Long term outlooks with short term implications

Recently,  both OPEC and the International Energy Agency released their long term outlooks through 2035. Effectively, since in the long run we’re all dead according to the economist J.M. Keynes, the most interesting bits are in the projections and considerations for the next few years.

By Maarten van Mourik

Maarten van Mourik is a Dutch economist who is specialized in the oil analysis business. The following article is published at LarsSchall.com with the personal authorization given by Mr. van Mourik.

Recently,  both OPEC and the International Energy Agency released their long term outlooks through 2035. Effectively, since in the long run we’re all dead according to the economist J.M. Keynes, the most interesting bits are in the projections and considerations for the next few years. First off, we should say that both Agencies have produced very balanced reports. Within their diplomatic constraints both are conveying a message that is spooky. We heartily subscribe to most of what they write, although we see the clash between demand and supply happening sooner and with more certainty. In short, both Agencies see underinvestment as a critical issue. Underinvestment in sufficient capacity to hold prices down that is.

For those long enough around to remember the Outlooks of the 90s and early ‘00s, this issue was never considered and all required capacity would be installed with oil prices at 25 USD, as 40 USD/bbl would kill the economy. No longer is that idea prevalent. Yet, the crucial element that has once again not been mentioned, is the fact that OPEC producer countries and private oil companies, and those stock exchange listed in particular, have investment motives that are much alike. As such, hoping that non-OPEC will invest when OPEC is hesitant is like placing bets without any horses to run.

On demand, both Agencies have more or less the same view. By 2015, the world is expected to consume between 92 and 92.6 Mb/d of liquids (OPEC and IEA respectively). That is around 2 Mb/d more than the expectation for 2012 and may well be on the low side, should the economies not collapse. Almost all increase is in developing countries, and most of it is transportation related. Whilst it may be too much detail, the Agencies assume significant efficiency effects over the medium to long term, to the extent that almost the entire increase in fuel demand for passenger cars over the next 25 years will be compensated for by fuel efficiency measures. To be more precise, the IEA calculates a near doubling of such fuel demand from 20 mb/d to 40 mb/d by 2035 on the basis of car sales projections. Almost 20 mb/d of the increase will be negated. Clearly, if anything goes wrong in this assumption, demand ends up much higher.

A reference to the Corporate Average Fuel Efficiency standards as set by the US Administration since the early 80s may illustrate that this is optimistic, to say the least. In effect, the IEA said so during the presentation of the WEO last week. In 2010 and 2011, fuel efficiency decreased, instead of increased as assumed in the WEO 2010. That is less surprising than one would think, as for instance less fuel efficient trucks were parked during the downturn and have since come back into use. Likewise, merchant vessels went on slow steaming. The IEA has already said at various occasions in their monthly reports, that demand is much less price and income sensitive than thought earlier. Effectively, over the last few years, their entire base of assumptions has been turned on its head. Supply is much less responsive and so is demand. How is that for projecting price?

Supply of conventional crude oil has peaked in 2008 at about 70 Mb/d, so says the IEA. If the world is lucky, it will be plateauing at about 68-69 Mb/d of crude oil for the next 25 years. The gap with demand is to be filled from NGLs, unconventional oils from tar sands mainly, Gas and Coal to Liquids, additives such as methanol and of course biofuels. At the same time, to remain at plateau, about two out of three currently producing barrels needs to be replaced. The effort is thus much, much bigger than the simple demand increase suggests. In order to replace the lost barrels of predominantly conventional non-OPEC oil, OPEC (Middle East and North Africa in particular) has to increase its capacity by 12 Mb/d by 2035. For 2015, though, expansion should be almost nothing. Yet, it gets worse, as the IEA now has its own cost index. We have shown earlier that monetary inflation has eroded more than half of the quadrupling of the E&P spending since 2000. The IEA confirms the number. The incremental amounts of oil have been pathetic, suggesting rapid increases in unit costs. Had it not been for rapidly rising prices, profits would have been under severe strain. Most likely, many more projects would have been stalled than has been the case so far.

As a consequence the world has found itself with a very tight demand-supply balance currently, and storage levels are even lower levels. Prices face continued upwards pressure and are highly volatile. The IEA has introduced a deferred investment scenario in the OPEC Middle East and North African countries to illustrate the effect of a further slowdown in investment. OPEC in its outlook says much the same thing; little capacity expansion required over the next few years and pressing social issues will lead to lower investment. In effect, OPEC says that the IEA scenario is almost a certainty. The IEA scenario then assumes the impact of 30% lower investment in MENA OPEC countries. By 2015, production will be 3.8 Mb/d lower in these countries than currently. Clearly, non-OPEC cannot hope to offset this shortfall by increasing production, as it pumps flat out, and the lead time to develop facilities is too long. Demand will have to take a hit. And the IEA projects that under this scenario the oil price will rise to 176 USD/bbl come 2015.

We believe that only the near term is of real importance, other than that the long term trend is that oil in big enough fields is increasingly scarce. And what history has taught us, is that physical stress in the system pushes up price ahead of the ultimate clash in demand and supply. Therefore, 2015 for this price level is too late. What’s more, given OPEC’s own statement on its reluctance to invest, the high price outcome is the most likely. And it will be with us soon. The IEA underwrites most of this. And it sees Carbon taxes as one way to impose efficiency, as this works as an effective price increase, although it regards the implementation of it as remote. And this brings us to a very interesting point. As the IEA considers that the world is oil short, and prices will rise to choke demand, someway, the consumer is going to pay. If it is through high oil prices, the dollars will end up with the producers. If it is done with a carbon tax, they end up with the consumers. Now, how come this sounds like the bells that tolled after the oil price hikes of the 70s after which the consumer governments (apart from the USA) implemented substantial taxation on oil use? And how likely is it that OPEC will accept that another time? Perhaps in the long run, the West may tax its way into efficient use. For now, it is likely that the producers will get their share first.

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