Part 2:
Surviving the Energy Crisis:
Paper Barrels, Missing Barrels, the Illusion of Technology andDepletion
National Ocean Industries Association27th Annual MeetingWashington, D.C.
March 27, 1999© Matthew R. Simmons.
It is an honor to address the membership of NOIA, an organization that
I have a strong fondness for, about the serious problems the oil and
gas industry has struggled through over the past year. When Bob
Stewart first suggested that I address you, oil was selling for just
above $10 per barrel and my talk was to address why this has created a
bone fide energy crisis. A lot has changed in just six weeks. With
luck, this week's announced production cuts by OPEC and several other
key oil producers will stick. If so, prices will stay at today's
levels or rise even higher, possibly much faster than many think. If
so, the industry moves back from the brink, but just in the nick of
time. However, if prices return to the $10 to $12 range, major
portions of the industry risk being destroyed.
If the worst of the crisis has hopefully passed, have we even started
to see the consequences from abnormally low oil prices? Or, are the
effects just beginning to work through the system, particularly in
regard to future non-OPEC oil supply? Finally, assuming the worst is
over, will the industry leaders learn from flirting so close to the
edge of a genuine disaster?
These are not trivial issues. Hopefully, over the course of the next
30 minutes, I can discuss how the industry survives this energy crisis
brought on by paper barrels, missing barrels, the illusion of oil
field technology and the furor of depletion.
...the 1998 oil collapse was the worst since 1900. Never in the past
98 years have we had a longer and more painful drop in what is still
the world's largest and arguably most important commodity.
The cover of the March 1st The Economist probably captures the essence
of the story better than any oil price graph. Their story, "Drowning
in Oil," encompasses the entire sordid tale: the world is awash in
excess oil. Technology is rapidly bringing down the cost of producing
oil while enabling new supplies to come onstream at a fast and furious
pace. Falling demand throughout Asia and other developing countries
merely exasperated the problem.
The story gets worse. It suggests that the price drop so far could be
just the beginning. According to this article, there is a risk that
oil could drop to as low as $5 per barrel and stay there for the next
five years. Ultimately, these low prices finally knock out many
sources of high-priced oil, which might be exactly what Saudi Arabiahas in mind.
I happened to have read this story with particular care since I spent
over an hour on the telephone with The Economist energy writer less
than a week before the issue hit the press. So, I had a good preview
of his $5 oil views. While I commented to him that it would probably
be impossible for oil prices to stay at $5 for such a long time
because even $10 oil for any extended period wipes out so much supply,
it was clear that his mind was made up. His story was essentially
finished. And, it reminded me of the wide number of people in our
industry who either fear or believe this same theory.
Regardless of where future prices go, the past year is history and the
drop was a record breaker. Here is the culprit for the sharp drop of
oil prices over the past two years. We had too much excess supply. It
seems hard to even remember that West Texas Intermediate crude oil
actually crossed $27 per barrel as 1996 came to a close. But, from the
start of 1997 onward, supply began to exceed demand; at least in the
minds of the International Energy Agency, or "IEA," whose widely
published supply and demand statistics for petroleum have become the
source data for almost all forecasts throughout the world.
According to the IEA's most recent estimates, world oil supplies have
exceeded demand for eight consecutive quarters. The worst gap was in
the first half of 1998, when first quarter excess supply was 1.5
million barrels per day and second quarter excess supply ballooned to
over 3.5 million barrels per day. This oversupply would have been bad
enough, but it was surrounded by six other quarters of too much
supply. As these excesses grew, oil prices fell and the term "Oil
Glut" quickly became a household term.
As the bearish news of oil grew, it became hard to decipher whether
the problem stemmed from too little demand or simply too much supply,
or a bad combination of both. The real story, as always, lies in the
numbers themselves.
Here is what happened, assuming the IEA numbers are correct. The
projected demand in 1997, using the highest original demand estimate
compared to the most current demand numbers of the IEA, was off by
400,000 barrels per day, a modest one-half of one percent. 1998 demand
was 1.9 million barrels per day less than original estimates, which
were prepared just as the Asian Flu was breaking out and before anyone
had news about the rapidly approaching El Nino weather patterns.
