Folks,

This is republished from Wealth Daily. It’s my critique of the latest oil data from the International Energy Agency (IEA), and concludes that we will be seeing higher oil prices soon.

–C

Something’s Gotta Give

By Chris Nelder

Wednesday, February 14th, 2007

When an irresistible force such as you

Meets an old immovable object like me

You can bet as sure as you live

Something’s gotta give

Something’s gotta give

Something’s gotta give

That Johnny Mercer standard was going through my head as I looked over the Oil Market Report published yesterday by the International Energy Agency. They forecast that global demand will increase this year at a rate of 1.6%—nearly double last year’s growth rate of 0.9%—to 86 mbpd, 1.4 mbpd higher than last year.

“Where exactly,” I asked myself, “do they think that oil is going to come from?”

The “irresistible force” in this case is the economic powerhouse of China. With a blistering economic growth rate of 10%, its demand for oil is rising at a rate of 5.4%, from 7.1 to 7.6 mbpd. China alone accounts for fully one third of the projected global increase in demand this year.

The “immovable object” would be, more accurately, the unrelenting reality of the nonrenewable resource that is oil.

The IEA says where they think that oil is going to come from: the former Soviet Union and Africa primarily, at 0.5 mbpd each, and a few little bumps from elsewhere: 0.2 from OPEC (all in the form of natural gas liquids, not crude), 0.2 from Latin America, and 0.1 from North America.

Put another way, the IEA says that the non-OPEC producers are going to increase their production at a rate of 2.8% in 2007 . . . when the growth rate last year was less than half that at 1.2%, and in 2005 was a mere 0.3%.

Well, now, that’s a mighty optimistic scenario! And look—the supply increase will exactly match the increase in demand. Amazing!

The IEA has data that the rest of us only wish we had. And they have lots of experts who really understand this stuff, or should. So why do they come up with a forecast that they must know is extremely optimistic, even wrong?

I suspect it’s because the thing that’s gotta give is the price, and they don’t want to be the ones to say it.

Between the geopolitical woes that continue to plague Africa’s oil industry and the lack of maintenance throughout Russia’s aged and rusting oil production infrastructure, it’s hard to imagine the two being able to increase production by a million barrels per day between them. And when you factor in the necessity of foreign investment and technology for the new oil projects and enhanced oil recovery of the older fields, then look again at the risks that Western oil firms would have to take to send their money and personnel to those far-off and unstable places . . . well, I just don’t see it happening.

The oil majors have preferred to prospect on Wall Street through mergers and acquisitions these last several years than to keep taking the risks of drilling three out of four dry holes or having their investments seized for far less than face value by a national oil company and being unceremoniously booted out once things get going. Other than the pressing need to maintain their reserves, which has proven to be a serious problem these last few years, there is little to make Big Oil want to take those chances.

The IEA is right to show some caution in its OPEC forecast. Increased recovery of natural gas liquids & condensates is possible, and 0.2 mbpd worth seems like an achievable target. But it’s telling that they don’t foresee any increase in actual crude from OPEC—very telling. Either they don’t believe the Saudi claim that they have some 2 mbpd of spare production capacity, or they believe that OPEC will honor recent production cuts and maintain production at existing levels in order to defend the price. Or perhaps they know that OPEC is tapped out, a paper tiger whose roar is becoming a bit tired and weak. At present, the demand for OPEC crude is 0.3 mbpd higher than in 2006 and remains above existing OPEC production.

So why not pin hopes for a balancing of supply and demand on the X-factor producers in FSU and Africa? There are too many variables in either case to make a serious production forecast, so any projections have a built-in CYA factor. A 2.8% growth rate over there . . . yeah, that’s the ticket!

The inconvenient truth that is apparently too much for IEA to bear saying is that those 1.4 mbpd are likely what Matthew Simmons calls “conceptual barrels.” You want them to be there in order to balance out supply and demand at current prices, but they’re only there on paper.

Unfortunately, as Simmons says, “Conceptual oil and gas reserves are easy to talk about but very hard to use.”

Here’s what we know to be true:

• The world’s top three oil fields are in decline, and the top four sources of U.S. imports are in decline. We know, with some certainty, that the existing top producers are in decline, but there is no way to predict with any certainty that the new projects expected to fill the gap this year will actually materialize.
• Russia, currently the world’s top producer of crude, just cut its oil production growth forecast for 2007 from 2.5% to 2.1%. But the IEA’s projection is that the FSU will increase its production by 4.1%. They must be very optimistic about bringing online new projects in the Caspian Basin—far more optimistic than I am, at least.
• Stockpiles of crude are dropping at more than three times their normal rate. According to the EIA, oil reserves will be down to their lowest level in
  three years by the end of June. And with the recent record-setting cold snap across most of the U.S., unusually large withdrawals from distillate and natural gas inventories are anticipated.
• With the U.S. planning to double its Strategic Petroleum Reserve and China having started filling its own, demand will stay strong.
• The IEA, like most of its peers, has an abysmal predictive track record, but there is something about it that’s actually fairly reliable: they consistently paint a rosier picture than actually comes to pass.
• Global demand is rising by 1.4 mbpd in a year that started off as the warmest on record.
• Experts like Matthew Simmons have already stated that the world is past the
  peak of global production. If this is true, then any increases projected for 2007 are pure fantasy.

Time will tell whether the IEA is just playing politics with this report or whether they know something that the rest of us don’t. But the numbers that we have, as imperfect and opaque as some of them are, seem to tell a different story.

Something’s gotta give. There is no reason to think that China’s overheated economy will slow this year, and the same goes for India. OECD countries are gradually getting a handle on their demand for energy and are slowing or even stopping their growth. Oil demand in the U.S., for example, actually fell by 0.4% in November, year on year, for the first time since 2001. We may expect further reductions in developed countries as their growth slows, efficiency improves and they continue switching over to natural gas from oil-based fuels for heating and electrical generation.

So if economic growth in developing countries is the “irresistible force,” and if supply gains are fantasy, then it’s clear what’s going to give: the price.

Barring some unforeseen favorable circumstances—which seem unlikely—we may expect crude prices to go higher, possibly much higher, into the spring.

Until next time.

Chris Nelder