had not been able to match that record-high output of 9.6 million barrels per day. By the end of that decade, America was replaced by Saudi Arabia as the world’s largest producer of oil – and it has stayed this way ever since.

The declining US production, surging inflation and unrest in the middle-East caused oil to embark on a gigantic bull-market. From $2 a barrel in 1973, oil formed an all-time high around $40 a barrel in 1980. Adjusting for inflation (in today’s dollar terms), oil had peaked at $90 a barrel in 1980!

Now, let’s return to the current situation. After bottoming out in December 1998 around $10 a barrel, oil is heating again! Over the past 7 years, crude has risen 500% to over $50 a barrel but it is still nowhere near its all-time peak of $90 a barrel recorded over two decades ago. So why has oil surged and where can it go in the years ahead? For this, let’s turn to the primary drivers – supply and demand.

Supply is extremely tight, OPEC is already pumping close to capacity and major oil fields are in decline. Some scientists are screaming that this time around the entire world’s oil peak is upon us and once again no one is listening.

Ghawar - the “king” of the world’s oil fields and responsible for producing over 50% of Saudi oil is hugely depleted, Mexico is in decline, Alaska is in decline and the North Sea is also struggling. So far, England has been self-sustained in its energy requirements but with the North Sea in decline, for the first time in history, soon it will be importing oil!

According to the Commodities Research Bureau, world oil production in 2003, the latest full reporting year rose to 69.25 million barrels a day, which was a new record-high. The world’s largest oil producers are Saudi Arabia (12.8% of world production), Russia (11.7%), U.S. (8.2%), Iran (5.5%) and China (4.9%). Despite what the Saudis claim, their oil fields are depleting fast. America is already well past it’s prime with production at a depressed 5.4 million barrels a day compared to 9.6 million barrels a day in 1980.

With its huge population and growing energy needs, China is already importing oil. Iran is a political time-bomb waiting to explode and Russia is not exactly best friends with the US. I don’t know about you but it is obvious to me that no new supplies of oil will be hitting the market anytime soon. There has not been a single major oil discovery also known as an “elephant strike” over the past 35 years!

Sure, there is some oil trapped deep below the surface in Canada. But the problem lies in getting to this oil and the enormous financial costs involved. It is going to take millions of dollars to gain access to the oil in Canada.

Along with the usual marine life, the Caspian Sea is also home to some of the largest untapped oil reserves in the world. But the problem is the location. The Caspian Sea lies to the north of Iran and is surrounded by fragments of what used to be the Soviet Union – Turkmenistan, Kazakstan, Azerbaijan and Russia itself. Due to political reasons, this untapped oil may never make it to the market. Ever wondered why the US is building a case against Iran and the nuclear threat it poses? The answer is deeply submerged in Iran’s oil and its strategic location around the Caspian Sea. If the Bush administration was so concerned about democracy and not so much about oil, why doesn’t it deal with North Korea instead, when it has openly announced its nuclear capabilities? Anyhow, my intention is not to go into the political arena, I am simply trying to discuss oil’s supply and demand dynamics.

Demand is another story altogether. Paris-based International Energy Agency (IEA) estimates that this year global demand for oil will hit 84.5 million barrels per day and rising. In the fourth quarter of this year (winter months), demand for crude is expected to surge to 86 million barrels a day!

Asian demand for oil is rising fast and is expected to double within the coming 8-10 years.

At present, India and China’s per capita consumption of oil is one of the lowest in the world. On average, Indians consume a miniscule 0.7 barrels of oil a year. The Chinese average comes in at a depressed 1.7 barrels of oil a year. On the other end, the average American consumes around 27 barrels of oil a year! In 2005, India with 1.1 billion people consumes 2.2 million barrels a day, China (1.3 billion people) consumes 6.2 million barrels a day and the United States (only 295 million people) consumes – 20.5 million barrels a day!!! Over time, I expect Asian demand for oil to really explode higher and this huge discrepancy between Asia and the West to shrink.

Take a look at the chart I provide below. It clearly shows that oil demand from the emerging world has almost caught up with the industrialised nations. Over time, we can expect the emerging economies to consume a lot more oil than the industrial world – a fact that can’t be disputed due to the sheer population numbers in developing countries. What will happen when the Asian demand for oil doubles to almost 40 million barrels a day in a few years time? Where will these extra 20 million barrels come from? The truth is that I don’t know, but wait, nobody else does either. This excess demand will most probably be tackled not by increased supply but by significantly higher prices.

The reality is stares us in the face. Demand for oil has been rising steadily and this trend will continue unless somebody can find a viable source of alternative energy. And I emphasize the word “viable” here. A lot of analysts are now claiming that wind power, solar energy or even hydrogen will replace our dependence on petroleum. Whilst I don’t argue that ultimately another source of energy will become dominant, I for one don’t expect this to happen in the near future. We can’t just suddenly replace the tens of thousands of petrol stations all over the world with hydrogen refuelling pumps! Nor can we simply dump the millions of automobiles in some junk yard and replace them with machines, which will be powered by wind or solar energy! A viable transition to another source of energy will take enormous capital and time. In the interim however, crude prices will continue to surge higher as the new and rapidly expanding middle-class in Asia becomes more thirsty for oil.

Finally, how high will prices go? Well, the global oil supply is tight, demand is rising, inflation is becoming evident and geo-political tensions are heating up – the same elements we saw in the 1970’s. I don’t like to play the guessing game but I am of the opinion that oil prices could at least double over the coming years.

Puru Saxena

Email – puru@purusaxena.com

Website (coming soon) – www.purusaxena.com

Puru Saxena is the editor and publisher of Money Matters, an economic and financial publication soon to be available at www.purusaxena.com

An investment adviser based in Hong Kong, he is a regular guest on CNBC, BBC World, Bloomberg TV & Radio, NDTV, RTHK Radio 3 and writes for several newspapers and financial journals.

Copyright © 2005 Puru Saxena Limited. All rights reserved