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I am pretty vocal with my opinion that high oil prices
are here to stay. In the long term, the key forces that sway the oil
supply-demand balance will all work to push prices upward: Demand will rise
as the global population rises; supplies will become constrained as
oil-producing nations retain greater portions of their production for
domestic use; and production costs will climb and climb as we run out of easy
oil and are forced to tap into more complex and costly reservoirs.
However, a bullish long-term perspective doesn't
preclude a bearish short-term viewpoint. And that is precisely what I have.
In the near term, oil prices are going to slide. The
largest economy on the planet, the EU, is slipping and sliding through a
financial storm that will likely tear the union apart. The world's
second-largest economy, the United States, is still struggling to keep its
head above water and now must contend with the uncertainty of a presidential
election. The third-largest economy on the globe and the one that has
propelled global growth for the last decade, China, is showing serious strain
– growth has slowed, inflation is rising, liquidity is evaporating, and
jobs are disappearing. In the fourth-largest economy in the world, Japan,
sovereign debt has reached 225% of GDP (in Greece, the ratio is only 140%)
and represents almost 2,000% of government revenues, which is a completely
unsustainable scenario.
Clearly, global economies are not in their prime. And
when the world's economies slow, demand for oil drops and declining demand
means lower prices. To boot, Iran just reached a tentative pact with the
United Nations on nuclear inspections. For several months oil prices have
carried a premium because of concerns that the Islamic Republic would
blockade the Strait of Hormuz or go to battle with Israel. Now those concerns
are easing, at least for the moment.
Since oil prices have been near or above the $100 mark
for what seems like ages now, you might think that oil companies have
breathing room and can handle a price slide of 15 to 35%. After all, oil
prices only climbed above $50 a barrel in late 2004 after averaging
approximately $25 for two decades.
If Big Oil could make money at $25 oil ten years ago,
surely they can survive at $70 oil today, right?
Wrong. A heck of a lot has changed in the oil sector in
the last ten years, and the primary result has been a dramatic increase in
production costs.
A decade ago it was standard for oil companies to
assess a new project's profitability using an oil price of US$17 to $20 per
barrel. Prices had been at that level for many years, and most reservoirs
were near surface and easy to access, which meant it often cost less than $10
to produce a barrel of oil.
Then we started to deplete the easy oil. The days when
a company could simply prick the Earth's crust in Texas or the Middle East
and let the black gold gush became a fond memory. Instead, companies had to
drill deeper to find oil, fracture tight rocks to enable oil to flow, figure
out how to produce oil from reservoirs underneath several miles of water, or
develop methods to separate sticky oil from sand. And production costs
soared.
By 2008 the cost to produce a barrel of oil from a new
project had climbed to between $50 and $75 per barrel. Today, it's even
worse.
New production from the Canadian oil sands and from Venezuela's
heavy oil deposits costs roughly $70 to $90 a barrel, all in. Deepwater oil production costs $70 to $85 per barrel. To
produce oil from tight oil formations in the United States such as the Bakken shale costs at least $80 a barrel. And production
from Arctic oil reservoirs, coal-to-liquids and gas-to-liquids projects, and
biofuels are even more expensive.
Here's a good example of why costs have climbed so
dramatically. In 1985, only 6% of the oil produced in the Gulf of Mexico came
from wells drilled in water more than 300 meters deep. By 2009, deepwater wells accounted for 80% of the Gulf's output. Deepwater wells are very technical and very risky, but
they are also more and more common as Big Oil tries to keep increasing output
to meet growing demand. The huge deposits off Brazil's coast will demand
similar deepwater operations, while the Arctic
deposits in northern Russia and Canada are in waters that are not only deep,
but also very rough and very cold.
Here it is important to note that most OPEC producers
can spit out a barrel of oil for considerably less than those estimates. In
most OPEC countries even new production costs approximately $50 a barrel.
However, most OPEC countries rely on oil income for the bulk of their
government spending, and that responsibility boosts the "cost" of
each barrel significantly.
In many OPEC countries, each barrel of oil sold to the
international markets has to generate enough revenue to pay for the massive
social programs used to placate their restive populations – programs
that ballooned in the wake of the Arab Spring as leaders bought their way to
stability with promises of handouts, jobs, greater security, and increased
benefits. Saudi Arabia now needs an oil price of almost $100 a barrel to meet
the billions in social-spending pledges made to quell Arab Spring discontent
(up from only $50 a barrel a few years ago); and many other major oil
countries, including Venezuela and Russia, are in a similar position.
As such, from Canada's oil sand to Brazil's offshore
reservoirs to Saudi Arabia's conventional fields, it is safe to say that most
producers need to make at least $85 from each barrel of oil sold in order to
meet their costs.
Today, West Texas Intermediate is trading at US$91.75
per barrel, while Brent oil is priced at US$109.20 a barrel. That is not a
lot higher than US$85, which means prices would not have to decline much
before producers start shutting down production from projects where the costs
outweigh the benefits.
The bottom line is that Big Oil's cost-benefit balance
is much tighter than many would think. For the investor, the question is
always: how can one profit? There are quite a few
ways to play a falling oil price, but in the upcoming Casey Energy Report I outline my suggestion. It's an
investing avenue that I'm excited enough about that I am actually creating a
special new section within the monthly CER with a supplemental recommendation…
but I've given enough away already.
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