Oil in Focus Again

Here we’ve had a few months of favorable oil prices, and as a result, oil has taken a back burner to other stories. It’s beginning to come to the fore, mainly in not-positive ways.

We have two items today, one a very good post on Econbrowser, “Saudi Oil Production Cuts,” and what they might say about their situation, another in the Financial Times, “Study sees harmful hunt for extra oil,” on the cost (high in financial and environmental terms) of developing “unconventional” oil like oil sands and Venezuela’s very heavy crude.

Econbrowser rejects the commonly-held idea that the Saudis have cut production to moderate the price of oil. It does, however, acknowledge their power as THE marginal supplier:

The future of world oil depends critically on what happens in Saudi Arabia. The country’s importance comes not just because it accounts for more than 10% of global production, but moreover from the fact that it produces almost a quarter of the oil globally available for export. Furthermore, nearly a third of the increase in global production by 2010 that is assumed in the EIA’s reference case forecast is supposed to come from Saudi Arabia.

The piece then goes through a series of charts that show that the oil prices have in fact not stabilized in the wake of Saudi supply curtailment. The cuts began when oil was trading at $62 per barrel, before it shot up to $78. The recent moderation is due to a temporary supply glut, thanks to an unusually warm winter (at least until recently). Remember that the oil price we hear bandied about is the spot market price. it reflect current demand and supply, not long term prospects.

The post continues:

We do know that concomitant with this decrease in Saudi production has been a huge increase in the effort they’re making to find and produce new oil, as evidenced by the number of oil rigs the Saudis are employing.

We also know that the decrease in production has coincided with a deterioration in the quality of oil that the Saudis are trying to sell and develop. For example, there was this story from Reuters last summer:

China will extend a 50,000 barrel per day (bpd) cut in Saudi crude oil imports into July and August after some refiners struggled to cope with new higher-sulphur supplies, industry officials said.

China contracted to buy 500,000 bpd of Saudi crude in 2006, but cut that back by 10 percent in the second quarter after refiners ill-equipped to handle the kingdom’s mainly heavy-sour oil were forced to slow production after running the grades, the officials said.

As another example, an important part of the Saudi’s new production plans evidently involve the Manifa oilfield, which the Saudis had discovered in 1957, but up to now had decided not to try to develop because existing refineries were unable to process its high-sulfur oil….Here are the two possibilities that I find most plausible.

The first possibility is that the Saudis could still pump 10 mbd or more today if they wanted to, but they are cutting back production and exploring like mad because they put an extremely high value on having 2-3 mbd of excess capacity. If so, the recent price behavior suggests that the reason they would seek such capacity is not because they want to stabilize the price, but because it puts them in an incredibly powerful negotiating position. For example, the ability at any time to flood the market could be used at an opportune moment to undercut expensive alternatives such as oil sands that require an oil price over $50.

The second and more natural interpretation is even more disturbing: the mighty Ghawar oil field is already in decline, and the Saudis don’t want anyone to know….

So, I find myself wondering the following– suppose that someone in the CIA knew for a fact that Ghawar was in decline– what would we be observing out of Washington? The ramifications are so enormous, many, many decision-makers would surely need to be informed. It’s hard for me to imagine that something so widely disseminated could remain a secret in Washington. According to this reasoning, perhaps we should read the fact that the story hasn’t yet been leaked as an indication that it hasn’t yet happened.

Unless the spooks don’t understand the full implications of the facts they are sitting on. Perhaps not unlike the Wall Street Journal.

Now I’d like to believe the CIA is smarter than the Wall Street Journal (although with the high level of departures, that may no longer be true). But I knew people who believed in the run up to the Iraq war that if there were no WMD, the story would surely have been leaked. Well, there were no WMD and there was no leak. Daniel Ellsberg, in his book Secrets, says that there are matters of vital importance to the public at large (like the fact that the Gulf of Tonkin incident was phony, for starters) that are held in confidence by hundreds, sometimes thousands of people. So the “gee it would have been leaked” idea is wishful thinking.

I see a variant of Econbrowser’s theory: the Saudis want reserve capacity because it gives them the whip hand over US policy in the Middle East. Saudi Arabia, like Iran, has been meddling in Iraq, but only Iran is getting heat. And the Saudis must know that the next Administration is likely to be less sympathetic towards them. The more cards they hold, the better.

But the deterioration of the Saudi’s oil is very likely the other big cause. It’s strictly anecdotal, but a friend’s middle aged son has spent his entire career as an oil engineer in the Middle East, and he says the Saudis have badly mismanaged their fields, meaning they have actually damaged them.

Which means the importance of alternative sources, including oil that would previously been regarded as marginal, becomes more important. And the FT story tells us that picture isn’t so pretty either. Note that the underlying report was prepared by Wood Mackenzie, an energy consulting firm (meaning not environmental advocates).

All the world’s extra oil supply is likely to come from expensive and environmentally damaging unconventional sources within 15 years, according to a detailed study.

This will mean increasing reliance on hard-to-develop sources of energy such as the Canadian oil sands and Venezuela’s Orinoco tar belt.

A report from Wood Mackenzie, the Edinburgh-based consultancy, calculates that the world holds 3,600bn barrels of unconventional oil and gas that need a lot of energy to extract.

So far only 8 per cent of that has begun to be developed, because the world has relied on easier sources of oil and gas.

Only 15 per cent of the 3,600bn is heavy and extra-heavy oil, with the rest being even more challenging.

The study makes clear the shift could come sooner than many people in the industry had expected, even though some major conventional oil fields will still be increasing their production in 2020. Those increases will not be enough to offset the decline at other fields.

“It becomes unclear beyond 2020 that conventional oil will be able to meet any of the demand growth,” Wood Mackenzie said. The report added that natural gas products such as liquids and condensate would also become important sources of growth.

The increasing reliance on unconventional oil will require a substantial reshaping of the energy industry.

Royal Dutch Shell and Total of Europe and ExxonMobil and Chevron, the US-based energy groups, have already begun to invest heavily in Canada and Venezuela.

Others – including Chinese energy groups – are looking at the possibility of extracting heavy oil from Madagascar.

On the gas front, Devon Energy last year spent $2.2bn (€1.7bn, £1.1bn) expanding its already sizeable position in Texas’s Barnett shale by acquiring Chief Oil and Gas. The development of such shale deposits is expected to help the US get 40 per cent of its production from unconventional sources by 2020.

But the challenge is huge, said Matthew Simmons, an industry banker who sent shock waves through the oil world when he questioned whether Saudi Arabia, the most important oil source, would be able to continue to expand production.

“The ability to extract this heavy oil in significant volumes is still non-existent,” he said in a recent speech.

“Worse, it takes vast quantities of scarce and valuable potable water and natural gas to turn unusable oil into heavy low-quality oil.”

“In a sense, this exercise is like turning gold into lead,” Mr Simmons said.

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