Surprised in October?

"The Saudis are out of capacity. That's my opinion... They have no infrastructure or extra pipes or gas, oil, and water separators [very expensive large globes used to separate what comes out of a water injection well]. They have very heavy oil which, through a conventional refinery, produces asphalt. We don't need asphalt. We need gasoline. It takes a complex refinery to make gasoline and it only takes 7-10 years to build one." -- Matt Simmons, Simmons & Co., a leading independent oil analyst (from Michael C. Ruppert, Peak Oil Revisited)

As July began, Saudi Arabian officials announced that they were satisfied with the current level of world oil prices, around $35 a barrel -- the clearest indication yet that the kingdom has abandoned support for the old OPEC price range of $22-$28 per barrel. Saudi Arabia's oil minister Ali al-Naimi indicated that, at current levels, oil prices were "fair." Two implications flow from this:

·         The Saudis have now lined up with the rest of the OPEC cartel in implicitly suggesting that the old reference benchmark of $22-$28 was less than fair. From this flows a simple but dramatic conclusion: It is highly unlikely that we shall see an "October surprise" in which the Saudis flood the crude oil market in order to bring prices down sharply and thereby help ensure a Bush re-election. Faced with rising welfare costs and escalating political tensions, the kingdom has a corresponding need for additional capital expenditure for increased oil capacity. Goldman Sachs estimates that the Saudis require an average price of at least $30 a barrel over the next 5 years just to maintain real per capita expenditure.

·         Perhaps more significant, the Saudi statement speaks volumes about the true state of supply/demand in the oil market. The kingdom's actions may in fact constitute an implicit fait accompli, an acceptance of their inability to increase production substantially beyond current levels, bringing the days of peak oil production ominously closer.

The latter point is especially germane to those who continue to harbor thoughts of a return to cheap oil. It remains the consensus among investors on Wall Street and among a number of policymakers in the West that current high prices are a temporary aberration. Such misplaced optimism mirrors the stated (inflated) production targets of oil companies and oil-producing nations. Oil companies themselves appear to be consistently overly optimistic because of their desire to convey to investors that they still have attractive growth prospects. This was certainly the case with Shell, which only recently sacked its CEO and director of exploration for persistently overstating the company's reserves.

The oil-producing nations of OPEC also continue to set forth ambitious production targets in an attempt to negotiate more favorable OPEC quotas. So far, careful analysis of these optimistic forecasts has revealed that they are based on questionable assumptions regarding investment and technology as well as unrealistic timetables. They all assume quite low depletion rates on existing output. Lastly, the historical record shows that this sort of optimistic bias has prevailed for some time, while actual production growth has consistently fallen short of optimistic forecasts.

It is striking that the vast majority of Wall Street oil analysts, indeed, the oil companies themselves, have continued to base their forecasts on the old OPEC targeted price range of $22-$28 per barrel in spite of increasing evidence of looming supply shortages. But the comments by Saudi Arabia last week, coupled with concerns raised by Nigeria, Iran, and Venezuela, all suggest that OPEC may finally be acknowledging the new reality: Depletion dynamics -- a technical term which simply refers to declines in production of existing fields regardless of demand or increased capital expenditure to improve them -- have now come to the fore. Investment aimed at newer, smaller reservoirs and improving existing fields will not be enough to overcome these depletion dynamics. Therefore even with higher prices and higher levels of investment, growth in global oil output will slow.

Which does call into question the efficacy of the planned production increase OPEC announced with some fanfare last month in Beirut. OPEC officials assured the world that the organization would increase production by 2m barrels per day to 25.3 million barrels per day in an attempt to cool down global oil prices. There is some question, however, about the sustainability of such production hikes, given that the cartel has not pumped out such volumes of crude since the second oil shock produced by the Iranian revolution over a quarter-century ago.

After the Oil Runs Out, an article by James Jordan and James R. Powell in the Washington Post 6/6/04 addressed just this point:

"If you're wondering about the direction of gasoline prices over the long term, forget for a moment about OPEC quotas and drilling in the Arctic National Wildlife Refuge and consider instead the matter of Hubbert's Peak. That's not a place, it's a concept developed a half-century ago by a geologist named M. King Hubbert, and it explains a lot about what's going on today at the gas pump. Hubbert argued that at a certain point oil production peaks, and thereafter it steadily declines regardless of demand. In 1956 he predicted that U.S. oil production would peak about 1970 and decline thereafter. Skeptics scoffed, but he was right.

"It now appears that world oil production, about 80 million barrels a day, will soon peak. In fact, conventional oil production has already peaked and is declining. For every 10 barrels of conventional oil consumed, only four new barrels are discovered. Without the unconventional oil from tar sands, liquefied natural gas and other deposits, world production would have peaked several years ago...

"Lost in the debate are three much bigger issues: the impact of declining oil production on society, the ways to minimize its effects and when we should act. Unfortunately, politicians and policymakers have ignored Hubbert's Peak and have no plans to deal with it: If it's beyond the next election, forget it."

The reference to "Hubbert's peak" -- after the geologist who first made the case for depletion dynamics in the oil patch -- omits to note that the prediction was highly controversial inside and outside of the oil business until the 1980s, when it was proven correct. The basic reasons for a bell curve in any plot of production over time are that exploration is not a random process and that oil and gas are depleting assets. When exploration of an area begins, the largest reservoirs are the easiest to find. Total production rises as they are brought into production, while exploration for smaller reservoirs continues. Eventually enough smaller reservoirs cannot be found to offset the declines in production from the depleting large reservoirs. Prices and technology affect the area under the curve -- the total amount of oil and gas recovered over time -- but not the shape of the curve. Think of it as a process similar to aging and death in living organisms, as Hubbert himself rightly surmised.

