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Dont lets ignore long-term trends!: Increasing Signs of Peak Oil Supply Pressure

Energy Strategy Commentary
Andrew McKillop
Senior Energy Strategist
October 2007

Increasing Signs of Peak Oil Supply Pressure

Through October to date (Week 43), with increasing media attention, oil prices continued to surge. Even the key phrase “Peak Oil” was to be heard, here and there, and usually denied through the regular and standard claims there is always more oil, somewhere, but it hasn’t yet been brought to market.

On September 29, the Wall Street Journal ran an article with a gung-ho optimistic tone, under the headline “How Economy Could Survive Oil At $100 a Barrel – Compared to 1980, U.S.Is More Able to Handle Once-Unthinkable Rise”. This article, almost inevitably, dismissed Peak Oil as a near-term reality. It focused the small role of energy in average US household spending (about 5.5% compared to 7% in 1980). It then gave a long list of other politically correct ways to explain high oil prices. These included the weakening US dollar against other moneys, consumer disinterest in energy saving compounded by automakers who go on building huge cars, fast-rising oil imports by China and India, resource nationalism in producer countries like Kazakhstan, Venezuela and Russia, and of course tensions and pressures in the Middle East wracked by wars in Afghanistan, Iraq, Palestine-Israel, Turkish threats to Kurdistan, Russian threats to Georgia, deepening crisis in Lebanon and growing unrest in Pakistan.

It then concluded, like any Happy Ending tale, with a forecast that the “bulge” in oil prices is “likely temporary”, because the real vilains are speculators, specially the hedge funds who play on worrying low crude oil and refined product stocks, and can drive up prices in a short-term hump that will “almost certainly” tail off seasonally, like they did one year ago. Of the supposed reasons for oil prices that are “approaching their all-time peak of 1980 in inflation corrected terms”, given as exactly $101.30 per barrel in this WSJ article, the supply context got an overall low billing, except as being negative mostly through geopolitics, not geology.

Giving a little reason to this jumbled assortment of politically correct ways to explain Peak Oil’s effects on oil prices without mentioning Peak Oil, the supposedly exact peak price tag of 1980 oil, $101.30, itself explains a lot. In 1980 there was no 24-hour electronic trading of oil and a big chunk of all traded oil (then about 40% of all oil consumed and utilised, today about 55%) was settled or paid by netback and offset methods that almost defy setting a fixed price in 1980 dollars. After that, we have to calculate the inflation adjustment and real purchasing powers of 1980 and 2007 dollars. In brief, the few solid studies of this subject show, oil price peaks attained in 1980 and converted to 2007 dollars were likely in a range of $85 to $135 per barrel.

Demand and Supply

Oil is an emotive subject where rational factors, simple facts and figures get swamped by the irrational, because of our near-total dependence on oil despite the frothy hope and excitement generated by biofuels, giant windmills and solar PV arrays giving us expensive electricity – in the daytime. The press and media is now full of talk about “100 dollar oil” in 1980, and its growing chances of coming back today.

In 1980 the world’s daily average oil burn was about 64.1 million barrels/day, but today it is around 87.5 – 88.5 Mbd, and just like the 1980 price, the number chosen has to be politically correct ! The US EIA and OECD IEA, and the big oil corporations like the lower number, enabling them to give a low figure for world demand growth in 2006-2007. But few agencies or experts will contest the 1980 figure, nor argue with average triannual (3-year cumulative) growth rates of world demand in that era, at the Dawn of the Gipper, of Ron Reagan’s reign, which brought fantastic US trade and budget deficits, and a weak dollar – exactly like today.

The 10 years of riproaring economic growth culminating in the Crash of 79, and “$101.30” oil in 80, regularly saw triannual growth rates of world oil demand well into double digit percentages. If we took only the first two of these periods, 1971-74 and 1975-78 we get a stupendous total for these two triannual periods of forty-five percent.
You read that right: world oil demand explosively grew by 45% in 6 years. The reason was simple : vintage economic growth, running at close to 5% annual for the world economy – exactly like today.

We can note that growth of demand through 1980-2007, at least 24 Mbd, is itself a stupendous number: today, small and apparently modest annual percentage rises generate big annual volume increments, like big annual percentage growth numbers did on a much smaller world demand base in 1980. To grasp how huge that 24 Mbd in 27 years really is, we can consider just two demand and supply facts. If you took the USA and India, their total current demand is about equal to 24 Mbd. If we forgot about the USA, this demand growth number is more than the combined current oil demand of all west European EU-15 countries plus China and India.

When we get on to supply, things get even more extreme.Depletion is at least now admitted in all kinds of places, from Mexico and the North Sea to Russia, Kuwait, Venezuela and USA. Taking simply Russia and the “FSU CSR”, or Former Soviet Union plus the Central Southern Republics, the various “-stans” like Kazakhstan, their combined total production in July 2007 was running at around 29.9 Mbd, and their domestic oil consumption is growing at close to 6%-per-year.

