Enjoy the cheap petrol, while it lasts  

Articles in the mainstream press about peak oil are pretty rare these days, but the SMH has one on the subject that never mentions the phrase (and flippantly dismisses Iraqi oil on the way) - Enjoy the cheap petrol, while it lasts.

With demand on the rise, existing wells drying up and a dearth of big discoveries, the oil price is only headed in one direction.

IN July 2008, the oil price hit a record high of $US147 a barrel. In its journey from the lows of 1998 to the highs of last year, many reasons were put forward for its ascent. Explanations included a so-called "war premium" , "a terrorist premium", hurricanes and evil speculators - the list of things and people to blame for the rise in oil prices was long.

As the price rose, calls were made by political leaders and interest groups for oil producers to lift production and for a cut in taxes on oil and petroleum. Accusations of price gouging and profiteering by oil companies and producers soon emerged.

Under the glare of TV cameras, OPEC promised to lift oil production and bring prices down. Yet the price continued its march upward and production rose only marginally.

The key point that appears to have been missed was that in the decade from 1998, demand grew about 16 million barrels a day while supply struggled to keep pace, particularly during the later years.

Now that the oil price has collapsed from $US147 to the $US40-$US50 region and it's off the front pages, it is yesterday's story. But is it really an old story. Have we been told the true state of play?

According to most mainstream news reports and even views presented by the investment community, oil was in a bubble and the global financial crisis has plunged the world into recession, which is leading to demand destruction for oil and hence the low oil prices.

However, in all the stories and debates that have taken place during the rise in oil price and its subsequent fall, very little attention has been paid to what is actually going on with supply.

What is also not well understood is that the oil price is set in what is called the "paper" or futures market, predominately in New York. The oil price is not set in the actual "physical" market as commonly perceived.

The players in the futures market do not all accept delivery for the contracts they trade. In fact, for a vast amount of trading that occurs, it is actually not done by oil companies or producers at all, and for a large portion of the contracts outstanding no actual oil delivery occurs. In effect, the physical barrels mirror the paper barrels and not the other way around.

In recent years, new investors such as specialised investment funds, exchange traded funds and hedge funds and oil speculators who play via the futures market have emerged. None of these are going to take oil delivery at contract expiry, either.

For the most part, it is a price-taking, not price-making, market for the producer. Rarely is this reported and this leads to a misunderstanding by the public as to the exact price setting mechanism for oil and the prices they pay at the petrol pump.

While ultimately fundamentals will win out, a big disconnect can occur between what occurs in the so-called paper market and what the reality is in the physical market. Markets are not perfect by any means. The credit crisis is a case in point.

It is in knowing these facts that we can begin to understand the basis of the wild gyrations in oil price.

To be sure, the futures market does play an important role. As with broader financial markets, there has been heavy selling in the oil market as various financial players seek to raise cash and deleverage their positions. Everything gets sold in the scramble to raise cash to pay off debts and shore up their balance sheets. This scramble would not necessarily result in prices that reflect the physical market or the fundamentals.

As we look at the numbers the International Energy Agency (IEA) publishes on oil production, a disturbing picture begins to emerge: conventional world oil production peaked about mid-2005 and has been on a slow decline since. Demand is being met by non-conventional oil sources.

Non-conventional oil is derived from activities such as oil sands and bio-oils. This production brings the supply of world oil productions up to about 86 million barrels a day, sufficient to meet current demand. Conventional crude production accounts for about 75 million barrels a day. Non-conventional sources are more expensive and require oil prices to be upward of $US30-$US40 to be viable. In fact, according to the IEA, to significantly expand non-conventional oil production to meet demand growth, prices would need to be well above current levels to make any sense.

Non-conventional sources are expensive compared to cheap Middle Eastern oil. Even deep water and ultra-deep water oil are expensive compared to Middle Eastern oil and still require oil prices well above current levels to be viable.

In the conventional oil space, Saudi Arabia, for so long the world's biggest oil producer, could potentially lose its leadership in conventional oil production, with Russia almost at level pegging according to 2007-08 data. In terms of overall energy production Russia is now the world's biggest producer.

Moreover, Saudi Arabia is resorting to massive water injections into some of its major wells to maintain production. It is difficult to know what are their true reserves and production capability.

According to IEA data, it appears Saudi Arabia's production peaked in 2005; it has not been able to surpass that year's production and has produced less and less oil in subsequent years, despite the "increased production rhetoric" that it maintains.

Unbeknown to most people, oil field discoveries peaked during the 1960s and 1970s. During the 2000s, there have been relatively few new major field discoveries - about 70 so far, versus more than 1200 during the 1960s and '70s.

In the IEA World Energy Outlook, it is estimated that the oil well decline rate is running at about 6.7 per cent. It is estimated that natural decline rates (without any capital spending to maximise production) would run at 9 per cent.

There are about 70,000 oil fields in production, with about 20 super-giant fields that account for more than 25 per cent of world production. Most of these fields are at least half a century old and well past their peak production years. For example, the top three fields of recent times in terms of reserves - Ghawar (Saudi Arabia), Cantarell (Mexico) and Burgan (Kuwait) - are all in decline.

The world is excessively reliant on oil production from "old" fields and has resulted in an implied belief of "cheap" oil continuing to flow.

Oil production is expected to decline at a significant rate from here on. To meet demand this decreased production output must be replaced and in fact added to, such that demand growth can be met in years to come.

The credit crisis has seen funds dry up for oil exploration and the commissioning of new production. Numerous projects globally have been shelved or put on hold. Many non-conventional sources of oil become uneconomic at $US30-$US40 a barrel and cannot be sustained long-term if prices remain at, or drop below, these levels. The key decision variable will be sustainable long-term price not short-term price blips. ...