by Jim Puplava

From the first commercial production of oil in the 19th century, the oil industry has been punctuated by a perpetual boom-and-bust cycle. During the early days, booms and busts were brought on by two races: the first to find the oil and the second to produce it as quickly and in as much volume as possible. While the market for oil grew at an extraordinary rate, the amount of oil reaching markets grew even more rapidly, resulting in wild price swings and frequent collapses. It was the erratic pricing cycles that finally drove John D. Rockefeller to single-handedly consolidate the industry. To Rockefeller, the production of oil was risky, volatile and far too speculative. In an effort to eliminate cutthroat pricing, overcapacity and lack of profits, Rockefeller created Standard Oil of Ohio – in effect, the first integrated oil company.

For a while, Rockefeller’s plan seemed to work. But failure would eventually come; global competition and new discoveries from Baku to Spindletop created a wider marketplace. In the United States, public opinion and the political process eventually revolted against Rockefeller’s near-monopoly, and by 1911 Standard Oil was dissolved. It was not until the formation of the Organization of the Petroleum Exporting Countries (OPEC) in 1960 that similar attempts were made to control the price of oil. Instead of an amalgamation of companies under one umbrella, however, OPEC was a cartel of producing countries. But like Standard Oil, OPEC would face the same challenges from new discoveries from the North Slopes of Alaska to the North Sea.

The combination of discoveries, energy efficiencies and business cycles kept oil prices in a narrow trading range between $10 and $20 a barrel for close to two decades. Despite the formation of a new cartel, the largest business in the world has been incapable of taming the price of the principal product it produces. The industry has settled for being a “price taker” rather than a “price maker.”

A Maturing Industry

It has been 150 years since Edwin L. Drake drilled the first commercial oil well in Titusville, Pennsylvania. The energy industry has matured and become highly sophisticated, employing advanced technologies. We know a lot more about finding and producing oil today than we did in Drake’s day. However, despite the great technological advances that have been made, the industry still suffers from the boom-bust pricing cycles of Rockefeller’s day. This is clearly evident after reviewing last year’s dramatic rise and fall in the price of oil.

We began 2008 with oil prices close to $100 a barrel. Oil prices rose rapidly during the first half of last year, eventually setting a record high at $147 a barrel during the first week of July, a price very few thought was possible. In a single year the price of energy rose nearly 50 percent, then collapsed by 74 percent during the final quarter of the year. From a low of $10 a barrel in 1998 until its apex in July 2008, oil prices rose nearly fifteen-fold. From a record low to a record high, oil’s price advance continued to confound the experts throughout its historic price run.

A litany of excuses and scapegoats were given to explain its ascent. They ranged from the second Gulf War, terrorist attacks, weather and the dollar to everyone’s favorite, “speculators.” Indeed, the dominant perception for oil’s theatrical rise – that it was due to speculators entering the market – was favored by mainstream media from CBS’s 60 Minutes to the Fox network’s The O’Reilly Factor.

However, it is clear from reviewing a chart of oil prices over the last decade (Figure 1) that something else was roiling underneath the surface. The real price driver was largely due to fundamental supply-and-demand factors. The demand for oil was growing faster than the supply. Demand was driven by a world economy expanding at its fastest pace in decades, led by explosive growth in emerging market countries. From 2004 to 2007, world economies grew by close to 5 percent per year, with a concomitant growth in oil consumption of 3.9 percent.

As demand grew, supply struggled to keep pace. Non-OPEC supply growth slowed, OPEC’s spare capacity shrank and oil inventories of the Organisation for Economic Co-operation and Development (OECD) countries fell. Thus, any new supply disruption – from hurricanes to refinery shutdowns and geopolitical events – exacerbated an already-tight supply chain, resulting in price spikes. In addition, as the imbalance between demand and supply grew, the persistence of this growing imbalance began to permeate market psychology. This led to upward pressure on prices and greater market reactions to any actual or perceived disruptions in available supply.

One reason supply failed to grow was due to the lack of new discoveries and the rise in world depletion rates. As the accompanying graphs illustrate, world oil discoveries peaked in the late 1960s and have fallen in each succeeding decade. As Figure 2 shows, discoveries have become fewer and smaller in size. While 70,000 oilfields are in production worldwide, the bulk of the industry’s production comes from just 20 super-giant oilfields, which together account for more than 25 percent of daily world production. The vast majority of these fields were discovered 50 to 70 years ago.

Compounding the dearth in new discoveries, depletion rates are rising as old fields mature and decline. Newer discoveries over the last two decades have 1) been smaller, and 2) often been offshore – two factors that point to a much faster depletion rate.