Petro Keynesian Growth

The WSJ article referred to above, and a swath of similar commentaries like to reassure readers by pointing the then-and-now differences since 1980. On the finance-positive side they point to the recycling of today’s petrodollars, much more powerful and systematic than 27 years ago, through massive urban development, industrial investment and consumer spending in exporter countries. More worrying to some perhaps, but a simple fact, the oil and resource exporter countries, and China, are quickly amassing huge “sovereign national wealth funds”, with a current estimated 2 700 Billion USD to reinject in the world’s finance circuits – in any way they decide, with little or no transparence. Rather surely, these funds will target company acquisitions in the energy sector downstream, in consumer countries, as well as their own national resource sector, infrastructures, transport, urban and industrial development – all of them energy and oil-intensive, making it sure and certain they will use more of their own oil.

In this way and to be sure, the huge increases in foreign exchange inflows to oil and other resource exporters riding the Commodity Super Cycle, and to China the new “Workshop of the World” riding the world’s current 1970-style economic growth, can only feedback in one way: faster and stronger growth. World liquidity, for example, is raised by high commodity and energy prices and itself speeds economic growth, for example by eroding real interest rates. Combined with declines of the US dollar – used to pay about 70% of traded world oil – many world consumers of oil and other commodities in fact can more easily afford to buy them now, at higher prices, than in the “New Economy” 1990s when oil and most commodities were dirt cheap.

There are good chances the rest of the world will play locomotive to the US economy, and perhaps also the Japanese and European economies, most of them suffering from sliding growth, rising inflation and threats of stagnation. Without Petro Keynesian growth this would be unlikely. With no single global locomotive, the triad of USA-Europe-Japan in the 1970s and 1980s, we could have a classic OECD-led world economic recession, if the triad decided to slump into stagflation. This in turn should be another simple reason for US political and finance leaders to be less than stressed about ‘vintage oil prices’

High Oil Prices and Market Indices

More closer to reality and in easily demonstrated fact rising oil prices drive equity prices, which is just about the exact opposite of ‘perceived wisdom’, built on the 1990s experience of slow economic growth, but fast equity growth. The so-called “New Economy” of the 1990s, we can surmise, was an aberration coming out of the 1980s rout of panic interest rate rises “to fight inflation and high oil prices”. Unrealistic equity growth on the back of sluggish real economy growth – and highly modes annual growth rates of oil demand – was doomed to end in a rout, the dotcom and technology crash.

Since 2003, when the Commodity Super Cycle led by oil pirce rises really got into the driver’s seat, the correlation of US stock prices, and oil prices is very clear:

Other Kinds of Stocks : Oil Stocks

One simple fact – but treated as either a cause or result of “extreme” oil prices by opposing schools with different choppers to grind – is that oil inventories in almost all countries, OECD and emerging, are low, very low or extreme low. For most oil economists, analysts or journalists holding to conventional wisdom, this is a technical issue, also driven by weather trends, refinery problems, and so on. The influence and role of Peak Oil is either denied or ignored, but it gives a better explanation of why stocks are so low, and oil prices, at the entry to Winter 07/08, are acting totally unlike they did in Q3 and Q4 2006.

A few mouse clicks in a myriad of Web sites will yield dozens of different definitions of what “Peak Oil” means or could and might mean.

Cutting through this, what we need is an operational definition – which essentially means that Peak Oil is when we move into persistent and increasing physical undersupply of oil markets, and continuing weakness of stock builds/strength of stock draws.

A few figures I cited in last month’s Newsletter (Vol 187, October 5) show how US oil stocks, in every category, are lower – sometimes 15% or 20% lower – than one year ago, specially for crude and heating oil. OECD-wide inventories, and individual country inventories, also including China and India tell the same story: stock draws in Q2 and Q3 2007, and sometimes since Q4 2006, are very high.

Any supposed “surprise” over this is, to my mind, the ultimate in disingenuity. With vintage economic growth and an infrastructure, manufacturing and urban development boom in countries covering two-thirds of the planet – plus accelerating oil depletion in the straight majority of older production provinces – is it really a surprise that oil stocks are low ?

Last Hope for Cheap Oil: Seasonal Demand Slump

Some people like to opine they “believe in Peak Oil” but don’t like to say when it will happen. Most still prefer to deny it because the bottom line is so simple: Crude oil and product prices will have to explode. The only way for that to be put back a little longer – according to extreme optimists until 2025 or beyond ! – is to argue for seasonal demand slumps. That is in September-December when summer vacation car drivers and airplane passengers get back to work in their energy efficient offices, but don’t need to heat their energy efficient homes because of climate changed warm winter. At that time and inch’allah, oil demand will fall away like snow in spring (if there is any snow), and with a few optimistic numbers on US heating oil or crude oil stocks, the bears can talk down oil prices. This gets heartfelt applause from the media – the same media that criticises traders talking up prices when stocks go on falling.

