by Richard R. Loomis

Consultants and experts everywhere love to make predictions about where the price of oil, natural gas, gold and other commodities will be priced in the future. In the past I have shied away from making those predictions because it is a surefire way to get it wrong, and while it makes for bold headlines it typically ends in excuses. However, as the price of oil sank to the mid $50s last year but the fundamentals had not significantly changed, I could not help myself. In a moment of weakness while visiting with one of my readers, I suggested that it would not be long before the price would be snapping back to the $100 level and that natural gas could not possibly sink below $5. He, of course, disagreed and suggested that not only would the price of oil continue to fall and remain low, but natural gas prices would continue to fall as well. Neither one of us touched on gold.

After a long and vigorous discussion, we agreed that we would watch and get back together at the Petroleum Club to discuss again. Needless to say, an industry event does not go by without this individual pointing out that not only was I wrong, I was way off the mark.

So why would I once again decide to make the prediction that prices in the United States have to go up from current levels? Well, for once, we need only look at the fundamentals and the folly of man to see where we are going. We have a mix of pent-up demand, government intervention, international pressure and, of course, my favorite – unintended consequences. With this combination of upward pressure, how could I possibly be wrong?

While the media and the federal government found it easy to blame speculators for being the cause for the run-up in price during the summer of 2008, the root cause of those price swings was, and remains, demand. Currently our production exceeds our daily demand and we have some surplus supply. Globally we are still using more than 80 million barrels of oil a day and over 18 million of those are used right here in the United States. Interestingly enough this represents some very expensive projects that began in 2008 with the hopes of expanding in 2009. With the crash in oil prices those expansions never occurred and this is keeping the price in the $60-$75 range for oil and the $2-$4 range for natural gas. As long as this is the case, the prices will remain relatively stable and in a relatively narrow price band. Since the United States has been in a downturn, it is likely that the prices will not go up until the recession ends and the economy recovers. Experts think this could take anywhere from one to five years.

Stop the Presses!

The head of the Federal Reserve has declared that the worst of the recession is over.

“Since we last met here, the world has been through the most severe financial crisis since the Great Depression. The crisis in turn sparked a deep global recession, from which we are only now beginning to emerge.” Chairman Ben S. Bernanke said at the Federal Reserve Bank of Kansas City’s Annual Economic Symposium in Jackson Hole, Wyoming, in August.

If the recession is over, the economy should begin to grow. If the economy begins to grow, we should start to see an uptick in demand for oil and natural gas. Since any economy needs energy – and one that is recovering would naturally require more energy – and since most of our energy comes from oil, natural gas and coal, we should see the numbers begin to rise quite quickly. At the peak of the price wars of the summer of 2008, barrels of oil were trading at $149 and natural gas at almost $14. At the time we were using 20 million of those barrels daily in the United States. Even with a moderate recovery we could soak up another million barrels, taking us close to that level again. But in today’s world we are not the only country competing for the supply of oil.

We are already getting numbers from China and India that show that demand is rising and at comparable levels to 2008.China consumed 33.35 million metric tons of crude oil in June, which was up nearly 2.6 percent from the corresponding month of 2008 and was the third month in a row to register a year-on-year increase in demand, a Platts analysis of official data showed July 22.

As if that is not enough, we also need to consider that lower prices have caused a pullback of investment by the industry. Throughout 2009 the industry has postponed, delayed and cancelled projects that would have been drilled or built had the commodity prices not come crashing down. The International Energy Agency estimated that this pullback could create a shortfall of several million barrels if demand begins to rise again. At the $30 range, projects in the unconventional resources simply could not be developed and some producers had to shut in real production. Canadian tar sands require an oil price higher than $60 to turn a profit and shale gas requires a price of $5 or more. Additionally, several companies have announced layoffs and others have decided to merge, which foretells more layoffs. The most recent is the announcement that Baker Hughes has decided to buy BJ Services, creating a Halliburton-like entity. As demand begins to creep up in the United States, we will see the commodity prices rise. The current trend of oil rising from $30 to $70 also suggests that the prices will continue to rise.

