Investing on the Hubbert curve - Oil & Gas Investor, January 2002
Author: Charles T Maxwell
The noted geophysicist M. King Hubbert (1903-1989) was the first man to
effectively apply principles of geology, physics and mathematics (in combination)
to the projection of future oil production from the U.S. reserve base.
The Shell employee and, later, geologist for the U.S. Geological Survey,
was a brilliant scientist but was described by contemporaries as sometimes
abrasive and having a short temper. He did not suffer fools gladly and
was always a center of controversy.
Yet, Hubbert's contributions to the industry included seminal research
papers on the formation of geological structures, the theory of petroleum
migration and the influence of fluid pressure on the movement of faults.
His most famous predictive analysis was published in 1956. In it, he indicated
that our conventional crude-oil production would go over the top of a great
curve in the early 1970s and start down. Much scientific heat was generated
by Hubbert's conclusion at that time. It was widely assumed that America's
oil output could still climb for many decades as new areas were opened
and new technologies applied.
In 1970, the U.S. hit its high point of oil output and subsequently entered
a period of production decline that has continued to this day.
Hubbert had been right on target. He had accomplished one of the most challenging
intellectual feats of the 20th century: measurement of the rate of depletion
of a main commodity resource underpinning society, with the implicit warning
that it was not inexhaustible, and that its peak production was closer
than many believed.
Hubbert's views logically suggested America would soon have to make a transition
from oil surpluses to oil deficits, from cheap oil to expensive oil, and
that this new universe of tightening supplies would be quite different
from what we were then experiencing (and are still experiencing now).
Although Hubbert lived to see his projections for the U.S. come true, the
oil industry and academia never fully accepted his views despite their
apparent accuracy. Partly owing to this and partly because U.S. companies
soon took their technology, experience and capital to foreign lands where
oil output quickly surged, allowing our national needs to be met by increasing
imports of crude (60% of total U.S. demand in the past six months), Hubbert's
name, and the concepts he developed, are not so well known today.
However, it seems likely that they will be again, since the principles
he used, now refined by computers, better data and improved modeling techniques,
are applicable to world crude output today in the same way they were to
U.S. output in the 1950s. Depletion of the global resource base of crude
oil continues to accelerate, while the classic days of successful exploration
(in terms of billions of barrels added each year to the world's reserves)
are falling far behind us.
Has anyone pointed out to you recently (after proper adjustments for the
true discovery date of reserves) that the world oil industry is now producing
approximately twice the volume of crude it is finding each year? That the
peak global oil discovery volumes were made in the mid-1960s and that we
have been in an inexorable descent since then? That in the late 1980s,
new discoveries fell below the level of current production, and are still
falling, despite the application of many powerful technological tools in
the 1990s? And that 70% of the oil you are consuming today was found 25
years ago or more?
These are points that oil companies (and governments) find awkward to discuss.
One reason is that there are so many conflicting views of "experts." Who
is one to believe? Another is that while the Hubbert Curve or Hubbert Peak
cannot be "proven" to work in any exact time sequence, widespread debate
about it would certainly raise warning flags for some elements in society,
and environmental passions in others. Should sleeping dogs be wakened in
this case? Lastly, recognition of the effects of Hubbert's math could imply
an end to volumetric growth for most oil companies in the intermediate
term-not an eagerly awaited event.
However, we are at a point now where these issues need airing. Effective
energy policies for the U.S. are part of an ongoing national debate, and
investors are asking where the flow of funds into the energy sector should
be concentrated to bring the best results. The shadow of Hubbert looms
large over these discussions. Suddenly, we are troubled by issues on a
world scale that he was dealing with on a national scale back in the 1950s.
And the resolution of them is just as elusive today as it must have been
back then, only now we have no new world of exploration to turn to as an
alternative to our depletion of the old one.
Hubbert's projections, at midcentury, were embodied in a rising line of
conventional U.S. oil production that eventually was to curve over the
top (1970), leading to a long descent on the other side. Enhanced oil recovery
techniques, new seismic methods of finding oil, and new types of drilling
and fracturing as examples of ongoing technological changes have not been
able to displace the assumed world peak much. The implications of this
are the truly frightening aspect of the Hubbert Curve.
Why does the Hubbert Curve work on the predictive side? Explorationists
look for the biggest, closest, least-complex prospects to drill first.
So, early drilling tends to be more productive in building reserves than
later drilling in the same region. New seismic techniques applicable to
land drilling in the 1950s and to ocean drilling in the 1960s allowed most
of the world's oil basins to be mapped in the 20 years after World War
II, so it is not surprising discovery rates were high in the years to 1975.
Recent applications of technology sharply encouraged production gains in
the 1980s and 1990s. However, these tools were focused more on rapidly
draining existing reserves than on finding new ones, thus accelerating
depletion rather than significantly adding to reserves. The role of technology
in extending the Hubbert Curve is still questionable. It may not turn out
to be the force we had once projected it to be.
What this means for prices
Suppose that, in the short period of years we may have before "facts on
the ground" close in on us, we are unable to shift the curve from the path
it is likely to take. What does that mean to us as energy investors and
consumers? Every expert will have his or her own view as to whether, when
or where the curve will affect us. The following developments could occur
in the relatively near future.
The non-OPEC world may well reach a peak in conventional, black crude-oil
output in 2005-07 at about 38- to 39 million barrels per day versus a current
level of close to 35 million. (This does not include heavy oils, tar sands,
gas liquids and condensate.)