Running out of Energy and Time

In its latest World Energy Outlook, the International Energy Agency (IEA) estimated that the average observed decline rate worldwide is currently 6.7 percent, increasing to 8.6 percent by 2030. The decline rate for the super-giants is 3.4 percent; it is 6.5 percent for giant oilfields and 10.4 percent for large fields (Figure 3). Moreover, the natural decline rate (which strips out ongoing investment) is estimated at 9 percent for post-peak fields. “The implications are far-reaching,” said the IEA. “Investment in 1 mb/d of additional capacity – equal to the entire capacity of Algeria today – is needed each year by the end of the projection just to offset the projected acceleration in the natural decline rate.”

To arrest natural decline rates in maturing fields, the IEA estimates it will require a cumulative investment of $26 trillion (in 2007 dollars) between 2007 and 2030. This investment is necessary to counter natural decline rates in existing fields and to meet rising demand. Given the precipitous decline in oil prices over the last four months, major investment seems unlikely, considering the announcements from international and national oil companies of cutbacks in capital expenditure over the next several years.

The IEA, which completed a comprehensive study of 800 producing oilfields, accounting for the bulk of the world’s oil production, began and ended its study with the following conclusion: “The world’s energy system is at a crossroads. Current global trends in energy supply and consumption are patently unsustainable – environmentally, economically, socially. … Time is running out and the time to act is now.”

Whether you have read the World Energy Outlook 2008 report, Robert L. Hirsch’s Peaking of World Oil Production: Impacts, Mitigation and Risk Management, the “Oil Shockwave” scenario developed in part by the National Commission on Energy Policy or the works of Matthew R. Simmons, one unmistakable conclusion is clear: The world is running out of time and cheap energy.

Reasons for the Run-up

I now want to address the reasons behind the price run-ups during this decade and suggest why I believe we are headed for another oil shock and record-high oil prices in the years ahead. In reviewing oil prices over the last two decades, I found that:

• oil tends to do better following a down year rather than an up year; and
• oil tends to rise by an average of 25 percent following a year of decline.

These findings held true for most of the last decade. However, by the beginning of this century, oil prices deviated from past price patterns. After following a decline of 25.97 percent in 2001, oil prices rose for six consecutive years. This pricing deviation was the first clue that something different was developing in the energy markets.

What contributed to the deviation?

• The combination of years of underinvestment, lack of discoveries, accelerating depletion rates and rising demand all contributed to the dramatic rise in oil prices.
• The price of discovering and producing oil began to rise dramatically with the industry experiencing double-digit annual cost inflation.
• The production of conventional oil began to flatten and then decline.
• To make up the difference between growing demand and flattening conventional oil production, the industry filled the gap through natural gas liquids, biofuels, refinery gains and occasional inventory liquidation.

As demand grew and supply flattened, nonconventional oil production began to fill the gap, which also contributed to raising the energy industry’s cost curve (Figure 4). Today the gap between conventional oil production of 73 million barrels per day (mb/d) and total consumption of more than 85 mb/d is made up by unconventional oil, which comes at a cost:

• Coal-to-liquid/gas-to-liquid ranges from $40 to $120 a barrel.
• Deepwater and ultra-deepwater can cost upwards of $65 to $75.
• Oil shale cost estimates range between $50 and $100.
• Extra-heavy and oil sands production costs $40 to $80.
• Enhanced oil recovery can range between $30 and $80.

According to the IEA, the Middle East and North Africa are among the few places left where conventional oil costs typically range from less than $10 to a high of $40. The Middle East is one of the world’s last remaining reservoirs of cheap oil.

The combination of declining oil discoveries and conventional oil production and the increased use of unconventional oil raised the tipping point for oil pricing:

From 2004 through the first half of 2008, the world saw a precipitous rise in the price of oil driven by strong emerging-market demand growth against a string of supply disruptions and increasing declines from mature oilfields.

Beginning in 2004, as demand began to outpace supply, sharply higher prices were necessary in order to take demand out of the system and keep the markets in balance. An unbalanced oil market combined with a series of supply disruptions (refinery shutdowns, severe cold weather and civil unrest in Nigeria among them) led to price spikes and record oil prices.

From 2004 on, price became the demand limiter leading to declining demand in OECD countries once oil broached $100 a barrel. Prices reached their extreme limit during the first half of 2008 with oil prices that peaked during the second week of July.

A Painful Paradigm Shift

The second half of 2008 was the flipside of the first half of the year. Instead of supply disruptions, we saw financial disruptions, which triggered a wave of deleveraging in the financial markets. A series of policy mistakes led in rapid succession to the government takeover of Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers and AIG, and the shotgun weddings of Merrill Lynch, Washington Mutual and Wachovia. As financial institutions failed or were merged, the credit system began to freeze up. Credit spreads blew out, and volatility in the markets reached record extremes. By the fourth quarter of 2008, the sharp deterioration in credit conditions spilled over into the general economy. There was a paradigm shift in the markets, which moved from supply disruption to a focus on demand destruction. Market psychology had changed overnight.

