Future oil prices likely higher than historic $18-22/bbl consensus

Sept. 29, 2003
This article will show that, despite the concerns of rising oil production from Russia and the Caspian Sea region and the possible further development of Iraqi reserves, the mean price of oil going forward is likely to be higher than the historic $18-22/bbl range of consensus.

This article will show that, despite the concerns of rising oil production from Russia and the Caspian Sea region and the possible further development of Iraqi reserves, the mean price of oil going forward is likely to be higher than the historic $18-22/bbl range of consensus.

There will still be meaningful volatility, perhaps even increased volatility, as the market adjusts to changing expectations.

In fact, the common knowledge about the $18-22/bbl historic price range is misleading. Despite swings in sentiment, economic cycles, and supposed bouts of collapse and unity within the Organization of Petroleum Exporting Countries during the past 26 years, West Texas Intermediate crude oil, while volatile, has actually averaged more than $22/bbl.

Indeed, even the 1987-to-present oil price has averaged $20.89/bbl.

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Fig. 1 shows that low-price declines or high-price spikes have always reverted toward the mean, or "normal" price range. The outlook for reversion to the mean in future oil prices is a healthy $23/bbl. Although this only $1-2/bbl above the historic average, proper price management through capital allocation and hedging could add that $1-2 to the profit margin per barrel, a truly substantial increase.

Fundamentals support hike

In assessing the next 5 years and thereafter, this analysis that market fundamentals support a possible modest increase to an average of $23/bbl or perhaps a bit more. This price change encompasses the timeframe of development of West Africa, the former Soviet Union, and the deepwater Gulf of Mexico. It includes the expectations of returning Iraqi oil, and lack of OPEC discipline in non-Persian Gulf producers. It assumes Venezuela and Nigeria seek to maximize output.

In summary, while expectations are for increasing pressure on OPEC and falling prices, the mean price of oil for the next decade could actually increase. As marginal revenue flows directly to profit, this is a more substantial change than gross revenue levels would suggest.

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The starting point is a shifting of oil-consuming economic growth in the world, as shown in Fig. 2, reflecting changes in oil demand of the developed economies (Organization for Economic Cooperation and Development), the FSU, and the developing world over the past decade.

Of significant importance, the FSU cannot go to zero oil consumption. The FSU consumption trend must reverse, as indeed the second half of the 1990s recorded a decelerating rate of decline as its economies began to function. The decline of demand in the FSU offset for several years and largely hid the dynamics of the developing economies.

Additional evidence of the future oil price level is reflected by the relative growth of energy-intensive economic segments within the various countries of the world.

Energy growth coefficients

When adjusted for intensity of usage, the developing world is more important in future oil consumption than is the developed world. Without the offsetting decline in FSU demand, total oil consumption will grow more rapidly than in the past.

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The Energy Growth Coefficients (EGCs) shown in Fig. 3 measure the amount of increase in oil demand for a unit of increase in economic development. The table compares the actual calculated EGCs for the 1990s, displayed by region.

(Author's note: The Middle East appears to be skewed by Iraqi smuggling through its neighbors, which magnifies demand from a low base by including smuggled volume. We now know that Iraq utilized a 240,000 b/d pipeline from Kirkuk to Bania, Syria, for smuggling oil to avoid United Nations monitoring and to finance his armamenst. US Special Forces have destroyed the line.)

The EGCs shown in Fig. 3 were calculated for 1991-2000 to encompass a timeframe that lagged the oil shocks of the 1970s and 1980s. Therefore the calculated EGCs embodied enough time for price response, as well as a timeframe that was appropriate for that response to have been absorbed in the economic growth of the period. Using a proprietary measurement of pressure upon the EGCs—in essence the second derivative of energy intensiveness—showed the rate of change in energy intensiveness of economic growth. This was a study of relative growth between energy-intensive and nonenergy-intensive economic sectors by country, over time.

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A surprising, and important, point regarding the EGCs shown in Fig. 3 is the lack of continued responsiveness by energy-intensive economies to their dependency on oil. While the developed world became more energy-efficient after the oil price spike of the late 1970s, a substantial amount of the efficiency was simply a shift of industry to the developing world, which now exhibits the energy intensiveness formerly associated with the OECD countries. The review indicates that, except for Japan and Eastern Europe, pressures on the EGC tended to be modestly upward. In essence, oil demand is increasing with economic growth, but also at an increasing rate in many countries as the developing world industrializes, and as the western world is more "comfort-than-cost"-driven in their homes and vehicles.

Oil demand understated

This review provides evidence that oil demand expectations are generally understated. Utilizing the EGCs and economic projections from the World Bank, the International Monetary Fund, and other sources, one can calculate a demand forecast that embodies the work of the EGC study. Table 1 projects demand, consistent with economic outlook and encompassing the EGC information.

