The Hindu Business Line : Stage set for an oil bull run

Even if we discover a new planet Earth worth of reserves, it would postpone peak oil only by about 33 years at the current consumption rate of 30 billion barrels a year, say SHANMUGANATHAN N and SATISH KUMAR, assessing the depletion scenarios and looking at the least acrimonious ways of tackling this deficit.

We have been presenting a case that a higher oil price is warranted by supply shocks alone. In the first essay in the "Hubbert Speak" series (June 20), we focussed on the macro-side — that is, global reserves — that would limit future production. The argument was based on the fact the planet has about two trillion barrels of crude, and that peak oil happens when we have consumed about 50 per cent of these reserves.

"Hubbertians" provide slightly different estimates of the reserves. Hubbert himself puts the reserves at two trillion barrels (2tb), Prof Deffeyes (author of Beyond Oil: The View from Hubbert's Peak) at 2.013tb and Dr Campbell (of Association for the Study of Peak Oil and Gas) at 1.9tb.Our argument is that, even if all of them are wrong, none of them is "very wrong". The fact that we have consumed over 1tb till date should mean that we are perilously close to Hubbert's Peak, if not already past it.

Even if we discover a new planet Earth worth of reserves, it would postpone peak oil only by about 33 years at the current consumption rate of 30 billion barrels a year. However, our monetary systems have been designed with assumptions of perpetual growth and so the peak will happen far sooner, perhaps in 15-20 years. Given that we do not have another planet Earth worth of reserves to discover, we probably have, if at all, a couple of years before reaching Hubbert's Peak.

Till this point, the focus has been on estimating the peak oil date on the basis of reserves without emphasis on the supply side caused by increased production. So what does a study of current production plans indicate? As will be evident soon, the demand-supply gap is set to worsen over the next few years and net production is set to decline — the very same conclusions reached by these writers on the basis of the reserves data.

Disappearance of spare capacity

From a spare capacity of over 5mbpd just four years back, we are now at a situation of less than 1mbpd (source: EIA, Apr 2006). Even in the absence of external shocks, this 0.5 mbpd isn't going to last too far into the future as Chart 1 indicates. All mature fields start declining once they reach their peak production with depletion rates ranging from 4 to 10 per cent.

Ironically, the main reason for the higher depletion rates is "New Technology", that allows for a faster-than-normal extraction without increasing the recoverable reserves. So any of the new fields that come online have to first account for the depletion in the existing fields before adding to the Net capacity. Given in Table 1 is an estimate of planned production till 2010.

As we can see, even without accounting for external shocks, we would be running a deficit this very year. Some producers have reported depletion rates much higher than the 3 per cent we have assumed. For example, for Saudi Arabia it is 8 per cent, Venezuela 7.8 per cent, UK at 8.9 per cent and Mexico at higher than 10 per cent.

So if our depletion rate of 3 per cent turns out to be conservative, then we are in greater supply shocks in the years ahead. And this is without factoring in Iran, Iraq, Nigeria, Weather, rig shortages etc.

We had earlier stated that the reserves as reported by some countries are highly questionable. Supporting that view, some of the largest fields have reported stunning declines. The Wall Street Journal (Feb 6, 2006) reported that because of encroaching water and gas at Cantarell, Mexico's biggest oilfield, output could drop precipitously over the next few years. From the current level of 2mbpd, production could drop to 0.9mbpd in 2007 and to 0.5mbpd by 2008.

In November 2005, Kuwait admitted that its largest oil-field Burgan is in "serious decline", when it stated: "Burgan, world's second largest oilfield having produced 2mbpd for decades is exhausted... by reducing production to 1.7mbpd we hope this sustains productions for decades to come".

More interestingly, a Petroleum Intelligence Weekly report of January 2006 stated that Kuwait's reserves could be just 45bb instead of the official claims of 98bb.

The conclusion is that the future "reserve surprises", if any, is likely to result in higher depletion rates rather than lower depletion rates. There are also other uncertainties that could alter our estimates of demand and supply. Listed in Table 2 are the factors and it's easy to see why any optimism isn't warranted.

Conclusions

So what happens by 2010 when demand would be 89mbpd and supply is likely to be 85mbpd? Outside of the "Oil Depletion Protocol" as suggested by Dr Campbell, we think a price rationing would be the least acrimonious way to solve such a problem and that would send prices soaring.

It is amusing that Lord Browne, Chairman of British Petroleum, is predicting that prices will drop to $40 in the medium and $30 in the long-term. The only scenarios that would permit such a situation would be the following:

Increased Supply: Chances for such an event are very bleak as any new project takes 5-6 years to come online (and that is after the oil has been discovered).

Lower Demand: We have assumed a very conservative 1 per cent increase (much lower than IEA estimates). Of course, a worldwide recession can indeed make that assumption go wrong.

Depletion lower than 3 per cent: A possible event though not very probable. But even at 2 per cent depletion the surplus capacity would be so miniscule that any shock can immediately wipe away that surplus.

As we can clearly see any hope of prices coming down anytime in the near future is just wishful thinking. In fact, we would need a worldwide recession that would decrease demand significantly or else the price of oil is going to zoom. On a longer time-frame, as we start on the downward slope of Hubbert's curve, oil will only get more and more expensive. We do not know what Lord Browne means by "long-term", but if our lifetime is a good enough definition for "long-term", then $30/barrel is not going to happen in that span.

(Shanmuganathan N is a financial advisor and can be reached at shanmuganathan. sundaram@gmail.com. Satish Kumar works at Sterling Commerce and can be contacted at satish_subbiah@stercomm.com)