The oil market includes all types of crude oil, condensate, natural gas liquids, oil recovered from shale and oil sands, and now, increasingly, biofuels.
Crude oil varies in grade, from solid bitumen through to heavy oils of an API grade of less than 15-17 degrees, and up to Brent at around 33 degrees API, West Texas Intermediary (WTI) at 42 degrees API right up to light Tapis type crude oils which grade around 48 degrees. As a rule of thumb, the price of crude varies about 1 per cent up or down from the quoted WTI marker price for every degree of API rank either side of the mark.
It is the judgement of Briefcase that, over the medium to long term, the price of oil will move substantially higher than today's price in real terms. Short-term trends are harder to forecast, especially since the commodity has become the subject of increased market attention by hedge funds and commodity traders.
The scene for the current strong repricing of oil, and indeed all energy commodities, was set during the 1990s when, in common with most other commodities and in response to all-time-low prices in real terms, the sector was subject to chronic underinvestment in exploration and new project development.
During the past three years, oilfield development costs have more than doubled. The price of drilling and completion equipment hire, along with labour costs, the cost of steel and indeed the cost of fuel have all lifted capital and operating costs, so that the breakeven oil price required to initiate new field development has risen from around $US25 per barrel at the beginning of the decade to more than$US40 per barrel, and a price of around $US75 per barrel is estimated to be required to provide an adequate return on capital in most cases, especially for larger projects.
Underinvestment in infrastructure, equipment and skills training has led to a chronic shortage of drilling and other oilfield equipment, along with the skills required to operate such equipment, so that the average age of professional engineers and geologists operating in the industry has risen to the mid 50s. While funds may be available, these shortages are hampering the progress of both exploration and development, while exacerbating an already rising cost environment.
Over the past couple of decades, there has been a clear trend for new oil discoveries to be smaller, deeper, more difficult oil types, located in relatively hostile parts of the world, from the standpoints of both their physical and political environments.
Huge new oil discoveries in Kazakhstan, Venezuela, Nigeria, Angola, Brazil and offshore Indonesia, all suffer from problematic fiscal regimes, potential or actual social unrest impacting on production, and often engineering challenges which stretch the boundaries of mankind's ingenuity and innovation.
Around the world, fiscal terms for oilfield operators have tightened. Governments are demanding and receiving higher taxes and tougher terms for production sharing contracts, where more than 90 per cent of the profit produced from an oilfield often ends up with a national oil company, leaving major independent oil companies holding all the financial and technical risk but in return receiving rates of return equivalent to those which might be more appropriate for a contract engineer, who simply provides a service.
No wonder that the boards of these companies are often reluctant to invest shareholders funds under such conditions, preferring to buy back shares or pay higher dividends, rather than take such unsustainable risks.
National oil companies increasingly control the lion's share of global oil production, with some estimates calculating 70 per cent of global production under their control. Nationalisation by law or by stealth is an increasingly prevalent influence on the level of investment directed towards the industry. This is likely to reduce the potential for efficient and timely oilfield exploration and development activity.
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In aggregate, global demand for oil continues to rise by around 1.4 million barrels per day, each year. While demand from OECD nations has been relatively stable, demand from China, other developing nations and indeed the major oil producing nations, has been rising at around 5 per cent annually. The price of petroleum products in most OPEC nations remains unsustainably low, since governments provide considerable financial support, which encourages wasteful use. Modifying this behaviour is unlikely in the medium term, given the likely social and political consequences of higher fuel costs in these nations, especially in an already high price environment for many basic foods, such as rice, corn and wheat.
Around the world, established oilfields are observed to experience rates of natural field production decline, averaging around 7.7 per cent a year. This rate of decline is much higher than previously assumed rates of 4-5 per cent. Oilfields in Mexico and the North Sea are observed to be declining at rates of more than 15 per cent a year.
With global oil production running at between 74 million and 75 million barrels per day and total liquids production, including condensate from the co-production of natural gas, oil from shale and oil sands, plus bio-fuels, hitting 87 million barrels per day, Briefcase estimates that new oil production of about 3.7 million barrels per day is required each year, just to maintain global liquids production at current levels, before making an impact on expanding daily output.
- Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au