Losing 1.9 million barrels per day of demand is not a trivial matter,
but it only represents a change of only 2.5%. 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.
Since the drop in demand was not as earth shattering as so many news
reports indicated, was the obvious culprit a soar in supply?
Ironically, the supply revisions all turned out to be cuts, not rises.
With the benefit of hindsight, it is amazing, or possibly
mind-boggling, to see what happened to all the world's oil supply
outside OPEC over the past two years. At the start of 1997, the IEA
pronounced that non-OPEC supply was about to enjoy the largest
increase ever, outstripping the projected growth in demand and putting
severe pressure on OPEC to reduce its supply.
Their original 1997 non-OPEC supply estimates had supply averaging
45.3 million barrels per day and by year-end 1997, exceeding 47
million barrels per day. Their estimates turned out to be wrong to the
tune of almost 1 million barrels per day. This error was merely a
warm-up to the downward supply revisions in 1998.
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 perday.
I will also bet anyone that the IEA's most recent fourth quarter
numbers are still too high. Over the next few months, they will
quietly come down another 200,000 to 300,000 barrels per day bringing
the shortfall to at least 4.5 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.
The only surge supply that did occur throughout this brutal collapse
in oil prices was Iraqi crude, which came on like gangbusters. 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.
What this behavior brings into question is why the Iraqi government
was so intent to push the production limits of its oil fields so hard.
Unless the UN lock box leaks like a sieve, no money raised by these
oil sales went into the government's hands.
There is an extremely interesting update on the current state of
Iraq's oil industry, which was published three weeks ago by Petroleum
Intelligence Weekly, after their London correspondent spent over a
week in Iraq, visiting both Baghdad and touring the Iraqi oil fields.
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.
The writer happened to be in Iraq just after U.S. planes accidentally
knocked out a major pumping station, which shut off almost half of
Iraq's exports. With amazing speed, Iraqi technicians repaired this
facility so Iraqi oil exports could continue flowing. When questioned
as to why an around the clock repair effort had been made, 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."
In a period of time when many respected oil analysts were speculating
that Saudi Arabia was master-minding the low oil prices to regain
control of its market share, we could have possibly been witnessing a
classic case of "economic warfare" with Iraq intentionally
overproducing its oil fields and underpricing oil in various world
markets to drive the price as low as possible. Whether this was
planned or accidental, they did a good job. This surge in Iraqi
production will turn out to have the same impact on our U.S. oil
supply as if Iraqi F-16's "were striking" U.S. oil fields. We still
may not have seen the end of an intentional plan for Iraq to drive oil
prices low, although this past week's OPEC production cuts might have
brought this effort to a close.
A close examination of the supply and demand numbers for oil show a
far different picture than what has been so widely publicized. Demand
was revised downward, but it still grew and the downward demand
revisions were less than one-half the downward revisions in all
non-OPEC supply. Non-OPEC supply had no surge. It has been effectively
flat for the past three years. So, was it just Iraq that drove the
price of oil so low? Or, is this what happens to the price of any
commodity when supply exceeds demand by any meaningful amount?
The story gets stranger. Be cautious as you absorb these IEA numbers
because they are probably wrong. The excess supplies that these IEA
supply and demand numbers portray cannot be verified by any reported
estimates of OECD or worldwide petroleum stocks. But, the IEA oil
analysts are standing firm on their supply and demand estimates and
believe, with some conviction, that we have "missing barrels" of oil
stored in various exotic places around the world, though they also
admit that they have not a clue where all this oil is hiding.
The "Missing Barrel" issue first surfaced last April when the IEA
noted that the majority of the excess supply over the previous six
months had yet to show up in any reported petroleum inventories. They
created the term "missing barrels" to explain what they also entitled
an "Arithmetic Mystery."
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 becorrect.
