Wall Street History

---

Wall Street History

07/30/2004

The Crude Story, Part II

Note: What follows is a continuation of last week’s piece, more
from our mystery analyst, a well-respected figure who spends his
days tracking the oil industry for a large money management
firm. This series is particularly timely in light of the Yukos
debacle and oil breaking through $43 a barrel the week of
7/26/04.

This time the analyst focuses on the supply-demand conundrum,
Saudi Arabia, and the outlook for prices. Some of it is a bit
technical in nature, but in editing his extensive report, I wanted
to give you a sense of the real issues facing those doing research
on this fascinating and vitally important sector of the global
economy.

--The Editor

---

I am modeling 2005 global oil demand to grow at 1.5 mm b/d,
which is significantly down from the torrid 2004 growth rate of
2.2 mm b/d. However, if there is a risk in this number, it’s that
the number is too low. I am modeling China’s oil production to
grow at only 400,000 b/d day in 2005, down from the 600,000
b/d growth rate in 2004, but given what is going on in China this
number may again be too low. We have consistently
underestimated oil demand for China over the last four years, to
do it again in 2005 would almost be predictable .

My analysis indicates that it is hard to see the global oil market
softening in the next several years. The fundamental condition
of weak, or little, non-OPEC supply growth, coupled with
demand growth which has returned to its 30-year trend line,
means that OPEC capacity utilization will move to 100% in the
next two years. What prices will do is anyone’s guess, as we
have never been there before, but my guess is that higher prices
will result. Based upon my modeling I think that oil prices will
average $40-$45 per barrel in 2005, and $45-$50 in 2006. It is
imperative to keep all energy positions in place .

With the tremendous increase in oil demand that is occurring in
2004, it looks as if we may reach 100% capacity utilization in
2006. [According to my calculations, we are currently at 97-
98% of capacity utilization.] Because we appear to be nearing
this point so quickly, there are several important points to be
made concerning the size and nature of OPEC’s production
capacity.

1) OPEC’s capacity utilization outside of Saudi Arabia is either
at 100%, or very close to it.

2) In the short term, little growth can be expected from OPEC
outside of Saudi Arabia. Oil production from several OPEC
members appears to have peaked, and they are struggling to
arrest production declines.

3) Saudi Arabia’s total pumping capability is somewhere
between 9.3 and 10.1 mm barrels per day.

4) There are plans to bring on four new field developments in
Saudi Arabia in the next several years. Depletion rates on
existing production will offset these additions, and it will be hard
for the Saudis to show any sustained production growth in the
next five years.

---

OPEC (ex the Saudis) has reached 100% capacity utilization

The production capacity from the 10 OPEC countries outside of
Saudi Arabia looks to be 100% utilized. Presently, the
production from two OPEC members is in decline and both
cannot meet their quotas (Indonesia and Venezuela). Seven
other members are producing at, or above, their quotas, and
pumping near their estimated 100% capacity utilizations.
Although Iraq still has some excess pumping capability, terrorist
and related disruptions call into question the sustainability of its
current 2.5 mm b/d production rate.

Little Short Term Growth Possible

Among the OPEC members, only Algeria and possibly Libya
appear to have the ability to boost oil production in the next
several years. If western oil companies are able to invest in
Libya in 2005, we could see some production growth in 2006.
Over the longer term, we should see growth in oil production
from Iran and Nigeria, although there seems little reason to
believe that production, given the lack of capital expenditures,
will grow in the next three years.

Kuwait’s production must be watched carefully. Over 90% of
Kuwait’s production comes from the old (and giant) Bergan
field, which is showing increased water production and some
declines in production. Although Kuwait has talked about
opening up its north fields (along the Iraq border) to western oil
companies for development, no plans have advanced, and the
issue has gone quiet in the last year. In the meantime, unless
further investment is made in either Bergan or in the north fields,
Kuwait will find it very hard to maintain its 2.3 mm b/d pumping
rate.

