Oil Price Drivers - a Look at the Fundamentals
On May 21 oil prices took a huge leap, up $4.19 a barrel. It was particularly galling, after repeated record-setting days, and after Saudi Arabia added 300,000 b/d to the market.
While oil traders bid up prices, the U.S. Senate Judiciary Committee scolded and grilled top executives of major U.S. oil companies. High gasoline prices and corporate profits topped the
agenda. Democratic senators wanted to know the pay of each executive, and challenged their ethics in earning record profits while American motorists suffer economic pain at the pump.
The Committee hearing was scheduled to consider a bill passed earlier by the House that classifies OPEC as a monopoly, violating the Sherman Antitrust Act. The Senate is also considering measures such as taxing windfall profits from high oil and product prices.
With all the back-biting and finger-pointing about high prices at the pump, we might take a time-out and examine with a cool head the driving forces behind oil prices, aside from the oft-cited effects of the falling dollar and new investors flooding into commodities.
Skyrocketing Coal Prices
Other energy commodities are setting price records. Natural gas is near record levels, but oil prices are double those of natural gas based on the same heat value.
Coal prices have risen in concert with oil. Last week Australian coal was priced at $134 per tonne; its high was $142 in February. The same grade of coal was $23.25/tonne in May 2003. The price of oil is almost four times higher than coal for the same heat value.
Crude Oil Inventories
The balance between supply and demand is critical to oil prices, but accurate numbers are not known for 3 or 4 months after the fact. Analysts follow supply and demand trends, but investors want to know how they are balanced NOW!
The trends of inventories, i.e., stocks of crude oil or products tell us how supply is balanced with demand. Analysts and traders track stocks, comparing the current year with recent years. Monthly inventory statistics around the world are not known for 2 months but in the U.S., DOE releases weekly inventory figures for crude oil and key products with a lag time of only 5 days.
Traders are all over those numbers. If inventories rise, supply exceeds demand; if they fall, demand exceeds supply. The immediate cause of the May 21 price leap was that U.S. crude inventories dropped by 5.4 million bbl the previous week, when a modest increase was expected. Such a discrepancy upset the market.
Generally, the industry builds inventories through the first half of the year, and pulls them down toward yearend for tax purposes. The figure below shows the trends of U.S. crude inventories for the most recent 5 years. The first half of 2008 has deviated only slightly from the 5-year average, but has been 3 to 6% below 2006 and 2007. Inventories don’t look bad, except for the recent drop.
What other drivers affect prices? News of discoveries, prospects for additional productive capacity, the ebb and flow of geopolitical events, reports about demand, all affect prices day-to-day. The recent flattening of non-OPEC production has raised anxiety in the market. Reports come out regularly and have short-term impacts on prices. But there is another trend that spotlights the intrinsic value of oil: increasing expenses that the industry incurs to explore for and extract oil.
Increasing Costs
In the Senate hearing, oil executives explained that profits are plowed back into the ground to cover increasing costs of exploration, development, production, and refining. The executives admitted that such arguments sound commonplace, but are accurate.
Let’s look at some costs. Matthew R. Simmons spoke at Houston’s Offshore Technology Conference in early May and presented some shocking costs. To avoid a serious decline in oil and gas production the global industry would have to invest $50 to $100 trillion in 7 years, including replacing and rehabilitating much of the existing infrastructure. We hear of
investments for new projects, but this is the first detailing of such monumental expenses merely to maintain existing facilities.
The Cambridge Energy Research Associates released a study showing that industry’s upstream costs have doubled since 2005. The biggest increase was for deepwater subsea equipment, up 12% in 6 months. This is especially critical because deepwater offshore is where much near-term productive capacity will be developed.
Costs for deepwater floating production systems are moving into the stratosphere. Last year, a system with capacity for 250,000 b/d was contracted for $1.2 billion. This year 160,000 b/d and 200,000 b/d systems cost $1.6 and $2.0 billion, respectively, a doubling of cost based on b/d productive capacity. The industry estimates that 158 floating production systems will be ordered between now and 2013, costing $81 billion.
Companies pay hefty fees to drill exploratory wells in federal waters. They recently bid for the right to drill in Alaska’s Chukchi Sea, infested with grinding pack ice for 9 months a year, bidding as much as $105 million for 3.6 square mile tracts. Royalties are paid later for any production. The U.S. Minerals Management Service offered several hundred tracts for bids, scattered over an area the size of New York State. The closest tract from land was 54 miles. Production systems have yet to be invented for deep Arctic waters at such distances from land. We should not expect first oil until the mid 2020s.
Production systems in ultradeep waters of the Gulf of Mexico will be developed under escalating cost regimes. Much has been written about the Jack discovery but it’s actually one of many discoveries scattered over thousands of square miles in water 7,000 to 9,000 feet deep. Each discovery will be produced separately from a permanently moored drillship where flexible pipelines (risers) connect to wellheads mounted on the seabed to transport oil, gas, and water to the surface. In the event of a hurricane, special connections would free drillships from their moorings and risers, allowing them to sail into sheltered ports.
Smaller discoveries have multiphase pumps push produced fluids through pipelines laid on the seabed to the nearest drillship, 20 miles or more away, where risers carry fluids to the surface. All facilities on the seabed are installed robotically and operated remotely from a ship. No one dives into water thousands of feet deep. All these exotic systems take big-time bucks.
On April 14, 2008 ASPO-USA posted my article Comments on Michael Lynch’s Commentary “Peak Oil, Uncommon Ground.” I wrote that oil prices will move steadily toward $200/bbl over the next 5 years. In view of recent events, and Goldman Sachs predicting $150 to $200 oil within 6 to 24 months, my prediction looks timid indeed.
Tom Standing began his career as a chemical engineer in refinery operations and later shifted to work as an engineer for the San Francisco water system. He is self-taught in the sciences of petroleum production, geology and geochemistry.
References
–Oil and Gas Journal, “Growth of Floating Production Systems Accelerate,” May 5, 2008
–Ibid, “Chukchi Sea Lease Sale Draws $2.66 Billion in High Bids,” February 7, 2008
–Ibid, “Reliance Contracts for New Transocean Drillship,” May 12, 2008
–Ibid, “Global Offshore Drilling to Reach $80 Billion in 2012,” April, 2008
–Ibid, “Deepwater Systems Offer New Life in Gulf of Mexico,” May 12, 2008
–Ibid, “OTC Speakers Highlight Offshore Industry’s Future,” May 12, 2008
–OGJonline, “Petrobras Inks CVA Contract for Gulf of Mexico FSPO,” April 10, 2008
–Ibid, BP to Increase King Oil Field Production by 20%,” December 6, 2007
–Ibid, “CERA: Upstream construction Costs Up 6% Over 6 Months,” May 19, 2008
–Ibid, “Gulf Lower Tertiary Deepwater Wildcats Drilling,” November 7, 2007
(Note: Commentaries do not necessarily represent ASPO-USA's positions; they are personal statements and observations by informed commentators.)
