In January 2004, I put together an article that appeared in the February 2004 issue of the Canadian Energy Viewpoint, which laid out the case for and against $50 oil. While the arguments against $50 oil have been thoroughly discredited, most market observers still do not understand that the price of oil will continue to head much higher. Below, I will examine several of the reasons why the price of oil will not significantly pull back from today’s levels and is likely to reach the $80 mark within the next 24 months.
At the foundation of many oil analysts’ argument for lower oil prices is the belief that OPEC can control the price of oil and use its spare capacity to keep the price within acceptable limits. There is one main reason this line of thinking is not valid – OPEC has no spare capacity whatsoever. OPEC, or more specifically Saudi Arabia, has given several indications over the past two years that it will increase production to keep oil prices at palatable levels, yet we continue to see oil prices reach new highs.
In past years, when there was excess production capacity both inside and outside of OPEC, high prices always brought additional supply onto the market. Times have changed and many analysts have failed to recognize it. Now that the world has reached the apex of Hubbert’s Peak (the thesis that once half of a petroleum-producing region’s reserves have been extracted, that region’s oil production will peak and decline along a bell-shaped curve), the world’s supply of oil will go down irrespective of price. This is an extremely bullish situation for the price of oil.
Some of the industry’s most informed participants believe there is little that can be done to increase worldwide oil production. Last year, British Petroleum announced that it will be returning to shareholders all cash flow it receives in excess of $25US per barrel. For every dollar the company receives in excess of $25US per barrel, BP will adjust its dividend or increase its share buyback program to return the cash flow to shareholders. BP has essentially given up its efforts to increase production or even keep production flat. Instead, the company has chosen to give shareholders back their capital with interest.
Another reason the price of oil is headed higher is that OPEC’s reserve base is vastly overstated. One of the world’s leading experts on petroleum supply, Dr. Colin Campbell, contends that OPEC has been vastly overstating its reserves for years. Campbell offers substantial evidence that OPEC reserve estimates are politically motivated. Kuwait is an excellent example of what is wrong with the way OPEC countries report reserves. The country reported a gradual decline in its reserve base from 1980 to 1984. This should be expected from a mature producing country. However in 1985, the country reported a 50% increase in reserves with no corresponding discovery. The Kuwaiti government increased its reserve estimate following the implementation of an OPEC production quota system that set country production levels based on country reserves. Kuwait was not alone in increasing its reserves for political reasons. In 1988, Abu Dhabi, Dubai, Iran and Iraq all significantly increased their reported reserves for political reasons. Even OPEC heavyweight Saudi Arabia followed suit and reported a massive increase in reserves in 1990.
Lack of new discoveries in both OPEC countries and non-OPEC countries has led to the current situation in which the world consumes far more oil each year than it discovers. According to Dr. Campbell, the world consumes four barrels of oil for every one it discovers. Clearly this situation cannot continue indefinitely since discovery and consumption must mirror each other.
The last reason I believe we will see $80 oil within the next 24 months is that worldwide oil supply is dropping and prices have not yet reached levels high enough to choke off demand. Despite record gasoline prices in the U.S. last summer, we saw demand increase 4% over 2003 levels. While Western economies will see modest demand growth due to the slow-growth nature of their economies, the developing world will see explosive demand growth for the foreseeable future. In 2004, China became the number two consumer of oil and the number two importer of oil behind the U.S. With Chinese oil imports up 30% from 2003 levels (despite today’s record prices), it is quite clear that oil prices would have to achieve much higher levels before Chinese demand recedes.
What does $80 oil mean for investors? Quite a lot. It is difficult to overstate the impact that $80 oil will have on every unhedged, publicly traded oil and gas producer. While most companies in North America are extremely profitable at $35 oil, $80 oil will generate earnings that will dwarf the so-called “windfall profits” of the 1970s. While many Wall Street and Bay Street analysts continue to use $35 oil in their assumptions for 2005, savvy investors should realize that the average price for oil will be far higher and should adjust their portfolios accordingly.
Bill Powers is the Editor of the Canadian Energy Viewpoint, an investment newsletter covering the Canadian exploration and production (E&P) sector. The investment philosophy of the Canadian Energy Viewpoint is a simple one: Investment in the Canadian E&P sector is the best way to profit from a falling U.S. dollar and rising energy prices. The newsletter is the only one published in the United States that focuses exclusively on investment in Canadian energy firms. Bill also recently began publishing the U.S. Energy Investor which focuses on investment opportunities in the US energy sector.
Bill’s work has appeared in the Wall Street Journal Online, CBS MarketWatch, Financial Sense Online, Dick Davis Digest and Prudentbear.com. He is a weekly contributor to the Financial Sense Newshour radio broadcast and has been a guest on Money Talks with Michael Campbell.
Bill has been an active investor for over 20 years and holds a BS in Finance from Georgetown University, Washington, DC.
For more on Bill’s work, visit Canadian Energy Viewpoint now.