A year ago, a barrel of West Texas sweet crude sold for $37.05 on the spot market. On July 5, the price was $59.59, a 60% spike in price.
But don't worry. That rate of increase isn't sustainable forever. Eventually the good old laws of supply and demand will combine to slow the meteoric rise in oil prices.
Unfortunately, in the near term, those laws are taking their sweet time to go to work. There's certainly a good chance that over the next few days or weeks, oil prices will retrace part of their recent run to $60 from $48 as speculators take profits. But the trend for the rest of this year, and for 2006, is still up. I'd say we're likely to test $75 oil before the laws of supply and demand kick in to: 1) at least put a damper on the rate of price increases and 2) maybe even send the price back toward $50 a barrel for a while.
Let me show you why that's the most likely scenario now.
It takes a long time, it turns out, to increase supply even when oil is selling for $60 a barrel. Take the ambitious plans from the
Royal Dutch/Shell Group
( RD) to expand production to 5 million barrels of oil equivalent a day by 2015 from 3.8 million barrels a day now.
That's an impressive increase of 32%. Put aside all doubts about whether the company can really find the 10 huge new sources of oil required, by its own estimates, to get this production increase. Instead just look at the company's timetable: Almost all that new production will come on line after 2009. The total increase in production from 2005 to 2009 is about 5%.
Out of Shape
And this isn't just a problem at Royal Dutch/Shell Group. After a decade, or more, of underinvestment in everything from refineries to oil field maintenance to engineering expertise, the global oil industry isn't in any shape to increase production overnight.
For example, in the Persian Gulf nation of Qatar,
have signed agreements to build three natural gas-to-liquid fuel (GTL) plants to exploit that nation's huge reserves of natural gas.
But the projects were recently delayed for at least three years because of a shortage of engineers to design the plants and because a shortage of construction materials had driven up costs. So much for the third-largest natural gas reserves in the world providing a quick shot to global supply.
The shortage of engineers may be the toughest supply-side problem to fix. The U.S. is still the leading global source for petroleum engineering expertise, but the number of petroleum engineers here has tumbled by 50% since the 1980s. A survey (of less than 20% of the U.S. oil industry) by the American Petroleum Institute projects a need for more than 5,000 engineers in the next two years. Total enrollment in petroleum engineering programs in the U.S. was just 1,500 in 2003, 85% below the 1985 peak.
The engineering shortage might not be so bad if so many of the proposals to increase supply weren't so engineering-heavy. For example, Royal Dutch/Shell Group, along with oil companies such as
Canadian Natural Resource
, sees Alberta's huge deposits of oil sands as a major source of new oil.
Getting that oil involves digging up the sand, moving it in bulk to the plants that cook the oil out of the sand, and then running the oil through refineries that turn the extremely heavy oil produced from these deposits into grades that can be refined using conventional methods. Each stage requires complex technology that hasn't been completely debugged.
A Long Process
The sands may indeed contain as much or more oil than sits under Saudi Arabia. But these companies are just now in the process of ramping up production from relatively modest daily flows, and even if everything goes right, that process takes a long time.
You can get a sense of the time scale from the Horizon oil sands project at Canadian Natural Resource. The potential is huge: 3.3 billion barrels of recoverable bitumen reserves. But the project, estimated to cost $11 billion (Canadian), will go into production over the next eight years. Synthetic oil product is scheduled to begin in the second half of 2008 at 110,000 barrels of oil a day.
In 2010, phase II kicks in, and production jumps to 155,000 barrels a day. Phase III, due in 2012, increases total production to 232,000 barrels a day. That's a significant addition to global oil supply, especially when you remember that Canadian Natural Resource isn't the only company wringing oil out of Canadian sands. Royal Dutch/Shell Group, for example, has a goal of 500,000 barrels a day from these same deposits.
It's striking how many of the supply-side solutions to the current explosion in oil prices are engineering-heavy, rely on new, and in some cases, untested technologies and face the prospect of strong local political opposition.
Liquefied natural gas, which requires the construction of plants to cool the natural gas into liquid and then special terminals to load and unload the liquid onto special LNG tankers, fits that profile. So does the attempt to revive nuclear power in the U.S. envisioned by the energy bill that recently passed the Senate. The same is true for the new refineries needed to turn the heavier grades of oil that Saudi Arabia is pumping into petroleum products such as gasoline.