The Saudis True Capacity

There is a large debate surrounding Saudi Arabia’s pumping
capability, but I think that basic arithmetic and some historical
insight, coupled with recent Saudi statements, give us a good
idea of what that rate is. In the late 1970s, during the Iranian
revolution, oil production from Iran was disrupted for close to a
year. During that disruption, the Saudis were able to pump a
sustained 10 mm b/d. – at the time assumed to be their maximum
pumping capability. With oil in the high $30s and with everyone
believing that oil was a scarce commodity, the Saudis had every
incentive to maximize production. I think it’s reasonable that the
10.0-10.2 mm production per day rate was most likely their
maximum rate.

Since 1980, only two factors have changed in the Saudis/ ability
to pump oil. One factor has been the gradual decline of the
Ghawar field, the foundation of the Saudi Arabia oil industry.
Back in the late 1970s, Ghawar’s total pumping capability
reached 6 mm b/d. Since then, water production (a classic sign
of field maturity) has continued to increase, resulting in declining
oil production. According to Schlumberger’s “Middle East
Reservoir Review,” production from Ghawar at the end of 2001,
stood at “around 4.6 mm barrels per day, down from 5 mm
barrels per day over the past year or so.” From that statement, it
appears that Ghawar has lost 1.4 mm barrels per day in pumping
capability over the last 20 years. The second factor is that during
that same time period, the only new field to come on-line has
been the Shaybah field. This field has been technically difficult
to develop, but has added 700,000 barrels per day to capacity.

Since no other field development has taken place in Saudi
Arabia, (except for future projects which are not pumping), my
analysis shows that the country’s current pumping capability
should be approximately 9.3-9.4 mm barrels per day (10 mm b/d
in 1980, subtract 1.4 mm b/d lost in Ghawar, and add .7 mm b/d
from Shaybah). This, I should point out, is the rate at which, in
February / March 2003, the Saudis claimed to have exhausted
their capacity. All the numbers, combined with what the Saudis
said under pressure last year, add up .

Although we don’t know specifically what Ghawar’s long-term
decline rate is, we do have a small piece of information that I
have used to construct a model of future Saudi production.
Earlier this year, Abd Allah Al-Saif, Aramco’s senior vice
president for exploration and production, confirmed that Saudi
production has a 2% base decline embedded in it .Even with
production ramp ups coming (from other fields), this will only be
enough to cover the depletion coming from the production base.

Unless the Saudis undertake further massive field development
projects, current planned expansions will do nothing to lift total
future pumping capability. As I mentioned earlier, if demand
next year increases by 1.5 mm b/d and we have only 400,000 b/d
day of non-OPEC supply growth, then the world oil market will
be operating at 100% capacity utilization in 2006 – something it
has never done before.

Demand and the Real Price of Oil

At the current high price levels, the question about whether these
prices are high enough to induce economic slowdown or
recession becomes an important issue. In 1973, 1980, and 1990,
large increases in the price of oil first prefaced economic
slowdown, and then recession. Could today’s higher than
expected prices lead to economic weakness, causing demand
destruction and balancing the market at a significantly lower
equilibrium price – disproving my belief in a secular bull oil
market?

There is general agreement over the way in which energy shocks
hurt the economy through, among other ways, their effects on
consumers’ disposable income, and corporate margin contraction
with its related disincentive to hire labor and invest capital.
However, there is little agreement over how much economic
growth has been lost because of the relatively high prices we
have been seeing, and whether these prices are high enough to
turn expansion into recession. Recently, the European Central
Bank increased its 2004 inflation rate forecast to 2.1% from
1.8%, and a Dallas Fed study predicts that .3% will be lost from
U.S. GDP over each of the next three years because of higher oil
and natural gas prices. Conversely, it is also argued that oil
prices are up because of increased demand, not reduced supply;
hardly a precursor of future economic weakness and reduced oil
demand.

Irrespective of the size of the impact on it, in many ways the U.S.
economy is better prepared to deal with the effects of higher oil
prices than it was during previous price shocks. There have been
energy efficiency gains by many industries such as the airlines
(engine power and efficiency increases) and even SUVs; fuel
injection and better transmissions increased their fuel efficiency
from 1990 to 2000 by 5%....

Recent trends in U.S. demand point out that rising prices have
done nothing to curb demand. In the second quarter of 2004, on
the refined product side, gasoline demand in the U.S. continued
to surge 1.3% year-over-year despite gasoline prices that are up
26% year-over-year .