For natural gas in the United States, there are some historical markers that we should also look at. We know that the price of natural gas goes up and down, but if we look closely at the last few cycles some interesting data reveals a pattern that foretells higher prices in the next 12 months. The last time that drilling dropped significantly was in 2002, when production fell 28 percent in conjunction with a 21 percent reduction in the price of natural gas. This was followed by gas prices increasing by 27 percent in 2003. Before this, in 1999, the drilling for natural gas fell by 25 percent because of a drop in price of 9.7 percent. This was followed by a price increase of 24 percent in 2000. Today drilling is off 41 to 50 percent so if the pattern continues, 2010 should be a very good year for natural gas prices.

To add to this issue we need to look at consumption on a daily basis. We currently produce 63 barrels of gas per day, and we need to add 15.75 barrels of new production each year to maintain the status quo. Since we know the rig count is off significantly, we could lose as many as six barrels; add to this the losses from the decline rates of gas wells and one can begin to see how the storage begins a drawdown of up to 16 barrels a day. That effectively soaks up the surplus supply and causes an increase in the price of natural gas.

Nearly 50 percent of our current production comes from wells that are less than two years old, so they have a steep decline curve. With these expensive wells not being drilled right now, the current set will decline rapidly before the industry has the opportunity to bring more shale gas into play.

So the number-one reason that prices will go up is pure economics: demand rising and supply reducing.

A No-brainer?

But just to be a contrarian, let us suppose that rising demand and lowering supply does not cause the price of oil and natural gas to rise and the market remains flat. We are not alone in raising this possibility. Self-proclaimed “energy icon” Karl Miller makes a credible case. “Mr. Miller cites the grossly understated number of jobless in the U.S., the grossly understated number of distressed and troubled mortgages/borrowers and lack of leverage available to the retail and industrial sectors as simply putting the absolute brakes on any credible demand increase,” said a PRNewswire release on Sept. 23. “The math is simple: no jobs, no credit, distressed home owners, equals no energy demand in either industrial, light commercial or retail sectors. The only people spending money right now in any meaningful way is the U.S. government.”

As Miller points out, we do have Uncle Sam standing behind us and spending our money. Congress is writing the next energy bill for the United States and it includes several critical parts designed to help keep the prices trending upward. The most obvious and discussed section of the bill deals with climate change. In the House bill and in the proposed Senate bill, this is the preferred method of reducing carbon dioxide (CO2) and other greenhouse gases and for raising money. Its side effect helps with the pricing of commodities by adding cost. The higher the carbon output of the energy the more cost is added to the price. So if demand does not cause prices to go up, cap and trade will.

In a cap and trade environment, energy becomes more expensive for the producer to provide and for the consumer to buy. Some sources of energy, like tar sands production or coal-fired generation, become unattainable. Since coal has the highest output of CO2 when used for power generation, it will be the hardest hit in this scheme. The idea can be best summed up by President Barack Obama, who said during his campaign, “If somebody wants to build a coal-powered plant, they can. It’s just that it will bankrupt them.” While cap and trade is not very good for coal producers it also has the interesting effect of making natural gas more attractive for power generation. Natural gas now accounts for 25 percent of our power production. Additionally, over the last ten years almost all of the new generation built in the United States has been set up to run on natural gas. If the cap and trade idea works as it should, this should cause more demand for natural gas – again pushing the price up as already discussed.