Slow to Respond
It makes immediate sense that the oil supply will expand relatively slowly, for all these reasons, despite higher oil prices.
What's harder to understand is why the run to $60-a-barrel oil hasn't reduced demand.
Demand for oil and gasoline, the key product refined from oil, has kept rising as oil has become more expensive. For example, U.S. petroleum demand grew at an annualized 3.3% rate in May, about double the February growth rate. The Energy Department shows that total distillate demand, which includes jet fuel, heating oil, diesel fuel and gasoline, was 7% higher in the most recent four-week period than it was a year ago. U.S. gasoline consumption climbed 2.5% in the four weeks ended June 17 from the same period in 2004. This came despite the fact that the average price of a gallon of unleaded gasoline was $2.22 in the week ending June 27, up 12 cents since the end of May.
And the phenomenon of rising demand in the face of rising prices isn't limited to the U.S.: The International Energy Agency has raised its forecast for world oil demand growth to 2.2% from 1.8%.
No Dent in Demand
What's driving this seemingly perverse response to higher oil and gasoline prices? Take a look at these three reasons that explain, in my opinion, why higher prices haven't yet depressed demand.
The rise in energy prices follows a decade of depressed prices. In that period, the price of everything from a movie ticket to college tuition rose faster than energy prices. On an inflation-adjusted basis, oil and gas prices aren't that high. They're still playing catch-up.
Behavior changes more slowly than you'd think. Gas costs 12 cents a gallon more? Well, you've still got to drive to work, run the kids to their soccer games and do the weekly shopping run to Wal-Mart. What's the alternative? Public transportation? Ever take a bus in Los Angeles or try to get from Silver Spring, Md., to Falls Church, Va., on Washington's Metro? Buy a new car that gets better mileage? Tempting, but forking over $20,000 to $40,000 to beat a 12-cents-a-gallon increase or even negotiating a new auto lease seems extreme. Maybe gas prices will fall again.
Much of the growth in demand is coming from consumers in China, India and other developing economies who are sheltered from the true world price of oil by domestic subsidies. Indonesia, which has moved from being a net oil exporter to an oil importer in the last year, will subsidize its oil refiners to the tune of about $4.3 billion this year.
In India, the state-owned oil companies have simply swallowed much of the recent price increase in gasoline, propane and kerosene. Total losses from that freeze are estimated at $2.7 billion in the 12 months that ended in March. Gasoline in China sells for below global prices, and the country has kept diesel fuel prices fixed out of a fear of hurting farmers.
Some of these demand-side factors have started to change in recent months. Fuel subsidies in Indonesia had become so expensive that the government raised gasoline and diesel prices by 30% in April; this will cut the size of the government subsidy to $4.3 billion in 2005 from $6.4 billion in 2004. China is introducing its first fuel-efficiency standards for cars in an effort to discourage SUV purchases. In the U.S., consumers faced with higher prices at the pump have scaled back purchases of SUVs.
Waiting for Real Reduction
But these trends are just the beginning of a demand-side response to higher fuel prices, and it will take more time and higher prices before we see a meaningful reduction in the oil and gas demand.
How much higher and how long? The Bank for International Settlements has projected that, thanks to the increased energy efficiency of some of the world's economies and the shift from an energy-intensive manufacturing economy in the U.S. to a service-oriented economy, it might take $75-a-barrel oil to put a serious nick in global demand.
Cambridge Energy Associates, which believes that higher oil production will push prices back toward $40 a barrel, pegs the increase in production and falling prices for 2007-08.
Both projections argue for higher-than-current oil prices through 2005 and certainly well into 2006.
Mind you, these are relatively short-term trends I'm talking about here. A drop to $40, even if it occurs, still leaves oil prices well above the $10- to $20-a-barrel lows before this run-up began. In other words, $40 would become the new floor for the next multiyear move higher.
How much higher and when depends on whether you think global oil production has peaked or when it will peak. On this one, I think the oil bears are the most useful guide. Cambridge Energy Associates basically pooh-poohs the belief that oil production has peaked, and believes those who put the peak in 2008 are just slightly less misguided.
But they still believe we're within shouting distance of a production peak. They put it in 2020.
At the time of publication, Jim Jubak did not own shares in any stocks mentioned in this column.