Oil supply seen threatened by limited E&P opportunities

The global oil supply-demand balance will continue to be tight through first half 2005, said WMRC, as demand growth in 2004 is "virtually unprecedented," while spare capacity has fallen substantially and will present a challenge to restore (Fig.1).

"Over the next 5 years there should be enough major development projects coming on stream to satisfy demand growth," the analysts said. "However, delays could add to market tightness."

Demand-supply surprises

Unprecedented economic and oil demand growth in China surprised many observers in 2004, while political instability disrupted production in Iraq and Nigeria and created worries about supply from Russia, Venezuela, and Saudi Arabia.

"There has been a pincer attack on oil prices from both the supply and demand sides that has resulted in an inexorable climb in prices over the course of the year," WMRC noted.

Futures prices for crude oil began breaking records on the New York Mercantile Exchange in August. Late that month the futures price for NYMEX crude was $38.30/bbl, and by early October it had rocketed to $50/bbl.

In early 2004, the Organization of Petroleum Exporting Countries underestimated global demand growth, which would become the highest it had been for more than 20 years, WMRC said.

Fearing a price collapse in late 2003, OPEC cut production and resisted increases well into second quarter 2004 despite calls by the International Energy Agency to increase production. IEA was revising Chinese demand growth upward each month "by hundreds of thousands of barrels."

With China an increasingly important global oil consumer, difficulty in accurately and quickly assessing its demand became another concern that spurred prices in 2004.

In the US, crude stocks have been low through 2004 and gasoline demand, high.

Early in the year, OPEC, fearing that rising Iraqi exports would flood the market, resisted quota increases. But damage by insurgents to infrastructure held Iraqi production below 2 million b/d for much of the year—and frequently less than 1 million b/d.

In Nigeria, ethnic violence shut in 450,000 b/d of production, while Norway's labor disputes curtailed oil production and UK oil output fell faster than expected. In addition, threats to oil production by domestic tension in Venezuela and Russia raised already high fears about supply disruption.

In late May OPEC increased quotas twice and was already producing above its ceilings and reducing spare capacity.

Short-term issues

Oil prices are not expected to fall substantially or oil demand to slacken within the next 12-18 months, WMRC emphasized. Through February 2005, the market will be "extremely tight." However, the global economy can cope in the short term, the analysts said.

"Prices are in fact not that high in real terms, and this means that there is still another $20-30/bbl that could be added on to oil prices before prices reach levels commensurate with those in 1980-81," WMRC said.

New capacity will be added, but amounts and timing are unclear. Major Nigerian developments could add a total of 600,000 b/d, and Caspian region developments can now move to markets via the Baku-Ceyhan pipeline. The UAE, Iran, and Saudi Arabia all plan to bring new fields on stream, and Iraqi oil production can increase if security improves. More deepwater production in the Gulf of Mexico (GOM) also will come on stream, and Brazilian production is rising.

Russian oil output, however, is unlikely to grow at 10%/year as it has during the past 5 years. OAO Yukos, under pressure from the government, will not be able to invest as much as it had planned, and Russian output growth remains limited by pipeline capacity.

IEA projects more strong demand growth, offsetting the increase in global production during the next 12-18 months, so there is little prospect of restoring spare capacity to the traditional 2-3 million b/d, WMRC reported.

Medium-term issues

Over the medium term, the outlook becomes less clear, but global oil demand is conservatively estimated to rise by 1.7-2%/year. At these levels, the oil industry will need to increase production by 7.8 million b/d to meet demand of 89.87 million b/d by 2009. This presents a sizeable challenge, but not an impossible one.

Deepwater West Africa and Central Asia will account for much of the production growth within the next 5 years, along with the start-up of oil from Kashagan field off Kazakhstan in 2008.

Angola, Nigeria, and possibly Sao Tome will add to production in West Africa. Extensions to mature production regions in the GOM and the North Sea could come on stream quickly, given existing infrastructure, but the amounts will not arrest overall production declines. China and deepwater Asia are areas of potential growth, and the Russian boom should add new production.

Algeria wants to open new oil tracts. Growth there will be strong but slow to 2009. Libya also is preparing to welcome foreign investors and raise production.

E&P investments low

National oil companies (NOCs) have dominated "hub-scale" discoveries of more than 300 million boe in the past 4-5 years, although they have been slow to develop them. Relatively low growth from these closed oil producers should be expected over the medium term.

IOC investment in new exploration and production, therefore, will determine much of the medium-term outlook. Traditionally, E&P spending mirrors oil price. During 1996-98, major oil companies spent $12-14 billion total on exploration, according to Deutsche Bank. This high rate of capital investment stopped in 1998-99, when the oil price collapsed to less than $10/bbl.

Oil majors spent more than $10 billion in 2001 as prices rose, but investment has been falling again since the recent 2001 peak. Deutsche Bank estimates 2003 spending at $8.98 billion. This figure is not expected to rise much this year or next.

