Oil Markets Tight Out to 2020

September, 2006

Oil prices are softening recently as the US economy slows and analysts—one-time bulls on the oil market—are now floating the dreaded bubble world. Softer prices are predicated on oil companies spending record amounts of money to boost production over the next few years, but what about further out? Recent estimates of oil demand from China over the long-term appear overly conservative. That and serious questions about production looking as far out as 2020 suggest that any softening in the price of oil will be short-lived.

Estimated oil demand appears to be too conservative in the near term, and especially looking out to 2020. In 2004, OPEC’s estimates of oil demand for 2005 were well short of results. Estimated oil demand for 2005 (reference case) of 81m. barrels per day (bpd) in OPEC’s 2004 edition of oil outlook to 2025 undershot actual demand which clocked in at roughly 84 m. bpd.

Looking further out, the waters are obviously murkier. Total world demand in the reference case is estimated at 105.8 m. bpd in 2020. In particular, and most prosaically, China’s demand is estimated at 11.4m. bpd for the year 2020. Similarly, the International Energy Agency (IEA) in its 2005 World Energy Outlook pegs China’s oil demand in 2020 at 11.1m. bpd.

In the OPEC report, the authors point out that “China and India are central to this growth [in emerging markets],” so estimates can hinge on China ’s demand. And with that point in mind, OPEC’s estimate for China appears low, considering the potential size of the auto industry in China by 2020. If current numbers are any indicator, the auto sector alone will push Chinese demand well above OPEC’s estimate of 11.4 m. bpd, and that excludes growth from any other area including non-auto transportation, industrial and commercial use.

China was already the world’s third largest car market in 2004 (based on the 5m. cars sold), and expectations are that it will be the biggest between 2010 and 2015 according to David Thomas, head of distribution in China for Ford. If those estimates come true, China could have 156m. cars on the road by 2020 according to the Development Research Center (DRC) of the State Council of China.

Consider that in the U.S. 130 m. autos consume 4.9m. bpd of oil or 25 percent of total oil consumption. A back of the envelope calculation suggests that China ’s auto industry will consume a minimum 6m. bpd of oil by 2020 and perhaps more.

Growth in incomes and demand for autos are rising even faster than GDP, suggesting that the DRC estimate of 8 percent growth in auto demand is eminently plausible. Per capita incomes in urban areas grew by 13.3 percent from 1990 to 2005. That has led to tremendous growth in the auto sector, albeit from a low base. The total number of vehicles, both cars and trucks, grew by 11 percent from 1990 to 2003.

The IEA reports in its June Oil Market report that, in 2005, China consumed 6.59 m. bpd of oil. Assuming no growth in oil demand outside China ’s auto sector, demand by 2020 is likely to top 12.6 m. bpd of oil, well higher than OPEC’s estimate back in 2004. If oil demand in China ex-autos grows by even 2 percent, OPEC and IEA estimates will be well short of projections, given that total transportation demand (cars, trucks, air, etc.) in China currently accounts for one quarter of total oil consumption.

Given the challenges in finding and producing oil this decade, there are serious doubts whether supply will be sufficient to meet total projected demand in 2020—overly conservative estimation issues notwithstanding. The World Bank noted recently in its 2006 edition of Global Development Finance that, despite sustained higher oil prices, supply has failed to respond to these incentives. They mark this fact in contrast to the 1970s and 1980s, “when increased output brought substantial new capacity on line, helping to reduce prices.”

Until very recently, the IEA has warned that the oil industry is underinvesting in oil projects to meet estimated demand looking far out into the future. Oil majors may be the culprits, returning an estimated US$ 250 bn. to shareholders from 2006 to 2008 according to UBS. The IEA says that Saudi Arabia would need to double current output from under 10 m. bpd to 20 m. bpd by 2030 to meet demand, and serious questions remain about the Saudi’s ability to do so.

The issue is not simply one of new supply but one of depletion. New supply must exceed current depletion to increase oil production. For example, last year, new non-OPEC supply was almost entirely nullified by depletion and storm damage. Gross additions of 1.42 m. bpd yielded a net addition of just 30,000 bpd according to the April 2006 edition of Petroleum Review.

Chris Skrebowski, editor of Petroleum Review, estimates current annual depletion at 5 percent per annum. Despite this drag on production, he estimates that oil demand is well covered out to 2010, based on the number of projects that are currently in production.

There are good reasons, however, to question official future production estimates. One of the biggest question marks relates back to depletion and the sustainability of new production. Saudi Arabia , for example, is spending roughly $11bn to revive its Khurais oil field, with grand production estimates of 1.2 m. bpd in 2009. Investment banker Matt Simmons, author of Twilight in the Desert, attributes the massive cost of this project in part to the building of two “massive pipelines” from the Persian Gulf to pump in 7 million barrels of seawater a day—the implication being that the field is suffering from primary depletion which raises doubts as to the sustainability of that supply.

Another major problem affecting new developments is a general shortage of staff and equipment in the oil-services industry. Oil-service equipment prices are experiencing rapid inflation, even triple-digit growth over the past eighteen months. The much-feared shortages in the spot-oil market have not materialized, but that is not the case in the oil-services industry. The result is that production plans are being delayed, and in some cases shelved due to soaring costs as evidenced by the recent major cost overruns in the joint-venture Athabasca Oil Sands Project in Canada.

In recent months, there have also been supply shocks caused by weather disturbances and politics. The severity of hurricanes is rising due to rising sea temperature, likely caused by global warming. Separate studies coming out of MIT and Georgia Tech both point to increasing hurricane “intensity and duration” by as much as 50 percent since 1970.

While the increased likelihood of hurricanes remains difficult to predict, political storms in the oil sector appear much more certain. Left-leaning governments in South America are forcing oil companies to renegotiate contracts under far less favourable terms and are threatening production capacity as a result.

Foreign firms pump roughly one-third of Venzuala’s oil, yet they are doing so under increasingly unfavourable conditions. Oil fields have been seized from French oil producer Total and Italian producer Eni. Exxon has sold out of the region entirely. Perhaps unsurprisingly, Venzuala’s oil output has fallen from 3.1m bpd to 2.6 m bpd since Hugo Chavez took power in 1998.

Russia, the world’s second largest oil producer, has recently questioned oil agreements for issues of “national security,” particularly over the Sakhalin 1 and 2 projects in which Exxon and Royal Dutch Shell have invested a combined $25 bn. The IEA recently warned that Russian oil-supply estimates are overly optimistic out to 2010.

Given these mounting forces that threaten to prolong the imbalances in the oil sector, oil prices may descend from its lofty heights over the next 18 months, but that respite may prove temporary. As the time horizon increases, so do the risks that oil prices will rise.