This is a commentary on a paper published by Matthew R. Simmons.
First, some excerpts from his paper, which can be found at:
simmonsco-intl.com
Lost in all this bearish news was an important fact. Demand still grew; year-to-year, and 1998 oil demand, while lower than it could have been, still set a new all-time world record.
For the year, in total, 1998 non-OPEC supply was 2.6 million barrels per day lower than originally forecast. But, the fourth quarter supply, which historically has always been the high point of the year, has now been revised downward by a stunning 4.1 million barrels per day.
While the untold story got buried in the avalanche of bearish oil news, the widely touted surge in non-OPEC supply simply fizzled out. In fact, if the last 12 quarters of non-OPEC supply are graphed, the line has a surprising flatness, much like the graph of U.S. natural gas supply over the same time period.
Some analysts are now attributing this drop to the fall in the price of oil. But, this is simply not true. Through the first seven months of last year, virtually every rig in the world was actively working. There was no way any more activity could have taken place for 85% of this period of time since the world had completely run out of spare rigs. The drop in oil prices will affect supply in a big way, but we are just starting to see this impact arrive.
If there was any single surprise that almost no one predicted, other than the Asian Flu, it was Iraq's ability to push its oil production far beyond the limits that virtually all the Iraqi oil experts thought was physically possible. But, the Iraqi's proved the world wrong as Iraq's internal production and its exports to world oil markets blew through everyone's highest estimates.
The report describes in detail how punishing the current production levels are to the best oil fields in Iraq, with rapidly rising water cuts and conning problems threatening to destroy some of Iraq's most prolific fields.
a "senior Iraqi official" was quoted as saying that Iraq was "not about to let Washington or Riyadh off the hook in seeing oil prices rise because Iraqi oil was bombed off the market."
The excess supplies that these IEA supply and demand numbers portray cannot be verified by any reported estimates of OECD or worldwide petroleum stocks.
At the time, the amount of IEA "missing barrels" totaled about 175 million barrels. Shortly after this issue first arose, I spent some time going back over historical IEA petroleum stock reports compared to revised data several years later to convince myself that reported petroleum stocks have always been far more accurate than any supply and demand numbers. Petroleum stocks are the industry's balance sheet, which has to foot before any supply and demand estimate can be correct.
To now reconcile the 1997 and 1998 IEA supply and demand estimates, we are now looking for an astonishing 690 million barrels of petroleum that the IEA analysts think are hiding somewhere outside the recorded storage of the industrial countries of the world. In their minds, this awful overhang of excess oil must all be absorbed before the market comes back into balance. This is also the primary logic behind our Department of Energy's EIA forecast that it might take up to seven years to return oil prices to an $18 per barrel level.
On the other hand, if these barrels exist only in the minds of the IEA's analysts, then the problem gets solved fast, assuming the total 225 million build is all excess stock in the first place.
We might have accidentally created a gigantic house of mirrors where bad data creates shorts on oil contracts, which brings prices down, which creates even more bearish data!
When you dig into the numbers, there is solid evidence that a large part of the 175 million commercial stock increase was simply due to growing demand for various petroleum products. If so, then correcting the world's glut in oil stocks will take even less time. It could be measured in weeks if the OPEC cuts are even close to full compliance.
We are clearly running out of capacity to either transport or store certain grades of petroleum supply necessary to logistically supply the world with 75 to 76 million barrels of oil each day.
Let me assure all of you that there is nothing normal about $10 oil. This price is far too low and quickly destroys virtually any oil producer's incentives to keep supply in place.
There are no "well-placed participants" for an era of $10 or lower oil just as there are no car manufacturers who can produce fine autos for $10,000 a car. The economics could work for a few of the Middle East producers if they have no social costs to absorb. But, to a country like Saudi Arabia, social costs are as real as overhead is to Exxon or Shell. So, $10 per barrel oil does not work anywhere. It simply destroys the oil industry.
Last fall, I decided to attempt to blow away this technology hype, once and for all, through my favorite technique: simply looking at the hard numbers. So, I selected a group of 10 well-known oil and gas companies, which as a group, literally represent the "best in class."
In a nutshell, these 10 companies spent, on average, $82 million per day for a decade to merely keep their production flat.
As I dug into this new data, it suddenly dawned on me why so many people get confused at what oil and gas economics are about. It turns out that GAAP accounting, combined with technology changes, has created what could almost be described as meaningless financial numbers for companies in the exploration and production of oil and gas.
