The Hindu Business Line : Crude oil: Super-spike ahead?

With the gas reserves position still unclear, and the uncertainties associated with the infrastructure, such as dropping rig count and aging pipelines, it should not be surprising at all if there is a super-spike in the price of crude oil in the years ahead. The real question is "how high and for how long," say N. SHANMUGANATHAN and SATISH KUMAR.

The crude oil price may have dipped in recent days, but that is no cause for long-term cheer. In estimating the future production of oil and gas, of particular importance is the lack of transparency in the reserves as well as field-by-field production data that permit accurate extrapolations. From a situation where almost 85 per cent of reserves were under the control of international oil companies during the 1950s, today these companies control less than 16 per cent. The rest are controlled by national oil companies, which are not subject to the same set of disclosure rules as the international oil companies are. In fact, it is in the interest of the national oil companies to maintain as much opaqueness as possible.

With those caveats in mind, it is probably a good time to present an estimate of the future production profile. The most detailed and methodical estimation comes from ASPO (Association for the Study of Peak Oil and Gas). It shows the combined package of hydrocarbons (Oil and Gas - Conventional + Non-Conventional) peaking by 2010.

Uncertainty limited

The major oilfields have been extensively drilled and so the uncertainty regarding the oil reserve estimates is limited. It is in the estimation of natural gas that there is a large uncertainty as very little drilling and almost no independent verifications have been done. The data regarding gas fields are so sketchy that they make the figures on oilfields look pristine. So, at this point, one is just "assuming" that the gas is there. The issue associated with the world's largest gas field, that is, the North Field is a case in point.

Qatar's North Field and Iran's South Pars (a geological extension to Qatar's North Field) are assumed to contain nearly 19 per cent of the world's reserves of natural gas. But, today, they have only two producing platforms in the huge area (over 3,000 sq km) and the assumptions of homogeneity of the field have been questioned when ConocoPhillips hit dry holes while drilling for the third platform.

Qatar has put a moratorium on all future projects to give Qatar Petroleum time to conduct field tests on the reserves. The results thatwill be known in 2008 will confirm the true potential though it is unlikely to be anywhere close to the currently believed numbers.

So it is possible that the above estimates turn out to be higher than the actual numbers especially for gas. Even otherwise, there are various issues in combining all types of hydrocarbons into one production pool:

The spare refining capacity is for conventional oil only. So even if we increase the production of heavy oil, we may not be able to use the same due to lack of refining capacity.

Most industrial applications cannot make a choice between utilising oil and gas on the basis of availability or price. So, shortage of either of the fuels could mean a problem even if the other is available in excess.

Natural gas is much more of a local commodity as it cannot be easily transported by tankers, as in the case of oil. One needs to build special LNG terminals and tankers or deep-sea pipelines to facilitate gas transportation.

None of the above problems can be solved in the short-term, that is, less than five years. On a longer time-frame, there is a serious problem of the declining production curve to contend with.

Most Hubbertians would agree with the above production profile but they disagree in terms of when the impact would be felt. They can be classified into two types — Early Peakers and Late Peakers. This difference comes about because the above production profile does not take into account the uncertainties associated with the infrastructure.

The Early Peakers argue that the "Wolf is in the Room" while the Late Peakers, though agreeing to the fundamental nature of the problem, contend that the "Wolf is at the Gate", that is, onestill has a few years (peaking between 2009 and 2012) before the problem hits us.

Early Peakers

The fundamental argument of the Early Peakers is that the 20-year bear market in oil has left the energy industry (upstream, downstream and production) infrastructure in shambles. They raise many key issues.

Rig Counts

From a peak of more than 5,500 rigs in 1981, less than 3,000 are operating today with more than 60 per cent of them being 30 years old. What this 25-year bear market in the oil rig industry has achieved is has left just a handful companies with the capability to build new rigs.

Not only that, the average age of a driller is now more than 50 years with very few new hands; who would want to deliberately enter a declining industry. The impact is a postponement of current projects due to the lack of availability of rigs and skilled workers.

Aging Pipelines

The average pipeline in the US is about 50 years old, while across the rest of the world it is about 40 years old.

The average planned lifespan of these pipelines was about 25 years, which means one is dependent on an aging and fragile infrastructure. Russia's Transneft, the world's largest pipeline operator, maintains a network of about 50,000 kilometres. Mr Semyon Mikhailovich, President Transneft, says: "At our current pipe replacement rates, the last station will have its upgrade completed 28 years from now... It should have been done yesterday".

While commenting on the recent BP disaster, energy industry investment banker Mr Matt Simmons says, "We'll look back on this event as the Pearl Harbour Day in energy. The chance that the leaks and corrosion found at Prudhoe Bay by BP, Europe's second-largest oil company, are an isolated occurrence is zero".

Oil Well Maintenance

Ironically, when the prices were low, companies were forced to produce at full tilt skipping the necessary maintenance schedules. This overproduction has severely damaged most fields. In a study of North Sea operations of Norway by the nation's Petroleum Safety Authority in June 2006, it was found that 18 per cent of the 406 wells had weaknesses and 8 per cent had faults that demanded that they be shut.

This has forced Norway to reduce is production by 25,000bpd (barrels per day) this year. The author of the study commented in August 2006 that, "This is a subject that people don't like to talk about. This is not particular to Norway. This is an industry problem".

Given the nature of the problems mentioned above, it should not be surprising at all, if we have a super-spike in the price of oil in the years ahead. The only silver-bullet would be a recession that would decrease demand significantly.

These conclusions in fact seem to be "no-brainers". The real question is "how high and for how long". Unlike the oil spikes of 1973 and 1979 — both of which were temporary, due to their political nature — it is going to be very different this time.

(The authors are Chennai-based Financial Advisors. They can be reached at shanmuganathan.sundaram@gmail.com and satish_101@yahoo.com.)