It’s useful to get a feeling for how high energy prices
(particularly oil and gasoline) need to rise before we experience
new highs in real dollar terms. Depending on to whom you
listen, the all-time high in average gas prices is around $2.90 per
gallon in today’s inflation adjusted dollars ($1.38 per gallon in
1981). $40 oil is around half of the historic peak price of more
than $70 per barrel in 2004 dollars that occurred in the 1970s.
From a global perspective, remember that in Europe, much of the
oil price rise has been negated by a weakening U.S. dollar. For
the Europeans, priced in euros, oil is barely above its four-year
average. I don’t think that oil priced in the mid-thirties threatens
global expansion; I think current levels are sustainable.

Risks

If my thesis is correct that current oil prices are sustainable and
do not threaten future oil prices through demand destruction, are
there other risks to my bullish outlook? Besides the possibility
of exceptionally high prices that approach the all-time highs in
real dollar terms, I believe there may be one risk to the price of
oil that no one is focusing on, and that is the price of gasoline.
To understand why this is so, it is important to understand that
U.S. gasoline consumption is the single largest component of
global crude oil demand (12%).

Presently, U.S. gasoline inventories, because of tremendous
demand growth in the first 6 months of 2004, are near record
lows. We are now entering the strong seasonal demand period
for gasoline in a very precarious position. During this time, it is
common to see demand for gasoline jump by over a million
gallons a day. Near record gasoline imports from Europe have
helped the U.S. inventory a little, but anecdotally we are starting
to hear that European refineries are also approaching full
capacity utilization.

My fear is that if the U.S. spikes gasoline prices this year, say to
$2.50 to $3.00 a gallon, this could eventually curb gasoline
demand. Although gasoline demand this year has risen strongly
in the face of rising prices, at some point price elasticity must
kick in. Given that U.S. gasoline consumption is the single
largest component of total global crude demand, a drop in U.S.
gasoline demand would curb crude oil demand, with a resulting
inventory build. Under this scenario, we would definitely see the
price of crude oil fall, especially since U.S. crude oil inventories
have been trending toward normal over the last six months. This
view is certainly not consensus, but nevertheless, I see it as
perhaps the only way that oil prices could be knocked down
through an economic slow-down (barring a massive exogenous
9/11 type shock).

Although this scenario is a potential risk to the price of crude, I
really don’t think that this is going to happen. I think that a
combination of refineries operating at full capacity, in addition to
gasoline imports, should enable us to get through a strong
seasonal demand period with adequate gasoline inventories. It is
more probably that we draw down crude oil inventories through
a combination of slowing non-OPEC supply growth and strong
global demand. In this scenario, the price risk to oil is higher,
not lower, with price spikes above $50 quite possible.

Conclusion

I am sure that if you put 100 investors in a room, and asked them
this question: “Will oil prices average higher or lower in 2005
vs. 2004,” 99 would say “lower.” However, my analysis says
that oil prices could very well be higher in 2005 and even higher
in 2006. Little research is being done on what the fundamental
supply-demand situation looks like in global oil markets in 2005
and 2006. Analysts have consistently overestimated non-OPEC
supply and have underestimated total global demand. This error
in analysis is still being carried over into the analysis of the oil
market in 2005 and 2006.

The analysis and models (I have presented) point to an oil market
that will continue to tighten in the next two years. Also, a new
incorrect perception is developing in analyzing the global oil
market. I think that analysts are overestimating the potential for
Saudi Arabian oil pumping growth and little research is being
done on what true Saudi Arabian oil pumping capability is. My
analysis says that Saudi Arabian oil pumping capacity cannot
grow significantly between now and the end of the decade.
Incorporating this research into my models leads to a prediction
that global capacity in the global oil industry could reach 100%
by 2006. We have never been in this situation before. I believe
the risk to oil prices remains to the upside.

---

*Thank you for understanding that I was unable to divulge the
source for the above. And, as always, I will continue to express
my own opinions on this topic in my "Week in Review" column.

Wall Street History returns August 6.

Brian Trumbore

---