Such a peak would be an important harbinger of a new era of oil pricing
and higher in-theground reserve values because it would imply that all
incremental barrels produced after that by the oil industry to meet global
increases in demand would have to come from OPEC, leaving that organization
to determine the terms and conditions on which this crucial new supply
would be made available to the non-OPEC world.
The price would no longer reflect the ebb and flow of supply and demand
in a relatively free market, as it has for many years (with occasional
manipulations thrown in). The price of oil would be largely determined
by a few powerful OPEC members. OPEC's pricing policy under these circumstances
might, at first, be quite reasonable. Oil prices might climb at, say, double
the rate of low world inflation in order to get back the purchasing power
OPEC has always claimed it lost since the early 1960s.
However, no consumer-country statesman in the non-OPEC world could afford
to be comforted by such apparent rationality. OPEC is, after all, intent
on running the crude-oil system for its own benefit, not for ours. As the
margin of excess producibility worldwide would be expected to tighten,
OPEC producers would surely be tempted to allow crude prices to rise a
bit faster, and then a bit faster.
The peaking of non-OPEC production would, in the event, likely resemble
a large flattish dome in 2005-07. The top could even extend longer, if
production commences from Kashagan Field in the north Caspian region of
Kazakhstan in 2006. Output here could begin at 500,000 barrels per day,
and add 500,000 barrels per day each year for the next six to eight years.
This would be the fastest field development ever accomplished by the oil
industry, but it would also represent a "last hurrah." Nothing like it
would probably be seen again.
For the record, the U.S. reached its peak production of crude oil in 1970,
and Russia in 1986. It appears likely that the North Sea will hit its top
this year. China, with new production coming onstream from Bohai Bay in
2002 and 2004, could peak in 2005-2006. Mexico appears to be five or six
years from the top of its Hubbert Curve, and could be declining in output
by 2007. Canada, with its growing tarsands output, may be able to push
to new highs in the next decade. These are the principal nonOPEC producers,
and, weighted by volumes, they are currently showing only small gains as
a group, while staring at large future declines.
The decline's implications
How would the peak of production from OPEC (in 2025 or 2030?) and non-OPEC
(2005-07?) production look when placed together? If the peak of non-OPEC
production touched off a sharp rise in crude prices after 2007, then the
slowing of world demand as a consequence would affect production and obviously
delay the overall high point of output.
Rising prices could be expected to ration supplies, and, in investment
terms, raise returns for those oil-based entities that might still hold
sizable reserves and production growth potential in an operating universe
that was critically short of both after 2007.
Some non-OPEC oil companies could derive considerable benefit from the
curve, however. Oil-stock investors need to begin considering now which
oil companies can rearrange their flows of development capital into long-life
reserves to carry them through the effects of the Hubbert Curve into an
age of higher oil prices with their volume growth intact, and their competitors
falling away.
Here is a list of major oil producing companies today that I believe can
achieve this transformation from mainly conventional oil (slowing volumetric
growth) to mainly nonconventional oil (accelerating volumetric growth).
It must be remembered that the attraction of investing in these companies
may not become obvious to institutions and the public for some time yet.
Still, we are discussing a perception change. And, when it comes, I am
convinced that it will be crystal clear.
Suncor Energy (NYSE: SU) has the strongest proportional position in the
Athabasca tar sands-it represents 85% of the company's assets. (See Oil
and Gas Investor, October 2001.)
Imperial Oil (Amex: IMO) has a solid Athabasca tar-sands position through
Syncrude, along with Cold Lake heavy-oil exposure. Imperial also has huge
land holdings yet to be exploited in Canada's Mackenzie River Valley and
Delta. (A takeover offer from 70%-owner ExxonMobil could also be in the
cards).
Conoco (NYSE: COC) is the only midcap integrated company with a good position
in both Athabasca (through the Gulf Canada acquisition) and Orinoco (Venezuela)
tar sands.
Phillips Petroleum (NYSE: P) has a storehouse of long-term "legacy" assets.
It has a 40% interest in the Hamaca project in the Orinoco tar sands as
well as 8 trillion cubic feet (Tcf) of gas in the Prudhoe Bay gas cap.
It also holds 7.14% of Kashagan's possible 30 billion recoverable barrels.
Oil-service companies and engineering and construction companies working
in the energy field are expected to derive huge amounts of new business
from the increasingly frenetic effort to develop smaller oil fields at
a pace that can keep up with the level of overall reserve depletion taking
place. Within five or six years, this effort may prove to be unavailing
in terms of providing net incremental barrels, but some incremental exploration
and production operations will be active, and will go on (literally) for
centuries.
Lastly, there are still the vast tar sands, heavy oil, gas-to-liquids,
LNG shipping and receiving, light fraction extraction, and refining, pipeline
and tanker operations and expansions to be handled. They are not subject
to any direct restraints imposed by the curve. Neither are the huge investments
in energy conservation equipment and technologies that will be called into
being as a result of "rationing by price."
So, I see the energy business as extremely attractive for investment in
the coming years. However, the new basis for doing business, that is, restrained
supplies at higher prices versus virtually unlimited supplies at lower
prices of the past, will entirely change the structure of opportunities,
supplier-customer relationships, the establishment and management of organizations,
and the market valuations we have seen before. After 142 years of Colonel
Drake's petroleum industry, a wholly new one is emerging. None of us has
been there before.
Without greater volumes of crude at reasonable prices, the world economic
system could verge on becoming dysfunctional for a time, until major adjustments
are made. So, investors should think ahead of the curve.
___
Charles T. Maxwell is a senior energy analyst with Greenwich, Connecticut-based
investment-banking and securities firm Weeden & Co. Inc. He has worked
in the oil industry since 1957. |