As the impact of credit paralysis spilled over into the general economy, the headlines filled with economic reports that pointed to a sharp drop in global economic growth. The financial media became obsessed with demand destruction as a means of explaining why oil prices fell 74 percent in the final months of the year. They focused on future demand reductions by the IEA, the EIA and OPEC. Buried in the headlines was the IEA’s increase in global depletion rates to 6.7 percent, with natural decline rates of 9 percent. The IEA’s admonition that the world’s energy system was at a crossroads and unsustainable, with time running out, went largely unnoticed. A cacophony of lesser-informed voices drowned out the warning.

However, something did not add up: It took nearly a decade for the price of oil to climb from a low of $10 in 1998 to its peak of $147 a barrel in July of 2008. The price rise was gradual, relentless and prolonged. But what of the sudden price drop in late 2008?

As Matt Simmons pointed out in his White Paper, “2008: A Wild Ride for Oil Markets”: “There are no factual statistics to rationalize this drop. None! A probable immediate impact of the credit freeze, which combined with oil prices falling, certainly caused some key oil trading firms to liquidate many oil paper contracts. This is the only plausible, but still unproven answer for why prices could fall by 74 percent in such a short time.”

It seems hard to conceive that a decade-long advance in oil prices driven by relentless demand and struggling supply could have been brought abruptly to an end. Has demand fallen to such an extent to justify a 74 percent decline in price? If – as it is widely believed – speculators were behind oil’s spectacular rise, are they also behind oil’s precipitous decline? If the decline in consumption is estimated to be 2-2.5 mb/d, then oil depletion rates alone would bring demand and supply into balance. If global-observed depletion rates are running 6.7 percent with natural depletion rates as high as 9 percent, has demand fallen by a similar percentage globally?

If demand has fallen faster than worldwide depletion rates, what about supply destruction (Figure 5)? The industry’s “all-in” marginal costs, which include cash production costs, capital expenditures, taxes and return on investment, are still above $85 a barrel, according to industry experts. Even with lower input costs, the geological elements have not changed. I have not read anywhere where governments are reducing production and export taxes. With government revenues in decline, politicians are considering raising energy taxes, not reducing them.

As a result, oil prices below $60 a barrel are leading to reduced capital spending by the energy industry on long-term investments. A fall in oil prices to $40 will only hasten capex reductions. Declines to $30 will lead to shut-ins, which approach cash operating costs for a sizable amount of production. According to IHS Herold, capital spending by exploration and production (E&P) companies is expected to decline by 13 percent in 2009.

Drowning in Oil?

From the desert sands of the Middle East to the oil sands of Alberta, oil companies are cutting back on production, curtailing existing projects or delaying new investment plans. Since mid-summer Saudi oil output has fallen to 7.7 mb/d, a drop of 2 mb/d. In addition to production cutbacks, Saudi Arabia is also delaying bidding on the construction of two new refineries on which it has partnered with ConocoPhillips and Total. At the same time the IEA is calling for annual investments of $350 billion a year in upstream investments, the industry is cutting back, and field-by-field declines in oil production are accelerating.

The situation today harkens back to 1998, when oil prices fell by almost 50 percent. The Asian crisis of 1997 was followed by the failure of the infamous Long-Term Capital Management hedge fund and Russia’s debt default in 1998. The perception in the markets at that time was that the world was awash in oil. The cover story of the March 4, 1999 Economist was “Drowning in Oil.” That article, pointing out that modern economies were less dependent on oil, predicted that over-production by Gulf states could send the price crashing to as little as $5 a barrel (Figure 6). Instead, oil prices rose fifteen-fold, and demand grew by more than 25 percent over the next decade.

Today, perceptions abound that the world is once again “drowning in oil.” Numerous references are made to a collapse in world oil demand in the fourth quarter of 2008. This misperception is reinforced by recent downward projections by the IEA, EIA, and OPEC. There is near-hysteria in the commodity trading pits over the buildup of oil inventories at Cushing. The current 33 million barrels of oil stored is higher than the norm, with a build of more than 18 million barrels in the last quarter. However, in the grand scheme of things, Cushing inventories are insignificant in comparison to other major grades of crude such as Brent and Dubai.