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As shown, projections based on anticipated economic growth and on oil demand calculated from the energy intensiveness of that economic growth indicate a healthy expansion of oil demand. Economic projections can vary, but "over-time" growth trends are more stable. An increase of 10 million b/d of oil consumption can absorb a considerable increase in supply, especially after replacing normal production decline. Demand dynamics clearly are bullish for oil prices, so supply projections become important.

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The other side of the price issue, supply, has already demonstrated several years of higher-than-expected decline curves, overestimated development volumes, and unexpected delays in West Africa and the Caspian region. These could be transitory and merely a function of price volatility impacting budgets and funding with uncertainty. However, the dynamics of proven reserve bases are startling when analyzed (Table 2).

After establishing a rising demand profile, it is difficult to see where non-OPEC supply can contribute any sustainable production gains of substance. Including even the FSU, this shows that exploration for reserves—not just development—is a necessary requirement to achieve any meaningful ability to satisfy increasing demand.

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Fig. 5 suggests that 2002 and 2003 should have been a rough time for OPEC market share, given the sharp increases in non-OPEC oil supply.

Indeed, there is no shortage of evidence that global supply is adequate; however, disruptions in Venezuela, Nigeria, and weather have drawn inventory levels to a below-normal situation. Government stocks have built in anticipation of Iraqi disruption, but those may or may not come on the market.

That leaves the current market at full supply, low inventory, and a weak economy.

However, the projection here for 2003-07 is for only a 5.245 million b/d (2.54 million b/d FSU) increase in non-OPEC supply against a 10.096 million b/d increase in demand.

Rising Persian Gulf dependence

If we add in the non-Persian Gulf OPEC reserve base, it shows there has been substantial growth by Venezuela, Nigeria, and Algeria (with Libya stunted by sanctions) shown in the South American and African reserve base growth (Table 3). Indonesia's need for more exploration and development and gaseous hydrocarbons shows up in the decline in Asia. However, while the OPEC reserve base aside from the Persian Gulf is robust, if non-OPEC is added back to the sum for the world excluding the Persian Gulf, we find that in 20 years, reserves have grown by only 15%.

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This is a startling number, which underscores the difficulty of meeting demand projected to grow over 13% in just the next 5 years. It also calls into question the industry's rosy forecasts of 3-4% annual production growth. We then are faced with a conundrum. The industry either must perform better in exploration and development the next few years than it has the last 20, or we are inescapably left again with the Persian Gulf OPEC members as the dynamic marginal suppliers of oil.

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The non-Persian Gulf OPEC members are forecast to increase production by less than 2 million b/d during 2003-07. This does assume a normalized base for Venezuela and Nigeria, so in absolute volumes, we would see Venezuela at 4 million b/d and Nigeria approaching 3 million b/d. This still leaves just over 3 million b/d of demand growth for the Persian Gulf OPEC producers (Fig. 6).

While capturing only 30% of the next 5 years' demand growth does represent a decline in OPEC.market share, it still is adequate to allow Iraq 4 million b/d and yet provide the Saudis and other Gulf Cooperation Council members better than flat production. As mentioned earlier, 2002-03 appears to be the most crucial timeframe. Absent an absolute volume squeeze, and expecting the future to improve, I believe that the Saudis and other Persian Gulf OPEC producers will be more attuned to defend their price band than to unleash a disastrous market share battle.

Supply growth to lag

In conclusion, growth of supply should be roughly as anticipated, but with a bias toward weakness, while the growth in demand could be above expectations, and result in adequate volumes for Persian Gulf OPEC countries, not a volume squeeze. Some analysts believe that OPEC is responsive to market share, and as low-cost producer will increase production against the FSU. However, the most painful period for the Persian Gulf countries' economies was the time that policy was followed, and the lesson was learned that the response is lagged meaningfully. The cost advantage is also an open question, as Russia and the Caspian region are more economic than the previous competitor, the North Sea. Absent unacceptable absolute volumes, the Persian Gulf producers will defend the OPEC price band, not market share.

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In fact, the futures curve has already adapted to a higher price outlook than historic prices, virtually matching this forecast (Fig. 7). While there will doubtless be substantial volatility, the futures curve becomes asymptotic [approaches convergence with the historic price line on the graph] at $24.50/bbl, vs. this forecast of similar mean of $23/bbl.

Understanding the influences and pressures on the average price of oil is crucial in a reversion to the mean-price strategy.1

The producing community requires it to set the basis of budgets, acquisitions, ranking of prospects, and optionality of when to hedge or not hedge production. And the financial community requires it to evaluate the asset value and profitability of investments and loans.

Reference

1. This strategy is developed more fully in A Reserve Buyer's Component Value methodology for selecting common stock investments in the energy sector.