Simmons & Company published our first report about these famous
missing barrels in May 1998. We suggested that unless there was a
quick and massive revision to reported OECD petroleum stocks, the
IEA's widely publicized excess oil supply was vastly overstated. At
the time, I wrote that by Labor Day, we would either have found these
missing barrels, or they were either "in the ground," meaning they
were never produced in the first place, or "in the air," as they wereconsumed.
There were no major revisions and the problem refused to go away.
While a remarkably few number of oil executives or energy analysts
ever took time to understand what the issue was about, the missing
barrels issue soared to a level that almost defies one's imagination.
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.
What has been badly confused with these missing barrels is also a
clear build in observed petroleum stocks. Over this same two-year
period, reported OECD stocks have grown by 225 million barrels. Of the
increase, three-fourth's is in commercial stocks. The balance is in
governmental strategic stocks.
If the IEA's missing barrels really exist, they have to be added to
the recorded growth so we have a stock build of over 900 million
barrels to absorb before our markets get back into balance. Even with
a 2 million barrel per day production cut, it would take a year or two
of constant stock draw before any sustained price relief is assured.
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.
I find this missing barrel issue simply incredible. There should be a
lot of red faces throughout the entire body of petroleum experts if
they prove to be an illusion.
In my opinion, it would be virtually impossible for these barrels to
exist. There was never the tanker capacity to get them across the
water and no tank farm capacity large enough to store so much extra
supply. It should have been easy for people to add up the numbers.
If there is any excuse to why so few analysts even understood this
issue, the drop in oil prices was so violent that most people simply
assumed the world had to be in the midst of an oil flood.
Even the IEA analysts last September woefully wrote that petroleum
data was getting way less reliable, as their missing barrels refused
to show up. But, they stated that "a touchstone in times of such data
uncertainty is to simply look at the screen." In other words, the
barrels must be hiding, otherwise, the price would not be so low. As I
read this pathetic plea, my response was that it represented a classic
case of circular logic. 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!
What makes the issue of the missing barrels so important is that if
they do not exist, then the IEA supply and demand numbers have to be
adjusted. Once that adjustment is made, you will find the worst of the
vast oil glut turned out to be only 2.2% of world oil supply for three
months last year. Two of the other seven quarters were in balance. In
three other quarters, the stock build ranged between one-half of 1%,
one-half of 1% and 1.1%. And, we finally had a stock draw to the tune
of 500,000 barrels per day in the fourth quarter of 1998.
It is fine to explain the collapse in oil prices as the result of too
much supply on the argument that any incremental barrel is simply
glut. But, I would argue that we need this much extra supply sometime
over the past 98 years without suffering a price collapse so severe
that it threatened the mere existence of some of our finest oil and
gas companies. In fact, it is hard to fine tune most industrial
markets any closer than these numbers suggest.
In light of the IEA's potentially incorrect numbers, it is
enlightening to examine several other 1998 supply and demand estimates
which have been published over the last six weeks. Here are three
other views compared to the IEA's estimated 1998 oversupply of 1.5
million barrels per day. Petroleum Intelligence Weekly numbers show an
excess supply of 600,000 barrels per day, but they also have 63
million missing barrels in their estimates, which they readily admit.
Groppe, Long & Littell published a special supply and demand
presentation in February primarily to highlight how misleading the IEA
numbers have become. In their estimate, 1998 excess supply totaled
only 100,000 barrels per day, or a tiny one-half of 1%.
The recently published Arthur Andersen/Cambridge Energy Research
Associates 1999 World Oil Trends data does not include a published
supply and demand estimate. But, a model can be developed by adding
their data on natural gas liquids, petroleum consumption, oil
production and then using the IEA's refinery processing gain
estimates. Through this analysis, they have an implied excess supply
of 400,000 barrels per day. And, the adjusted IEA numbers, once their
1998 "missing barrels" are excluded, come right in line with these
three other sources at 300,000 barrels per day excess supply.
All of this comes back to the strange "Missing Barrels" and the fact
that if such barrels do not exist, then we never had anything remotely
as awash as the IEA's bearish numbers suggest.
