FACTS: Oil market suffering from investment lull of 1990s

Oct. 16, 2006
The global oil market is suffering now from a lack of investments in the 1990s when oil prices were low and refining margins poor, said analysts at Fesharaki Associates Consulting & Technical Services Inc. (FACTS), Honolulu.

The global oil market is suffering now from a lack of investments in the 1990s when oil prices were low and refining margins poor, said analysts at Fesharaki Associates Consulting & Technical Services Inc. (FACTS), Honolulu.

“Low excess upstream capacity and persistent threats to supply security have continued to keep [crude] prices high. Moreover, refining capacity has been tight due to low investments over the past decade, particularly in the upgrading capacity needed to refine heavy crudes into lighter products,” said Jit Yang Lim, senior FACTS consultant, in a recent report.

The historically cyclical oil and gas industry is on a new plateau, said Lim. More crude is needed from the Organization of Petroleum Exporting Countries as non-OPEC supply growth falls further behind demand growth. But political, legal, and management problems are unlikely to allow OPEC to add new capacity large enough to respond to demand growth. “Furthermore, we expect the costs throughout the entire production chain to increase rapidly,” Lim said.

Paris-based International Energy Agency earlier predicted a strong increase in non-OPEC crude production this year but has been forced to reduce its forecast month by month. In July, it expected the growth of crude supplies outside of OPEC to accelerate to 1.7 million b/d in 2007 from 1.1 million b/d in 2006. IEA said non-OPEC supply, including biofuels, should average 53 million b/d next year, with countries from the former Soviet Union and Africa accounting for 60% of the growth and the Americas for 30%. “New oil fields and an assumed rebound after severe 2005-06 outages underpin the increase in 2007. The North Sea and OECD Pacific also [should] see a temporary respite in 2007 from recent declines,” it said (OGJ Online, July 12, 2006).

IEA forecasts a 1.2 million b/d (1.4%) increase in crude consumption globally during 2006 and a 1.6 million b/d (1.9%) increase in 2007.

Analysts at the Houston office of Raymond James & Associates Inc. said, “IEA believes that Asian, South American, and Saudi Arabian producers may help fill suspended supply from the US. However, the agency has also raised its 2006 Chinese oil demand growth forecast from 6.1% to 6.5%.” (OGJ Online, Aug. 11, 2006).

Energy prices

In the future, oil prices are likely to be driven by a shortage of crude oil production capacity instead of refined products-“exactly the mirror image of the situation today,” said Lim. “Additional refining capacity is limited in the short term, but much more is coming before the end of the decade. China will add 2.3 million b/d of refining capacity between now and 2010, while India will add more than 1.3 million b/d of refining capacity by 2010” Lim said. “In addition, the Middle East is expected to add around 3 million b/d of capacity by 2012, and another 1.2 million b/d is expected to be added in the US. There is a potential refining surplus looming by 2010-12, and this surplus will have a worldwide impact,” he said.

The global market has been growing strongly with incremental demand close to 1.5 million b/d since 1995. Demand projections by IEA, OPEC, and the US Energy Information Administration average about 1.5 million b/d in annual growth for the next 5 years. “The Asia Pacific has been the engine for this growth. Demand growth in China and India is likely to stay strong,” FACTS reported.

China, the “key driver” of demand growth, accounted for 73.1% of Asia’s 1.07 million b/d incremental demand in 2004. “This solid growth can be traced to China’s robust economic performance, with 10.1% real GDP growth and the corresponding growth in petroleum use in almost every sector of the economy,” FACTS reported.

India’s energy demand growth is likely to stay strong, with expanding demand in its agricultural sector after growing strongly in the past 2 years. Japan’s demand is declining, with its nuclear power issue “somewhat resolved.” Although Japan’s economic situation improved recently, its mature economy and soon-to-be-shrinking population are not promising prospects for long-term growth of oil demand, FACTS said.

South Korea has recovered somewhat from the brief recession of early 2003 and is expected to grow at a moderate rate as a maturing economy. “Overall, Asia Pacific is expected to have an incremental demand of around 700,000 b/d for 2006,” Lim said.

