I received an email a few nights ago from a coalition of airline companies with the tag line, "You can help keep travel affordable." Curious, I read on. The email began with the obvious conclusions: High oil prices exacerbate economic pain, and the airline industry is being suffocated by the continued rise in fuel cost. Fair enough. As I continued reading, the letter proclaimed in bold type:
Some market experts estimate that current prices reflect as much as $30 to $60 per barrel in unnecessary speculative costs.
Unfortunately for us, we are not sure who these "experts" really are. While I am certainly no expert either, I do understand basic economics, and to suggest that mere speculation could be inflating the price of oil by $60 a barrel is absurd.
While it's certainly true that Wall Street always loves too much of a good thing -- Internet stocks, securitizations, etc. -- which almost always leads to speculative bubbles, it's a fantasy to think that without "speculation," oil would be around $80 a barrel. The basic supply and demand laws suggest that we may never see $80 barrel oil again.
The Basic Economic Case
Let's step back and look at some various oil data provided by the Energy Administration Information.
The current worldwide consumption of crude oil is about 86 million barrels a day. Of this amount, the U.S. consumes about 21 million barrels a day with a population of 300 million people.
It appears that high gas prices are making a small dent in U.S. consumption, with the EIA predicting a consumption decline in the U.S. of around 500,000 barrels a day. This past July Fourth holiday weekend saw the least car traffic in a decade, so the basic laws of economics seem to be holding true.
Now onto China, a country with 1.3 billion people wanting to drive, eat, live and travel like Europeans and Americans. China currently consumes about 8 million barrels a day. It's obvious the direction Chinese oil consumption is heading.
To be fair, the Chinese government subsidizes gas prices, which are certainly having an effect on consumption levels. The long-term consequences of China's global might are clear: A nation with four times the population of the U.S. that consumes only half the amount of oil is likely to consume more oil over time. It's easy to draw a similar conclusion for the other emerging nations like India, Brazil and even Russia.
The Holy Grail of Oil
Now on to what really matters in the oil industry: reserves. The long-term value of any oil company rests not on how much oil it sells every year, but instead on the supply of oil it holds. In other words, the key metric is the replacement rate of oil reserves relative to annual production.
, the world's biggest oil company, had a reserve replacement ratio of just over 100% in 2007, meaning that for every barrel of oil sold, Exxon was able to find another barrel. Replacing 100% of your production each year would be great for prices if oil consumption were fixed or declining, but that's not the case.
On top of that, the era of easy oil is over. Long gone are the good old days of drilling in your backyard and hitting gushers of oil. The oil of the future is going to come from remote locations with limited access. As a result, the technical challenges of drilling will become much more difficult. That means escalating drilling costs and longer recovery times. According to data provided by
, proved reserves in nations composing the Organization for Economic Cooperation and Development fell from 113 billion barrels in 1997 to about 80 billion barrels in 2006. The last major confirmed oil discovery happened more than 30 years ago. Major oil outfits such as
are devoting increasing amounts of capital looking for oil in more difficult environments.
A recent company presentation by that company illustrates my point. From 2002 to 2006, the reserve replacement (not reflecting the company's reported proved reserves) through exploration for the major oil companies like Exxon,
Royal Dutch Shell
and the like was less than 100%. Only Chevron exceeded 100%.
Where is all the new oil coming from? Areas like the Canadian oil sands, politically unstable locations like Iraq, and the current hot spot -- Brazil. Brazilian oil giant
has quickly risen to become one of the most valuable companies in the world as a result of a potential new underwater discovery supposedly holding nearly 6 billion barrels of oil.
However, exploring for oil underwater is an exceedingly challenging and very expensive process, which doesn't make economic sense when oil prices are low. Even locations like the tar sands only become economical exploratory options when oil prices are higher, not lower.
So what's the general conclusion? The days of $80-a-barrel oil are history, at least for many years. The cost of finding additional reserves is climbing rapidly and the worldwide demand will continue to rise. If the price to produce a product goes up without a significant decline in demand, prices will rise.
I won't deny that human speculative greed is helping elevate the price oil, but I am reluctant to believe that speculative activities are the primary causes of high oil prices. Market prices are a wonderful proxy. Over time, as airlines cut capacity, more fuel-efficient cars come to market, and alternative fuel sources become readily available, it's reasonable to see $100-a-barrel oil, but the era of cheap oil is likely nothing more than a fond memory.
This column was written by
contributor Sham Gad. For more information about
please click here.
At the time of publication, Gad had no positions in the stocks mentioned, although positions may change at any time.
Sham Gad is the managing partner of the
, a value-centric investment partnership modeled after the original 1950s' Buffett Partnerships. Previously, Gad was a writer for The Motley Fool and a securities analyst for UAS Asset Management, a small, value-focused fund in New York City.
Gad also runs a
inspired by the teachings of Benjamin Graham and Warren Buffett. Gad is working on a value investing book (title forthcoming) to be published by John Wiley and Sons in the summer of 2009. Reach Gad at