Oil’s Supply Side Constraints

``Nixon Administration officials were convinced that cutting the dollar's tie to gold and devaluing it against other currencies would increase our exports, slash imports and give us a fabulous round of prosperity. Instead, unhinging the dollar from gold gave us more than a decade of debilitating inflation, catastrophic increases in the price of oil and record-high interest rates.”-Steve Forbes

Well today’s rising oil prices is coming amidst further signs of deterioration in the US economy (growing signs of stagflation???)...

Figure 3: Economist: Spiraling Housing Inventories

Housing inventories in the US are scaling higher as shown by the Economist chart, see Figure 3. This denotes of a further downdraft in the housing industry. Cycles take time to unfold. This will not be an exemption, especially one that has been inflated by credit excesses.

According to the Austrian School of economics, recessions would begin at the “higher stages of production and not on the consumption stage”. And this had been the case in 2000, let me excerpt Mr. Gerard Jackson of Economic editor of BrookesNews, ``On 22 January 2004 the Joint Economic Committee’s Vice Chairman Jim Saxton pointed out that unemployment in manufacturing had been rising over a longer period. The unemployment situation was confirmed by the ISM’s manufacturing employment index which in 2000 had fallen below 50, showing that employment was contracting in manufacturing was still falling. The committee also reported that consumer spending continued to expand throughout 2001.”

Figure 4: Northern Trust: ISM Manufacturing Falls Below 50!

From Northern Trust’s Ms. Asha Bangalore ``Readings below 50.0 denote a contraction in factory activity. The PMI has held above 50.0 for 42 months. The details of the November ISM manufacturing report is important evidence for the FOMC about noteworthy slowing conditions in the factory sector. Historically, the PMI has a strong positive relationship with the year-to-year change in GDP when it is advanced by one quarter.”

With manufacturing showing signs of corrosion, would the Austrian’s viewpoint be re-affirmed again?

Of course, mainstream analysts usually base their comments from the framework of demand-supply dynamics, from which we do not dispute. However, our concern is today, can oil prices rise amidst an economic slowdown?

Figure 5 Chartoftheday: The Long term Oil cycle

The answer is yes, depending on the condition. So aside from the fraying state of the purchasing power of the US dollar, decreased demand can be cushioned by---an even faster rate of decreasing supplies!

I’d like to bring back an old chart from Chartofthday.com, which shows of the thirty year horizon and the previous declining oil cycle. As indicated in Figure 5, Oil has undergone a massive declining phase for about TWO decades, prior to the present upside cycle. The present cycle, of course, doesn’t indicate exemptions from obstacles as any trend does. The 2000 recession did bring oil prices down temporarily, but such decline was apparently utilized as a springboard for establishing new highs!

As mentioned above, politics have been undermining much of the progression of putting on stream the already strained oil supplies, evidently due to the color of money....and leverage for added political power.

A serious ramification to these developments have been the inability of Western major oil companies to replace their reserves, according to analyst Sean Brodrick, ``the Western oil majors — like ExxonMobil, Chevron, BP, and Shell — are failing to replace the reserves they pump. In 1997, they were able to replace 140% of their reserves; in 2005, they were able to replace only 75%! This indicates just how hard it’s becoming to find oil. Everyone’s trying to grab what they can, while they can. And as you know, limited supply will likely equal higher prices going forward.”

Yes, because of ongoing global trends of nationalization of the industry. For instance, in Bolivia and Venezuela contracts with private companies have been either cancelled or renegotiated for a higher share of revenue for the host government.

In addition, ``Last month, Russia threatened to revoke permanently the operating licenses of Western oil majors in the Sakhalin-1 and Sakhalin-2 project, while state-controlled Gazprom is excluding all foreign (notably Western) energy majors from its giant Shtokman gas project” adds Sean Brodrick of MoneyandMarkets.com.

According to analyst Martin Spring, ``Russia is extending its ownership of and control over natural resources and other industries regarded as strategic, as well as buying companies in other countries giving control over markets, such as pipelines and refineries. France has announced that cross-border mergers will not be allowed in 11 industries. The US has blocked foreign takeovers of ports and the oil/gas producer Unocal.”

There is also the unfolding phenomenon of utilizing domestic natural resources as political leverage for expanding political power. According to analyst Mr. Spring, ``Countries with large commodity reserves are increasingly using them to apply political leverage to achieve national aims. 85 per cent of the world’s oil reserves are effectively under state control.”

As Russia recently surpassed Saudi Arabia to become the world’s largest producer of oil and gas, according to Mr Brodrick, ``it’s ripping up contracts and forcing new deals on customers from Western Europe to the Asian steppes. The country uses its muscle to reward allies, like Armenia, by charging them much less for natural gas than critics like Georgia.”

Figure 6: US Global Investors: Rising Production Cost per Barrel

Moreover, there are also the cumulative effects of growing shortages in tools and equipments, rigs and importantly personnel like engineers and geologists to undertake such projects.

An added dimension would be the rising cost of production as shown in Figure 6!

Figure 7: WTRG Economics: World Rig Count

World rig utilization rates are at very high levels or at 93% according to DBS Vickers, see Figure 7.

According to WTRG Economics, ``International rig count, which excludes the US and Canada, was up 16 to 965 for the month of October, 2006 and is 114 rigs or 14.1 percent above last year's 846. The total number of rotary rigs worldwide in October was 3,130 down 4 from September and 264 higher than last year. US workover rig count for October, 2006 was down 8 to 1,562 and is 131 rigs above last year's level of 1,431.”

On the other hand, rig deployment level, while below the record numbers of the 1980s are at 15 year highs.

Yet, the technologically challenged oil rigs have been due to years of underinvestment, let me quote DBS Vickers, ``there has been massive underinvestment in rigs. Only 24 units were built since 1993 and only 40 units were built in the last 20 years. Thus, about 85% of the jackups rig fleet is older than 20 years. Currently, there are about 42 units under construction. However, including normal attrition, the jackup fleet could well remain flat over the next 2-3 years.”

Nonetheless, despite the massive deployment of rigs, only a handful of discoveries have been made, the largest of which have been at the Gulf of Mexico by Chevron, Devon Energy and Statoil ASA which found an estimated 3 to 15 billion barrels in several fields about 175 miles offshore and 30,000 feet below the gulf’s surface! Conventional oil gets harder to come by!

An additional constrain would be increased environmentalism which is doubling the lead time to operate these projects.

So as capital or required investments are diverted away due to increasing trends of political interference, aside from prospective supplies equally hampered by infrastructure shortages and production bottlenecks, the demand equation is unequally met by diminishing supplies!