The plan is also set to remove subsidies from domestic producers of oil and natural gas to make the production of hydrocarbons more expensive. In his testimony on September 10, 2009, Alan B. Krueger, assistant secretary for economic policy and chief economist for the U.S. Department of Treasury Subcommittee on Energy, Natural Resources, and Infrastructure, outlined what the administration’s intention:

“Current law provides a number of credits and deductions that are targeted towards certain oil and gas activities. The Administration proposes to repeal the following tax preferences that are currently available for certain non-integrated oil and gas firms: (1) the use of percentage depletion with respect to oil and gas wells; (2) the exception to passive loss limitations provided to working interests in oil and natural gas properties; and (3) two-year amortization of non-integrated producer’s geological and geophysical expenditures, instead allowing amortization over the same seven-year period as for integrated oil and gas producers. Eliminating these three tax preferences is projected to raise revenues by approximately $10.3 billion from 2010 to 2019.

The Administration proposes to repeal the following tax preferences that are currently available for both integrated and non-integrated oil and gas firms: (1) the expensing of intangible drilling costs; (2) the deduction for costs paid or incurred for any tertiary injectant used as part of a tertiary recovery method; (3) the ability to claim the domestic manufacturing deduction against income derived from the production of oil and gas. Eliminating these three tax preferences is projected to raise revenues by approximately $20.3 billion from 2010 to 2019.”

Later in his testimony Krueger explained that by ceasing these subsidies we will discourage exploration in the United States. Later in the month when President Obama addressed the G20, he asked the leaders of the industrialized world to stop subsidizing hydrocarbons and hydrocarbon use within their countries. If they follow through on their taciturn agreement, the rest of the world will also see higher gasoline prices.

Additionally Secretary of the Interior Ken Salazar has delayed the opening of the offshore allowed by President George W. Bush and Congress when they lifted the ban and went further in restricting access to federal lands. Lately, he has even gone after the royalty-in-kind program, taking away the ability for companies to pay their royalties in product instead of in cash.

“Clearly, the Department’s energy leasing and royalty programs have not been working as they should and the American people have not been receiving the full benefits from these valuable assets. After a thorough review of the controversial royalty-in-kind program, I am today announcing a phased-in termination of the program and an orderly transition over time to a more transparent and accountable royalty collection program,” Secretary Salazar said on Sept. 16.

Since cash is extremely hard to come by in today’s environment, it stands to reason that smaller offshore producers will either have to reduce production or sell their assets at a reduced price to larger producers with balance sheets that can support the additional cash payments. Some smaller and less profitable oil fields will remain shut in and never be produced under this scenario.

So the second reason that commodity prices will rise stems from our government. This reason is three-fold:

• By increasing the costs on the producers and limiting the areas that they can explore, bringing more supply to the market is very difficult.
• Fuel-switching caused by cap and trade will further increase the demand on natural gas to make up the shortfall that renewable energy provides for us.
• Combining economic factors causing demand to rise with the federal government’s recent moves makes a compelling case on its own for commodity prices to rise – but we do not stop there.

A Look Around

We also have to take into account what is occurring internationally. Production declines are happening around the world with few exceptions. All of the major basins of the world are reporting that they are producing less today than they did in 2005, which does not bode well for increasing supply as demand picks up. Looking first to the north, the media and environmental groups are trying to encourage President Obama to limit access to oil produced in the Canadian tar sands. The government in Alberta is also piling on costs to the producers, making it more difficult to turn a profit. To the south, Mexico has announced more reductions in production mainly from the continued depletion of its major fields. Since PEMEX is heavily taxed by the Mexican government, its ability to increase production is highly unlikely. Looking further south is Venezuela, once the darling of the industry in Latin America and now a mere shadow of its former self – and not a fan of the United States. Production in Venezuela has dropped from a peak of 3.4 million barrels a day to fewer than 2 million – while at the same time it is making deals with other consumers on the planet, including Russia.

A bright spot on the continent has certainly been Brazil, but even Brazil cannot make up for everyone else.

Looking across the sea, we have been relying heavily on Nigeria for crude oil supplies. Unfortunately, the people of Nigeria would like to participate in this arrangement, so every couple of months they take some hostages and shut down production in one region or another. We also need to realize that others would like to gain access to these supplies as well. For example, the Associated Press reported that one of China’s three energy majors is negotiating with Nigeria to buy large stakes in some of the world’s richest oil blocs. If confirmed, it shows how aggressively China is going after new reserves in Africa, challenging major Western oil companies that dominate the region.

