Why High Oil Prices will Return, Reaching New All-Time Highs --Brent Voss

I asked a good friend of mine to write an essay in which he answers the question: Why will the price of oil increase significantly post-recession? Here it is:


The consumer has scored a victory in the midst of the financial crisis. Cheap gas! Drivers are thrilled that prices have returned to "normal" so that they may more easily continue the modern lifestyle. Last summer virtually everyone thought that $4 gas was literally highway robbery and could not continue. And as it turned out, they were right...for now.

Today both the world oil market and the consumer have ignored an all too important fact: World oil production went flat in 2004 at around 85 million barrel/day (mb/d), i.e. supply stopped increasing. A majority of current world oil supply comes from as few as 10 super-giant oil-fields, the youngest of which was discovered in 1969. These fields experience increases in production as wells are drilled and extraction technology improves, up to a point. Over time oil production plateaus and heads into irreversible decline.

In its 2007 World Energy Outlook, the International Energy Agency (IEA) predicted a rate of decline from the world's existing oilfields of 3.7%, only to admit 12 months later that the speed of the fall was more likely 6.7% and is expected to accelerate to 8.6% by 2030.
Assuming the IEA is correct in their 6.7% depletion rate, the world's oil companies need to discover approximately 5.7 mb/d of new oil production every year just to keep overall production flat. This is how the IEA came to this startling conclusion in their World Energy Outlook 2008:

"Even if oil demand was to remain flat to 2030, 45 mb/d of gross capacity – roughly four
times the current capacity of Saudi Arabia – would need to be built worldwide by 2030
just to offset the effect of oilfield decline."

Further, considering that demand will almost certainly not remain flat, and if the IEA's demand growth projections prove correct, by 2030 64 mb/d of new oil production is required to meet demand and counter depletion. That's the equivalent to 6 new Saudi Arabias. That's right, the largest oil producer in the world today times 6 in new production just to maintain the current supply and demand relationship. This strikes me as impossible.

Obviously, massive capital investment is necessary to discover and develop the world's remaining oil reserves. And herein lies the problem: The price of oil is too low to attract the badly needed capital.

"Below $70, it will be non-economical to invest in the hydrocarbon sector....Today there is no cheap oil" - Qatar's Energy Minister Abdullah Bin Hamad Al Attiyah

Even Saudi Arabia has come out with a "fair price" of $75 per barrel. It's not that Saudi needs that price, but it understands that oil at that level would encourage new output from marginal, higher-cost sources. For example in the northern Alberta, Canada oil sands, where oil prices of $75 a barrel had been adequate to ensure a good profit, UBS-analyst Andrew Potter now says $100 a barrel is likely needed to produce a 10% return. The IEA projects $6.3 Trillion is needed for investment in crude oil exploration, development, refining and shipping. And an additional $5.5 Trillion in projected investment is needed for natural gas exploration, development and transport.

As I write, West Texas Intermediate (WTI) crude futures are at $43.60/barrel. The marginal cost of a new barrel of production is between $65 and $75 per barrel. In order to make new discoveries and bring them to market, oil prices would need to rise 49-72% from current levels.
If the price does not rise to levels that attract investment, new production needed to simply offset oilfield decline/depletion will not find it's way to the local gas station. In the not too distant future the fundamental principle of economics, scarcity, will get the consumers attention.

You may be thinking that we'll never run short of oil and the price of a gallon of gasoline will never reach $7 in the next decade. With all the talk of energy independence you may think that we'll come up with viable alternatives that reduce our reliance on imported crude oil. The former Saudi Chief of Intelligence Prince Turki Al-Faisal recently said US oil independence "is non-applicable" despite US President-elect Barrak Obama's assurances. "Saudi should not be worried concerning Obama's attempts to launch oil independence, as oil remains the cheapest source of power, therefore it cannot be made indispensable."

I recently read that Toyota was cancelling their planned Prius plant in Mississippi. A friend just told me of $1.27/gal gas in Kansas City. I suppose these two events are related. Cheap energy and the credit crunch is killing investment in more efficient vehicles. The same goes for wind and solar energy investment. It would take trillions of dollars to replace our current vehicle fleet with the most fuel efficient models. This transition simply won't happen in a one year, five years or even in a decade even with fuel prices much higher than they are today.

We live in a world in which incentives matter. As long as crude oil costs remain low, there is no incentive to change behavior, keeping the world hooked on a substance the dealer of which may not be able to supply in quantities sufficient to get our fix. Yes, the withdrawal from crude oil will likely be one of the more painful experiences in modern history since virtually everything is fueled by or made from crude oil.

It is ironic that the very low prices that we're now celebrating will lead to even greater economic pain down the road.