Indeed, since 1970, the three largest non OPEC oil discoveries have all been in offshore areas and are expected to achieve peak production of only 1¼ million barrels a day -- far less than the peak production of the major discoveries of the past in the U.S., Russia, the Middle East, Mexico, Venezuela, and Nigeria. However much one trumpets these new discoveries, it is important to note that they will only offset declines in production on existing fields, and not increase the overall aggregate supply of global crude oil. Indeed, the disappointing exploration "successes" of the past 30 years have occurred despite huge investments engendered by dramatically higher oil prices in the 1970s and much of the 1980s. The record of the last two decades suggests that no more mega-fields may be discovered to replace the depletion of today's largest oil reserves and provide the growth in oil output that most market participants today take for granted.

Unfortunately, the Washington Post story relied on generalities about peak and decline to the exclusion of the hard data that has surfaced over the last two years, all of which points to an imminent acceleration in global depletion dynamics, notably in Saudi Arabia. There, Ghawar, the largest field in the world and all of Saudi Arabia's other large fields are old and tired. In recent years, the Saudis have resorted to both water injection and so-called "bottle-brush" drilling to maintain production -- techniques that tend to accelerate decline and damage reservoirs.

For a country with an allegedly huge marginal surplus of oil production, turning to such extraction techniques is likely to prove an unwise move. With bottle-brush drilling, a shaft is drilled horizontally over long distances with a number of brush-like openings. Water is then forced under pressure into the reservoir, forcing the oil upwards toward the well heads. Extraction is thereby increased. However, when the water table hits the horizontal shaft, often without warning, the whole field may go virtually dead and production will immediately drop off to virtually nothing.

Examples of what has happened in other oil producing countries when "bottle-brush" drilling was employed abound. Syria's oil production is now in terminal decline. Yemen is following, according to Ali Samsam Bakhtiari, Vice President of the National Iranian oil Company, who has long suggested that Saudi oil production might have peaked in the spring of 2003. Adds analyst William Kennedy, "For the record, Ghawar's ultimate recoverable reserves in 1975 were estimated at 60 billion barrels -- by Exxon, Mobil, Texaco and Chevron. It had produced 55 billion barrels up to the end of 2003 and is still producing at 1.8 billion per annum. That shows you how close it might be to the end. When Ghawar dies, the world is officially in decline."

In the short term, speculation in futures markets has contributed significantly to the fall in the oil price over the last month, although even with oil traders liquidating these futures positions on commodities exchanges, prices have stubbornly remained above $35 a barrel, well in excess of the old reference benchmarks. And while such speculative positions may influence the level of oil prices by several dollars a barrel over the short run, in the medium to longer term, supply/demand considerations will trump all else. Strong growth in global energy demand, a loss of capacity in some OPEC states, and rising depletion rates will all continue to contribute to a much tighter market. Moreover, as the Financial Times notes, "A build-up of inventories is now needed ahead of peak seasonal demand in the fourth quarter. But higher crude inventories do not address the problem of insufficient refining capacity in the US."

It is beside the point to maintain that current prevailing high oil prices are the result of a "political instability" premium, when the Saudis have set themselves up for additional terrorist attacks on their oil installations through repeated pledges to boost oil production and drive down prices. The Saudis were the only OPEC member to come out of the Amsterdam meeting 3 weeks ago with planned production hikes. This isolated position has likely earned them the ire of terrorists and given them a further vested interest in disrupting oil production, as has already been occurring with increasing frequency in Iraq over the past 12 months. Some security experts believe that key Saudi installations like Ras Tanoura and Abqaiq, the world's largest oil-processing complex, are vulnerable to attack. Questions about the competence and loyalty of elements within the Saudi security forces remain, as their ranks are said to be infiltrated by Islamic extremists. Recent attacks on foreign oil personnel in the kingdom seem to have revealed intricate personal and tribal links between the security forces and the alleged Al Qaeda operatives in the country.

Then there is the worst case scenario -- a complete collapse of the House of Saud. Were a collapse of the Saudi regime to remove the country's oil supply from world markets, even temporarily, the impact on prices would be far greater than those sustained during the two OPEC oil shocks of the 1970s. This would up the tab for a debt-ridden, cheap-oil driven American economy currently importing almost 60% of its crude from abroad.

"Whither oil prices?" is not simply an academic question. Future American economic growth is largely dependent upon reliable, accessible, and affordable supplies of energy. Hints of an impending oil-production peak are already beginning to impact seriously on economic growth against a backdrop of unprecedented financial fragility. The inexorable tightening of supply is destabilizing oil markets, which now manifest extreme price behavior in response to the smallest potential disturbance. Higher oil prices continue to increase the strain on consumption, particularly in the United States, while simultaneously reducing disposable income. How well equipped are we to deal with substantially higher energy prices? This is a question that no policy maker has honestly confronted yet. The markets remain in denial, but high energy prices are the new economic reality.

If there is indeed an "October oil surprise," the resultant shock is likely to be one which neither consumers, nor western policymakers will appreciate, since it could entail prices sharply higher than those currently prevailing. The days of cheap oil prices are over; the only question is, how high, how fast from here?

Marshall Auerback is an international portfolio strategist for David W. Tice & Associates, LLC, a USVI-based money management firm. He is also a contributor to the Japan Policy Research Institute. His weekly work can be viewed at prudentbear.com

Copyright C2004 Marshall Auerback

[This article first appeared on Tomdispatch.com, a weblog of the Nation Institute, which offers a steady flow of alternate sources, news, and opinion from Tom Engelhardt, long time editor in publishing and author of The End of Victory Culture and The Last Days of Publishing.]