The Financial Times reported that state-owned CNOOC Ltd. is trying to buy 6 billion barrels of oil – a sixth of the proven reserves in Nigeria – in a move that could put China in competition with Royal Dutch Shell PLC, Chevron, Total SA and ExxonMobil Corp.

Moving into the Middle East, we see the instability in the region. With the United States already engaged in two conflicts there and Iran trying to pull us into a third, signs of peace are not in the air. Firing missiles and creating underground nuclear facilities do not add to stability. Add to this the ever-hungry Dragon and we have a hard mix to swallow. A Sept. 29 New York Times release put it well:

“In June, China National Petroleum signed a $5 billion deal to develop Iran’s South Pars natural gas field. In July, Iran invited Chinese companies to join a $42.8 billion project to build seven new oil refineries and a 1,019-mile trans-Iran pipeline. And in August, almost as the Americans arrived in China, Tehran and Beijing struck another deal, this time for $3 billion, for Chinese help in expanding two more oil refineries.”

Yes, they are talking about the same Iran now under the close eye of the United Nations for its controversial nuclear enrichment program. While we are considering putting more sanctions on Iran, China is discussing giving it more money. Israel is thinking about putting its nuclear program out of business and has left the military option on the table. Should Israel decide to act – and it really does not need to discuss it with us – the region could be plunged into conflict.

Having the international players reducing supply and developing nations like China, India and others increasing the demand creates a formula for higher prices across the globe. So if our supply and demand issues at home combined with our government’s new policies do not raise the price, then international market pressures will drive up the prices.

Unintended Consequences … Or Are They?

All of this leads to the unintended consequence, including higher commodity prices in the United States when it comes to energy. Or are they really unintended at all? As we look at oil, we see several producers who would like the price to rise rapidly. Venezuela, Brazil, Mexico, Canada, Saudi Arabia, Nigeria, Angola and other members of OPEC would all prefer higher oil prices. This would help these countries and their leaders continue to spend the higher revenues. On natural gas, Qatar would like to see the prices rise so that its liquefied natural gas projects would be even more profitable. This might explain why world leaders are encouraging the United States to work on carbon reductions and to initiate negotiations with Iran. If they could avoid tax issues, any number of oil and gas companies around the world would like to see prices rise.

The one fan of higher oil and natural gas prices that might surprise you is the U.S. government. While the rhetoric coming from the White House is that we are trying to recover from a recession and we need to create those green jobs that will keep our energy prices down, the policies tell a different story. For instance, the administration is spending billions on renewable energy investments; and as the price of hydrocarbons goes ever higher, these investments look wiser. The higher the price of oil, the better electric and bio fuels look. The higher the price of natural gas and coal, the better wind and solar investments look.

Unintended consequences strike again. As the commodity prices rise, oil, natural gas and coal industries begin to rake in the cash. With the limits on where they can go and what they can produce, the prices spiral ever higher. As the cash sits on the balance sheet, domestic producers become the targets of more taxes. And we all know what the U.S. government needs right now is an industry from which it can raise more money.

Nowhere to Go But Up

Unfortunately, what all this relates to is a real lack of incentive to keep prices down for the consumer. As those prices rise the people who can least afford to pay more to drive their cars or heat their homes are left in the lurch. When 97 percent of our transportation and 75 percent of our power comes from hydrocarbons – and none of the renewable technologies available are currently in a position to make a significant difference – we need to find ways to reduce the cost of our energy. These policies simply do not get us there.

Where they do get us is to my prediction that oil and natural gas prices have got to go up. Now, do not try to get me to predict how far they will go up and how quickly they will go up. Those discussions are better left to the industry analysts and the pundits who love to make their predictions grab headlines.