Before I leave the subject of petroleum stocks, I want to return to
the growth in petroleum stocks that can be counted and question how
much of this build was real excess supply. Remember my prior reference
to the fact that commercial petroleum stocks in the industrialized
countries of the world grew by 175 million barrels over the course of
the past two years? This growth consisted of the following: crude
supplies accounted for only 30% of the increase, they grew by 6% over
the course of two years. Motor gasoline grew by 30 million barrels.
Residual fuel stocks actually fell. The only clear sign of real excess
supply was in the middle distillates. This is heating oil. We clearly
had too much. This happened because of two back-to-back El Nino
winters. But, a heating oil overhang has nothing to do with an
oversupply at the wellhead.
It is also interesting to note that 75% of this entire stock build
occurred in the U.S. This is the one country where every industry
participant has been desperate to effect just-in-time inventory as
margins have been so poor. But, it is also one part of the world
enjoying record levels of demand for virtually every petroleum product
other than heating oil over this same period of time.
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.
But, the growth in these stocks has created another serious problem
that began creeping up on the industry several years ago, with zero
notice or fan-fare. 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 oileach day.
The rumors that the Cushing, Oklahoma oil terminals were so full last
spring that you could not find any place to put an extra barrel were
true. The system was operating at 100% capacity. But, it was
enlightening to see that all this high level of PADD II supply turned
out to be needed to make it safely through the Midwest's 1998 summer
driving system, a luxury we might not enjoy this coming summer.
The lack of adequate storage facilities is a real problem that needs
to be addressed, but like having too much heating oil, it has nothing
to do with having a glut of too much oil being produced at thewellhead.
If there is little evidence that a vast flood of excess supply created
the worst collapse in oil prices this century, then perhaps the
"Technology Theory," which is repeated so often, is true. You have
heard the story as many times as I have. Oil field technology has
created a continuously fall in finding costs. We now have far greater
recovery of the oil we simply used to leave in place. It is easier to
find new fields these days. Success rates are up by as much as
eight-fold what they used to be. Projects are developed in far faster
periods of time, etc. etc.
Thus, $10 oil is now normal. It simply represents "technology in fullbloom!"
This technology myth has been repeated so often that most energy
writers are certain it is true. The Economist writer arguing that we
were possibly heading to $5 oil had clearly heard this story from too
many seemingly knowledgeable people to even question whether the story
had a grain of truth.
I have a hard time deciding which is a worse industry-wide mistake:
missing barrels or the technology hype. This was probably a harmless
theory as long as oil never got close to this level, but it became
totally invalid once such prices really happened. 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."
All operate on a worldwide basis and all have access to the best
technology invented. All have financial resources to do almost
anything within reason. And, most important, all have audited
financial data and use similar accounting techniques.
Here is what I found. Over the course of the past 10 years, 1988
through 1997, these companies spent $298 billion on their exploration
and production activities. As the decades progressed, costs
continually rose. Many of these companies reported continuous upward
revisions to their reported reserves. But, as a group, their daily oil
and gas production increased by only seven-tenths of 1% each year.
In a nutshell, these 10 companies spent, on average, $82 million per
day for a decade to merely keep their production flat. For those who
want to argue the real cost of an incremental barrel of oil, you can
come up with some pretty amazing sums. If you price out the cost to
change 15.5 million barrels of oil equivalent each day to 16.5
million, using the cost to create a peak barrel, these best in class
companies spent $303,000 a barrel!
I was frankly surprised at these numbers. They were far more graphic
than I suspected, though I suspected what the trend might show before
having one of our analysts spend the better part of five weekends
digging out this data.
To make sure we had not made some simple miscalculations, I decided to
carefully dig into some other numbers contained in an annual book of
petroleum data entitled The Performance Profile for Major U.S. Energy
Producers to see if any different conclusions could be reached. This
book is published by the Department of Energy and uses results from
our top 24 oil and gas companies. All 10 of my best in class are
obviously included, though some foreign activities are excluded. But
this report also picks up the results from 14 other companies. And,
the numbers are laid out in far better detail than any annual report discloses.
continued.... |