Indeed, the recent inventory build at Cushing reinforces the developing oil-glut story. The market seems obsessed with Cushing, with numerous stories circulating that trades are being made in the front month and sold simultaneously in the far month as oil is stored on tankers or at Cushing. Bloomberg recently reported that Frontline Ltd., the world’s biggest owner of supertankers, said 80 million barrels of crude oil are being stored in tankers as traders seek to take advantage of higher prices later in the year. If this is the big story that traders are making it to be, then why aren’t tanker rates rising? Ed Hyman’s International Strategy & Investment Group (ISI Group) did a study of the contango/storage story and found that tanker rates continue to decline around the globe from the U.S. Gulf of Mexico to Singapore.

Contango Extremes

Currently West Texas Intermediate (WTI) prices are trading at a steep discount to other grades of crude, such as Brent, so there is an economic disincentive to bring new supplies to Cushing. According to ISI Group, a so-called supercontango reflects situations where there is excess near-term crude supply. A supercontango is resolved from supply reductions (i.e., OPEC production cuts). In regard to the recent contango extremes, in looking back over the last two decades, such extremes have historically coincided with oil price bottoms. ISI Group concluded that the extreme fall in energy prices over the last quarter is more reflective of a major fund or group of funds deleveraging than it is a demand-destruction or supply-glut story, and a similar conclusion was reached by Matt Simmons. As he wrote in “2008: A Wild Ride for Oil Markets”: “In reality, it is extremely expensive to actually buy physical oil and store it. Moreover, the world has few empty tank farms to suddenly start filling up with oil. Reports of armadas of tankers sailing the high seas loaded with oil are always true because countries around the globe import over 40 million barrels of oil from afar daily. But almost all of this oil is being delivered to refineries, not [being held by] speculators storing excessive oil.”

In summary, the markets are once again making the same mistakes of the past two decades in assuming demand destruction is a long-term trend and the world is awash in oil. While global demand may have fallen, governments around the world are pulling out all stops to reinflate their economies through massive monetary and fiscal-stimulus programs (Figure 7). While governments make every effort to stimulate demand, supply destruction is accelerating through natural depletion and sharp cutbacks in capex spending. Another factor – climate change – is reasserting itself. At the American Geophysical Union in San Francisco, Western Washington University professor Don J. Easterbrook made the strong case for another cycle of global cooling.

According to Easterbrook, there have been 23 periods of climatic warming and cooling over the last 500 years. Each warming and cooling cycle lasted 25 to 30 years (average 27 years). Recent measurements of global temperatures suggest a gradual cooling trend since 1998. The cooling trend will be reinforced as the sun enters a cycle of lower radiance and the Pacific Ocean changes from its warm mode to its cool mode. Recent NASA data seems to reinforce Easterbrook’s assertion on a trend toward global cooling. A global cooling trend will translate into greater energy use through the use of heating oil and natural gas to heat homes.

An “Up-cycle” Trifecta

What is shaping up is the perfect energy trifecta: rising demand, declining supply and cooling global temperatures. During the next energy up cycle, prices are set to rise, dramatically surpassing the records set in July 2008. The price curve is being reset as a result of accelerating depletion. Whereas in the recent cycle, demand destruction did not occur until oil prices surpassed $100 a barrel, this time around demand destruction will take place at much lower prices, in the $75 to $85 range.

What’s more:

• The much-needed investments to slow down natural depletion rates are not being made.
• The industry’s infrastructure is aging and rusting, from the well bore, tank farms, pipelines, tankers and refineries to drilling rigs.
• The energy workforce is aging and will have to be replaced by new geologists, engineers and business executives. Where will the next energy employee crop come from? University enrollments for geologists have declined over the last two decades.

What seems remarkable is that energy became the basis of the postwar-developed economies. It led to the suburbanization movement in the latter half of the 20th century. Today oil is embedded in our daily lives in so many ways. It is the lifeblood of suburban communities, determining where and how we live and travel. Oil supports agriculture and manufacturing, and it is essential to our transportation system. It is the very lifeblood behind the modern conveniences of 21st-century living. The tragedy is that it is given very little thought. Only when its price rises are we reminded of its geological limitations.

Jim Puplava is president of Puplava Securities, Inc., and he oversees the portfolio management team at Puplava Financial Services, Inc., and Puplava Securities, Inc. He has hosted Financial Sense TalkRadio for more than two decades, and he also writes commentary for the Financial Sense Web site.

Keywords: boom-and-bust cycle; John D. Rockefeller; Organization of the Petroleum Exporting Countries (OPEC); Edwin L. Drake; oil prices; oil discoveries; International Energy Agency (IEA); Robert L. Hirsch; National Commission on Energy Policy; Matthew R. Simmons; oil production; oil demand; Cushing; Frontline Ltd.; Ed Hyman; International Strategy & Investment Group; ISI Group; supercontango; Don J. Easterbrook; Puplava Securities