Comparing November or December crude and product price forwards of late 2006 with late 2007 should sober up the optimists: they are radically or even totally different; In late 2006 the price curve was only one way: down. Open a newspaper to find out which way they are going today.

In other words the “seasonal demand slump” isnt happening this year or we are at Peak Oil on the supply side. In my estimation and analysis it is now at least 65/35 that the second proposition is the right one. Strands of information, or rather propaganda from the EIA, IEA and the major oil corporations (none of which today control more than about 2.8 Mbd of crude oil output capacity – but refine and distribute oil products to get shareholder value) tends to confirm this. Since September 2007 estimates of world oil demand growth in year to date are resolutely, and suspiciously low after going into higher ground earlier this year. In other words it was politically correct to imagine world oil demand growth was running at above 1.8 Mbd-per-year earlier on, but now the numbers have to be a lot lower to give the trader bears, likely an endangered species, a chance.

The foolish hermetism of this reminds us that economics and religious doctrine share a lot of common traits: chanting the same thing enough times can finish with belief it might be true, specially when troubling real world facts are rigorously excluded. In 2007 YTD world auto manufacturers have already produced about 60 million new cars and 20 million new motorcycles and scooters – for the whole year we may attain 70 million cars and 25 million 2-wheelers, and that excludes the 4 million heavy trucks, and several million new tractors, combine harvesters (sometimes with 600 HP engines, just able to beat Ferrari and Porsche for gas guzzling), scrapers, dozers, mobile cranes and the rest. World airplane manufacture, like bulk cargo and container ship construction (with Megawatt-sized oil burning engines) is at record levels. The very thing any purchaser or operator does with their proud new acquisition is fill the tank.

To be sure, world oil demand is now extremely impacted by seasonal change, but this itself is Peak Oil related. If or when we have that straange thing – a semi normal winter – we can be sure that net long positions in crude futures will be yet more massive than today. According to the US government’s commodity trade watchdog, the CFTC, net long positions in crude oil grew 27% in Week 42.

Price Definition

By “price explosion” we can take the ‘magic’ 3-digit price in USD/bbl, that is 100 USD/bbl, or to keep WSJ happy $101.30.

We can note that ML, GS, Lehman Bros among others regularly put out price warnings for oil in Q4 2007 at well over 85 USD/bbl average. Analysts now seem able to say 100-dollars per barrel without averting their gaze, quite often.

In fact only one thing could surely avert triple digit oil prices on a very short-time base, that is a coordinated set of big interest rate hikes by the US Fed, ECB and BoJ. To some ideologues in these organization this complies with orthodox monetarist doctrine, honed in the 1980s rout, and telling them high interest rates can kill high oil prices through killing the economy. However, and interestingly, none other than Ben Bernanke is hostile to this “sure and certain remedy”, perhaps because he wants to keep his job, which could be compromised if he set the US economy on the hara-kiri track of all-out recession simply because gasoline cost as much as $3.50 or $4 a gallon at the pump – compared to over $7 per US gallon in plenty of European countries today.

What Comes Next

The 1980s rout was a long time back in time, and world depletion is catching up with the Petroleum Age. While the OECD IEA and the US EIA, and plenty of government-friendly consulting firms like CERA and WoodMac still invoke Saudi Arabia’s “massive spare capacity” (and only Saudi Arabia is now cited – not like the Good Old Days of the 1990s when spare capacity was ‘everywhere’), real output from the Wahabite Kingdom has hardly budged in the last 3 years. Maybe it really cant be raised more than, say, 1 Mbd ? Maybe it cant be raised at all ? One thing we can be sure of is this: Saudi Arabia’s domestic oil consumption is increasing at around 5% – 7% per year, like domestic demand in most other OPEC and NOPEC countries.

This is a two-pronged attack on suplly, comprising reduced net exports and decreasing output – when the final peak is attained. To increasing numbers of analysts and researchers that final peak has ben attained, right now in 2007 and not “in 2035” or some far-off date in the misty future.

We cannot be at all sure the Fed, ECB and BoJ will operate a gut/kneejerk reaction to triple-digit oil prices until well into 2008. We are surely in ‘wait and see’ mode. While financial, monetary and economic deciders will surely and certainly hope ‘reason will prevail’ and oil producers – that is Saudi Arabia – will somehow magic up hidden, unused capacity and ‘flood the market’, this is almost totally unlikely. If the prop of a hoped-for seasonal slump in demand due to climate changed extra warm Winter does not happen, oil prices will go on growing.


Andrew McKillop
Juno ME Asset Mgmt
New York
October 2007

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