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The bull case for oil prices

by Sid Moran, Petroleum Geologist & Venture Analyst

Opinion has been divided between bearish analysts who argue that we are in for an extended period of low oil prices and that $20-30 oil is in fact the long term average price, adjusted for inflation. Further, there is considerable surplus production capacity than can be called upon if needed.

The bulls argue that we may be heading towards tight supplies, or even shortfalls, in the next couple of years, despite the current overproduction and large volumes of oil in storage. I believe they are correct. In a nutshell, the reasons are: (1) in the absence of new development, world production would decline by several million barrels a day PER YEAR, and (2) that most new development must come from high cost areas, such as shale, deep water, tar sands, oil sands, and other high cost sources, and on average this requires a price of about $60 per barrel. The capital structures of many oil companies have been damaged, some to the point of bankruptcy, and even if they were not, companies would need to see $60 oil and be convinced that it would remain at that level or higher in order to justify the high cost of development. Many companies have downsized, and most U.S. drilling rigs are idle, along with a significant fraction of international rigs. Restarting a full-scale drilling and development program will require quite some time.

A  well-researched paper delivered to the Houston Geological Society by Arthur Berman, a highly respected  petroleum industry professional, revealed that most of the new oil development in recent years has come from high cost sources, and that lower cost oil production is actually in decline. Production in fully developed fields typically declines each year and eventually stops. Hence the much-maligned depletion allowance, which applies to a great many mineral and metal ores in addition to oil and gas. In principle, a manufacturing plant can continue indefinitely, perhaps with upgrades and new technology, but an oil “factory” has a limited life and new fields must be developed to offset depletion of older fields. The fact that many of the new fields are very capital intensive is analogous to production of minerals and metals from higher cost ores as lower cost ores become scarcer.

The history of oil production since WWII is instructive. Demand increased steadily from 1945 to 1973 at a compound rate of about 7% per year. Oil prices ranged from about $2.50 to $3 per barrel and were declining in inflation adjusted terms. This ended abruptly with the Arab oil embargo of 1973 when prices jumped almost overnight to about $11 per barrel and then  rose to about $15 per barrel until the Iranian crisis of 1979 when prices jumped to over $30 per barrel and climbed briefly as high as $40, in 1980.

Although these increases were disruptive, I think they were a blessing in disguise. Assuming unlimited supplies of oil and no environmental impact, OPEC oil demand increases of 7% per year, would require production of about 400 million barrels per day! The price increases averted a looming supply disaster. World demand decreased slightly in 1974 and 1975, and then began to increase again at about 4.5% per year, until 1979. Even at that rate of increase, the demand for OPEC oil would be over 150 million barrels per day now! But the 1979-1980 increases, combined with the 1973 increase, amounted to more than a 12 fold increase in the price of oil in seven years, and resulted in a sharp long lasting decrease in demand. World demand fell by 10 million barrels per day from 1980 to 1985, and non- OPEC production, in response to high oil prices, rose by 5 million barrels per day during the same period... This led to a 15 million barrel drop in OPEC demand, and prices, after drifting from late 1980 to 1985, collapsed in 1986.World production did not recover to the 1980 level until after the turn of the century. However, the decline in world production was in response to sharply higher oil prices, and not low prices such as we have now. A worldwide severe recession might result in a decrease in demand, though not likely very large. World demand continued to increase during the sharp recession beginning in 2008.

Bottom line: it may be impossible to meet demand within a year or two unless prices recover, and remain above $60 per barrel. But because of long development startup times, severe shortages might develop regardless. Further, in times of feared shortages, prices may greatly overshoot the minimum required price for new high-cost development, such as occurred in 2008.