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The Globe and Mail: Why some reserves are going untapped

Wednesday, March 26, 2008

OTTAWA — Under the original optimistic plans, nearly half a million barrels a day of crude oil should now be flowing from Kazakhstan’s Kashagan field, which contains the world’s largest untapped reserves.

Despite record crude prices, however, not a single barrel has made it out of the ground. Rather than stimulate production, the rising price of oil has actually contributed to lengthy delays with the Kashagan project.

Already facing extremely hostile physical conditions, the companies developing the project watched as skyrocketing oil prices fuelled inflation in construction costs and prompted the Kazakh government to revisit the production agreement.

A project that was supposed to come on stream in 2005 is now slated to start up in 2011, assuming no further delays by its much-criticized operator, Italy’s Eni SpA, which is partnering with Western giants such as Exxon Mobil Corp. and Royal Dutch Shell PLC.

The problems facing the Kashagan project are increasingly common in today’s global oil industry. Despite a six-year runup in crude prices, which hit a record $110 (U.S.) a barrel last week, oil companies – both publicly traded and state-owned – are having difficulty keeping up with rising world demand.

There are myriad reasons for the surprisingly weak supply response to high prices: a paucity of major discoveries in the past several decades; the more costly and complicated nature of developing resources from unconventional sources like oil sands and deep-water fields; the rise of nationalism in resource-rich countries; and the innate conservatism of oil industry executives, who have been burned by oil price collapses in the past.

But higher prices themselves may actually discourage the addition of new supply in some circumstances, analysts at Swiss investment bank UBS Ltd. say in a study released yesterday.

“Price inflation has created new obstacles as companies and governments try to make sense of project costs,” they said.

“With the temptation for governments to tighten fiscal terms with rising prices, the task of identifying appropriate returns has become tougher.”

The UBS team, led by London-based analyst Jon Rigby, compiled a roster of major projects – those with expected production of more than 100,000 barrels a day – due to come on stream through 2015.

With rising demand, plus declining production from existing fields, the industry needs to add at least 4.5 million barrels a day of new supply each year.

But relying on major projects won’t meet that target. In the current year, the UBS analysts estimate new supply sources will produce 4.4 million barrels a day, but that figure drops to 2.9 million in 2009 and a paltry 1.7 million in 2010.

That suggests prices could ease this year, as new additions in Saudi Arabia and the former Soviet Union provide a cushion in the face of demand weakened by the global economic slowdown.

Thereafter, the market will tighten again as new production is unable to keep up with demand growth.

Leading members of the Organization of Petroleum Exporting Countries, like Venezuela and Iran, are underinvesting in their oil fields.

Instead, they are using revenue to provide social subsidies to large and restive populations.

Among OPEC members, only Saudi Arabia – and new members such as Angola – have a large slate of new crude oil projects coming on stream in the near future.

Canada is well represented in the UBS list, with some two-dozen oil sands projects forecast to add 2.3 million barrels a day by 2016.

Despite the increasing power of national oil companies in places like Russia, Venezuela and the Middle East, the international majors have not lost their clout. But they are being careful with their cash.

Corporations like Exxon Mobil are returning cash to shareholders rather than invest in projects that don’t meet their high profitability standards.

Analyst David Kirsch of PFC Energy Group said companies tend to use extremely conservative price assumptions to determine which projects will proceed.

“You just see some deeply ingrained conservatism in what oil price forecast you use when you are pursuing future projects,” Mr. Kirsch said. “And I don’t see that culture changing over night.”

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