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Insight: Prepare for lower oil prices
By Chris Watling

Published: December 29 2009 16:18 | Last updated: December 29 2009 16:18

The outlook for the oil price remains mired in much confusion. Peak oil theorists see production in terminal decline. Others, who expect the oil price to revisit its 2008 highs, argue that rapid demand growth from emerging markets, most notably China, will underpin a long and aggressive rally in the price.

Some even argue that as the world runs out of oil we shall slip back into pre-industrial ways as energy is rationed and human behaviour has to change as a result – an argument that has been regularly trotted out over the last five centuries. First, in Britain in the 16th century as the country was perceived to be running out of wood, its primary energy source at that time. Then 300 years later by economist William Jevons who believed that Britain’s coal supply, and therefore primary energy supply, was in terminal decline.

Market price signals, however, have an uncanny ability to change long term supply and demand dynamics. Indeed the high and rising price of oil from 2004/05 onwards, but most particularly in 2008, would appear to have delivered a very clear and identifiable supply response. Using conservative assumptions we expect that the future supply of oil will increase by approximately 9-10m barrels per day by 2017. That equates to a 10-12 per cent increase in global production capacity. Importantly it will more than absorb our estimated 5m bpd increase in Chinese demand, the biggest single driver of demand growth, over that time frame.

That increase in supply reflects four key trends that are playing out at a country level. First there are those countries where politics, ageing fields and a poor investment environment have resulted in and are likely to continue to result in falling or, at best, stable production, despite often plentiful oil reserves.

This group includes Venezuela, Mexico, Russia, Nigeria and Iran (representing 26 per cent of the world’s reserves). Second is a group of countries, mostly western, where production peaked a number of years ago and where that trend seems likely to persist. This group typically fits the peak oil theorist’s prescriptions and includes the UK (peaked in 1999), the US (1970 peak) and Norway (2001 peak).

Those losses are amply offset, however, by the third and fourth groups. In category three, large incumbent reserve owners (Saudi Arabia, Iraq, Kuwait among others) representing 38 per cent of global reserves, have been steadily increasing and plan to continue to increase capacity and production levels over coming years. In Iraq, with the signing of a number of agreements with international oil companies in recent weeks, and assuming continued improving security, production capacity is set to increase from 2.5m bpd today to 6.2m bpd by 2017.

In Kuwait the trend is the same, while Saudi Arabia, having increased capacity from 9.5 to 11.5m bpd in the past 5 years, has expressed its intention to increase it further up to 15m bpd, if necessary.

Finally there are a number of new entrants into the top league of global oil producers. Canada, because of technological advance and a higher oil price, is recognised as having the world’s second largest oil reserves. Brazil, with its recent discoveries, is looking to double production by 2020 (to close to 4m bpd) while Angola – which has doubled production in the last 6 years – is expected to add another 50 per cent by 2015. Kazakhstan has also rapidly ramped up production (from 0.5 to 1.5m bpd in the last decade) in response to China’s growing oil appetite.

Over and above those four key trends, the increasing push for environmental change coupled with the high price of oil energy, is delivering new, and in some cases the re-use of old, technologies. China is targeting 15 per cent of its total energy use from alternative sources by 2020 (including wind and solar). Most European countries now offer subsidies for a variety of green energies. The US has also legislated recently to raise mileage per gallon on new vehicles.

Post the last major US effort to cut energy intensity in response to the oil price spikes in the 1970s (with late 1970s conservation legislation under Jimmy Carter), US oil demand fell 18 per cent in four years (between 1978 and 1982). Moreover, despite this year’s 115 per cent rally in the oil price, inventories are above long run average levels while Opec spare capacity is around 6m bpd, ie, back at 2002 levels (when the oil price averaged $26 per barrel).

While geopolitics, continued security threats and unstable political regimes increase the challenges associated with long range oil price forecasting, it seems clear that the price signal has been effective. Dramatic increases in the oil supply over coming years coupled with significant current spare capacity suggest that the recent technical breakdown in the oil price is signalling something significant – possibly a coming oil supply glut and a revisit of end 2008 oil price lows.

Chris Watling is CEO of Longview Economics