On a per barrel basis, the apparent cash cost to create oil is just over $6 per barrel including overhead. Even after deducting DD&A, some other expenses and paying a hefty
$14 to $15 billion in taxes, these 24 companies, just in their exploration and production business, generated $20 billion after-tax or almost $4 per barrel in both 1996 and 1997.
Look at the stunning difference, though, when you change from using GAAP accounting and return to an old fashioned "cash-in, cash-out" system. Remember the $50 billion of "free cash"? It ignores cash expenditures of $26.5 billion in 1996 and $34 billion in 1997, which were capitalized onto their company balance sheets. These costs ultimately do get expensed as DD&A over a fuzzy estimated life of various oil and gas fields, but whenever prices fall, "impairment to value" tests cause DD&A to get written down. So, while the cost to maintain flat production soared, the reported exploration and production expenses using GAAP accounting methods fell.
Their breakeven cash cost after-taxes totaled almost $16 per barrel.
These numbers show in graphic detail how much money any significant oil and gas producer must spend merely to keep production flat. Technology did wonderful things for the oil business through the past decade, but it also accidentally created dazzling illusions that costs were dropping down when they were actually starting to soar.
Before leaving these "best in class" numbers, you can argue, based on these figures, that the price of a hydrocarbon, on a barrels of oil equivalent basis, must be in excess $20 per barrel if these participants want to make a return on total capital equal to their cost of capital. The idea that a clearing cost for an efficient oil company was around $6 per barrel was simply an illusion.
So the picture becomes even more confusing. If the oil glut is possibly an illusion, and if the real cost to produce oil is far higher than $10 per barrel oil allows, then why did the industry suffer through the worst collapse ever? The answer is simple. We now live in an era of paper barrels. Oil prices are set on the floor of the NYMEX. Whatever the paper barrel prices end up each day becomes the de facto cash price for oil almost every day.
Over the course of the past two-and-one-half years, in the few times when the funds had a net long position in NYMEX crude contracts, oil prices had risen, generally by a wide margin. Conversely, when they changed their view and turn back into net short holders, oil prices fell, often by a lot. Whether this makes any sense is an entirely different matter. But, the data is straightforward and hard to refute.
In the world of paper barrel pricing, oil could drop to $5 per barrel. In fact, paper barrel prices could go anywhere. The system has no circuit breakers. There is not even the mechanism to only short an oil contract on an up-tick, like exists in the rules of shorting common stocks. But, paper barrel pricing only lasts until supply and demand meet. Then, fundamentals regain the lead. Real physical supply and demand constraints always win out over paper markets. Oil prices would have ultimately have risen, even had OPEC not engineered this week's production cuts, because $10 oil will have a savage effect on the world's current oil supply.
My worry is that even our estimated drop will be too light. There is a chance that by year-end non-OPEC supply could drop by as much as 3.5 to 4 million barrels per day. While this is not a most likely case, it is not impossibility, either.
When I see the rig count in a state such as Kansas, which two weeks ago had only two rigs at work, or the state of North Dakota, which last week had not one single rig at work, let me assure you that it will be easy for the U.S. to lose 1 million barrels of daily oil supply. Whether we can recover from this bout of $10 oil is an entirely different matter.
This is an industry that needs to spend virtually all the cash that $15 oil generates, simply to maintain flat supply.
You do not need to shut in a well to effect a drop in supply. You merely have to experience "depletion."
Almost none of the published oil supply estimates have any model for the decline rate of the existing production base production, let alone how this decline rate will likely increase. Every field ever found declines at some point. And, when the decline begins, it generally accelerates.
Look, though, at the what the fury of depletion rates are all about. The world's current oil and gas production base is just over 110 million barrels of oil equivalent per day. When I first began preparing a graph to show how much fresh supply needs to be added to cope with depletion, I used a 3% estimated depletion rate. Before long, I realized that a 3% decline was far too low. So, I produced the graph you now see which shows the impact of both a 5% rate and a 10% rate. However, this was before I realized the difference between gross depletion and net declines. By definition, this dotted line must be gross, before anything is done to halt the decline.
Thus, to merely keep the current production base flat over the next 11 years, so we begin the year 2010 with the same amount of hydrocarbon supply as we now enjoy, the industry must add an astonishing 83 million barrels per day. And, this has zero impact on any further growth in demand.
It turns out that most everything we buy is simply a commodity in one form or another: Microsoft's software, personal computers, diamond rings, and even cars. However, hydrocarbons might rank as the world's most precious, costly and certainly most useful commodity, even exceeding the Internet! |