Deutsche Bank estimates that only 6 of 15 major oil companies have managed a reserves-replacement rate better than 100% during 2001-03. Royal Dutch/Shell, Total SA, ConocoPhillips, and ExxonMobil Corp. all fell short of that target.

Consolidation, cost-cutting, maximizing shareholder revenues, and lack of opportunity are given as the reasons for upstream investment to have fallen behind the rate of increase in oil prices.

Relatively low investment by IOCs in E&P, together with expected slow growth from NOCs, raises worries over medium-term output. While there is still a considerable amount of oil set to come on stream, there could still be problems if demand growth maintains its current upward trajectory.

Long-term issues

The standard argument that the industry adjusts to prices over any extended period of time through increased investment is being challenged in light of recent oil price rises and growing interest in when oil production will peak, WMRC noted (OGJ series, July 14-Aug. 18, 2003).

Essentially the longer-term picture for oil production depends on IOC access to known reserves, exploration success in new oil territories, and technological innovation and prices, it said.

Majors are seeking projects large enough to help them grow. The challenge is evident in the number of companies hoarding capital or distributing it to shareholders.

Areas of opportunity for large-scale development, such as in East Siberia, the Persian Gulf, and Iraq, are largely off limits to IOCs. ExxonMobil Chairman and CEO Lee Raymond has said he believes most of the world's largest oil fields have been found, leaving large opportunities only in Russia, Iraq, Libya, and Saudi Arabia.

The biggest discoveries in recent years have come from West Africa, Central Asia, and Brazil. Further discoveries have been made in mature areas such as the GOM, Persian Gulf, and North Africa, while Southeast Asia also has shown promise. Although acreage remains available for license, the oil majors already have large holdings in these regions.

Technology

Technological innovation is difficult to predict, but a 1% increase in the recovery rate adds 11.1 billion bbl to reserves globally, the analysts said.

"Given recovery rates that are, on average, below 40%, there is plenty of room for growth here," they said.

But the problem grows with demand.

"Assuming a 1.8% annual increase in oil demand, production will need to reach an average of 100 million b/d by 2015." WMRC said. "This is a significant amount of production to add within just 11 years, roughly corresponding to the output from two new Saudi Arabias or one new Libya each year.

"With some 18 million b/d of new production needed, it does not seem that the areas [now] open to IOC oil exploration will be able to meet this need," cautioned WMRC.

Worrisome trends

It is too soon to abandon an analytical framework that has served the oil industry well, WMRC said. However, there are some worrisome trends that, if continued, would warrant looking again at that model:

• Spare capacity. The 2004 price spike is unique in that it was demand-driven, with numerous output problems intensifying the effect. Saudi Arabia's spare capacity has been eroded and is unlikely to rebuild unless an oil glut develops. That does not seem likely in the immediate future.

"For perhaps the first time in recent memory, spare capacity has all but vanished from the oil market," WMRC said. This tightness contributes greatly to the oil "risk premium"—the additional per-barrel oil price attributable to geopolitical risk. "With little ability to compensate, supply threats are more significant." Now that OPEC members cannot simply increase production in the event of oil flow disruptions, questions arise as to the permanence of the risk premium, how long the tight supply-demand balance will last, and whether this is the start of a new oil market or just a glitch.

• Reserves concentration in "closed" countries. Oil majors know where the oil is, but much of it, in countries such as Saudi Arabia and Iraq, is unavailable to them. Iraqi opportunities could arise later, but it is much too unstable now. Russia, however, has shown some willingness to work with international companies, and Libya could be the best hope for some oil majors.
• Increased finding costs. The rise in finding costs is too recent to be called a trend, but it does suggest less oil to find where IOCs are permitted to explore and more difficult and costly exploration in hard-to-access areas. "Reserve growth in IOCs has been relatively flat, and the outlook is not good," said WMRC.
• Low E&P investment. With an increased focus on reserves, it is surprising that E&P investment is not higher. Low investment now indicates lower growth in 5-10 years hence, although again, this can quickly change.
• Lack of opportunity. Falling E&P investment by IOCs at a time of rising prices indicates cost-cutting, but it also suggests reduced opportunities. This applies, especially to the "hub-scale" fields that the majors require. Opening Siberia and other northern prospects will require substantial investment in infrastructure that is not happening yet.
• Political risk. Political risks are increasing in areas where new production is coming on stream, such as West Africa, the Caspian Sea, and the Middle East. The effect of the "risk premium" on oil prices was apparent in 2004, and these political risks are unlikely to decrease.

Future production

Investment patterns over the past 3-4 years cause some concern, WMRC said.

"IOC exploration spending is down, drilling is down, discoveries are down, and new opportunities are not opening up with the speed the industry would like," it said. "In addition to thisUlead-in times for new projects are becoming longer.

"IOCs are undoubtedly concerned about the current price spike's being little more than a bubble, but if this proves not to be the case, there could well be a lack of new oil in 10-15 years' time."