With oil prices holding at relatively high levels in a prolonged increasing trend, observers now seem to be more receptive to Colin Campbell’s theory of peak oil, which holds that “oil production is going to be flat or even decline in the near future,” said FACTS. “We believe that the issue is not so much that the oil is not there in the coming decades, but that it will be more difficult to deliver the oil to the market,” its analysts said.

Key factors contributing to high prices are persistently strong, though moderating, demand and the perception of tighter supply and rising costs in the future. Unexpected strong demand for petroleum products led to a sudden reduction in spare refining capacity worldwide that drove up product prices, bringing with them increases in crude prices, said FACTS analysts. “Petroleum prices have so far been product-led and demand-driven, but there is now the underlying fundamental concern with the industry’s lack of resources or problem of adding new production capacity,” Lim said.

That has been exacerbated by the “alleged speculative factor caused by hedge funds that inflate the prices further above what the fundamentals would indicate,” he said. “The bullish sentiment of the energy market has led to a rise in activities by hedge funds in the futures markets.”

Lim said, “The price of crude may rise steadily from 2007 onwards due to the tightness of supply. As such, we believe that in the longer run, oil prices in real terms have to increase to a level which curbs the demand growth.” He said real prices would have to rise “by at least 50-100% on the back of moderate economic growth before demand is curbed, resulting in lower demand due to more efficiency and new technologies that will reduce dependency on oil.”

The key to the future oil market is US policy on domestic tax and auto standards, said FACTS analysts. “Current prices have moderated demand in a big way in emerging markets but not in the US. Only higher prices can stop or cut US demand, and new policies will need to be enacted. There is no political will or courage in the US to embark on such a task, so only prices can force a demand adjustment,” Lim said. “The rest of the world, particularly the developing world, will suffer until the US is forced to change course.”

Crude prices are likely to stay strong-above $50/bbl in the near term, Lim said.

Crude supplies

World oil production may be insufficient to meet future demand, Lim said. FACTS sees non-OPEC supply growth slowing, averaging 500,000 b/d in 2007-10 and likely plateauing by 2015. Global production should peak in 2015-20 at 100 million b/d, as a result of resource and policy constraints.

Most non-OPEC countries are not expected to have significant output increases in the next few years, except for Russia, where high taxes on extraction and exports and growing state control have increased uncertainty for investment. There seems to be a government decision to not allow an output growth much above 10 million b/d to ensure long-term sustainable production, Lim reported.

“A similar policy is also seen in Mexico, with little or no growth in output expected.”

With non-OPEC production averaging 500,000 b/d in 2007-10 and OPEC’s decline rate of 1.2 million b/d annually, OPEC would have to add more than 10 million b/d of new production by 2010. Lim questions whether it can handle that increase.

Overall, OPEC faces a natural decline of some 1.2 million b/d annually, roughly one-fourth in Iran and Saudi Arabia each, FACTS reported. Indonesia and Venezuela’s production capacities have declined significantly over the past 5 years.

“Adding capacity is very difficult, as much new capacity is needed just to stay in the same place. The production is also subject to [political] uncertainties,” the study concluded. And the delivery of oil to markets remains a continuing challenge.

Refining capacity

Refining capacity has remained tight because of low investment in those facilities over the past decade, particularly in upgrading capacity to refine heavy crudes into lighter products. “The situation has worsened as many countries move towards lower-sulfur specifications, making the need for sophisticated capacities and light-sweet crudes even more dramatic,” Lim said.

The switch from methyl tertiary butyl ether (MTBE) to ethanol as an oxygenate blend in reformulated gasoline in the US due to environmental issues added more strain on the sector, keeping product prices high.

“Additional refining capacity is limited in the short term, but much more is coming before the end of the decade. The bulk of the expansions will be in China and India, with some potential large-scale expansions in South Korea,” said Lim. FACTS projects that Asian refining capacity will increase by more than 4.3 million b/d by the end of 2010. China is expected to add 2.3 million b/d of refining capacity, while India will add more than 1.3 million b/d of refining capacity in that same period. The Middle East also is expected to add around 3 million b/d of capacity by 2012. Another 1.2 million b/d of new capacity is scheduled in the US.

Most of China’s refining addition is driven by domestic demand, but capacity additions in India and the Middle East pose a threat to future refining margins.

The potential refining surplus expected by 2010-12 will not only be critical in Asia but will also have a worldwide impact, Lim reported.