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The Energy Policy Research Foundation Inc. (EPRINC) was incorporated in 1944 and is a not-for-profit organization that studies energy economics with special emphasis on oil. It is supported by approximately 35 oil companies ranging from major internationals to regional marketers.The chart at the end of this article provides a summary of developments over the past 10 years that have removed substantial supplies of oil and gas from the world oil market. We characterize these supply problems as "a series of unfortunate events," although others may view these supply constraints as variants in what is now often referred to as "resource nationalism." The oil market seems to be undergoing a true Lemony Snicket experience. As the market adjusts to a given supply disruption, several more problems quickly emerge. Over the past 10 years, the world oil market has clearly experienced an unprecedented number of new and sustained impediments to upstream development, including unilateral contract renegotiation, nationalization, lack of investment by national oil companies (e.g., Pemex, et al), restrictive access to resources (e.g., Russia, U.S.), war and civil strife (e.g., Iraq, Nigeria, Sudan), reduced excess production capacity among OPEC producers, and taxes that create uncertainty and constrain development of higher cost prospects (e.g., Alberta, Russia).
When these "unfortunate events" occur, the world oil market not only loses existing production, but expectations on the availability of future supplies are also revised downward.
"Resource Nationalism"
Resource nationalism can be defined as the recent (or perhaps recurring) trend in the international oil industry in which host countries use a number of extra-legal measures to unilaterally change the terms of their contracts with international oil companies (IOCs) developing indigenous oil and gas resources. Encouraged by the rapid escalation of oil prices in recent years, this trend is now spreading rapidly.
Rising oil prices have emboldened governments to take a greater share of the revenue of projects negotiated in a time of substantially lower oil prices. In some cases, the host country has concluded that the existing contract terms do not adequately permit a fair distribution of the good fortune of rising prices and so contract terms should be changed. In other cases, adjustments in export duties, arbitrary and capricious fines, or other measures are used to redistribute income and even regain project control. Even in Canada and the U.S., investors are not totally immune from attempts by their respective legislative and administrative bodies to change previously agreed-upon contract terms.
Operating companies, with some notable exceptions, have had little choice but to accept these new terms to protect residual value in their projects, as existing legal alternatives are either too cumbersome or present further risks to remaining operations in the host county. Host countries presumably believe these unilateral adjustments are justified, given rising oil prices or unexpected costs that reduce net revenue to the state.
The longer term consequences of these unilateral actions are much more than a redistribution of revenue. These actions are likely to result in further reductions in investment in the exploration and development of petroleum resources, an arena in which there is a growing consensus that the industry is already "effort constrained."
Projects that present relatively high technical thresholds, extraordinary project completion risks, and very long lead times until initial production, may now be unable to attract adequate capital to go forward. This trend in unilateral contract changes, combined with growing limitations on access to resource development, and in many cases unrealistic terms for new projects, is adding to the so-called "Peak Oil" problem, which is now more about constraints above the ground than below.
In a kind of perfect storm of bad luck, the resurgence in resource nationalism has been supplemented by civil strife and armed conflicts in several important producing regions in the world. Iraq, Nigeria and Sudan are all important producing regions experiencing production cuts and constrained exploration and development activity as a secure environment cannot be established to undertake operations.
Role of Expectations
Ultimately, prices in the world oil market are set by the fundamentals of supply and demand. However, crude oil prices at any given moment reflect a wide range of considerations that go well beyond immediate conditions in the market, but also include expectations on future events, including world demand, technological advances, availability of highly skilled workers, availability of future supplies, replacement cost of new supplies, technical and political risk, war and terrorism, among others. In many cases, the immediate loss in output from any number of unexpected events has much less effect on the world market than the resulting shift in expectations on the availability of expanded output over the next 5-10 years.
It is our view that major price shifts in crude oil prices since the early 1970s can be explained in part (perhaps largely) by major shifts in expectations on future output.
Prices Take Off
Since mid-2004, the price of oil has risen dramatically as the world oil market has faced what can only be viewed as a perfect storm of bad luck. Virtually every major producing region has experienced variants of resource nationalism harming not only near term output, but shifting dramatically expectations on future production. In the years just after the entry of the new millennium, world oil prices rose, in nominal terms, to approximately $30/barrel. While this was substantially above the levels experienced in the 1990s, it likely reflected some combination of rising demand and increases in replacement cost for new reserves as the industry moved to technically more challenging environments. Nevertheless, the supply outlook was generally positive with new discoveries and rising investment throughout the former Soviet Union and prospects for expanded output in Latin America and Africa. Even in the U.S., there was a general sense that domestic opportunities in the U.S., such as prospective reserves in the Arctic National Wildlife Reserve in Alaska, North Slope gas, and even some offshore regions might provide new sources of supply.
This "era of positive expectations" came to an end in the mid-2000s as the world market began to face a much more pessimistic outlook on new supplies. The early days of the war in Iraq were accompanied by expectations that the market would see an opportunity for substantial new investment opportunities for field rehabilitation. This positive expectation was soon reversed as the security situation remained too unstable to permit major new investment. At approximately the same time, expectations on rising opportunities for investment in oil and gas projects in Nigeria, Russia, Sudan, Venezuela and even in the U.S. soon evolved into an environment where projects were postponed, access to resources was denied and/or contract terms were changed. Within a few years, the era of positive expectations (2000-2004) began to transition into an era of negative expectations, and the bad news has continued into early 2008. Clearly, other forces are at play, including rising demand accompanying rapid economic growth in China and India, the relatively inelastic demand for petroleum in the U.S. (at least in the short term) and lagging capacity additions in Saudi Arabia, but all these factors pale in comparison to what can only be viewed as a "perfect storm" of a series of unexpected events.
The accompanying graph shows the forces at play that brought about much of the shift in expectations on new production. Note that by mid-2005, forecasts on production growth, made just a few years earlier, were unrealized, and combined with falling OPEC excess capacity helped to drive crude oil prices upward. Clearly, the discovery and development of new oil and gas fields are becoming both more expensive and technically more challenging, and "Peak Oil" concerns deserve a series examination, but the Lemony Snicket effect cannot be ignored. The market has seen more than its share of bad luck -- and most of it has occurred above the ground.
This summary was drawn from a longer analysis by EPRINC. To read the entire article, including a detailed chart showing estimates of how much oil has been taken out of production worldwide, click here.
POSTED BY: Ken Naugle (March 25, 2008 08:06 AM)
The statement "expectations for an improved supply are grim" is the scariest of all. Some sources believe that world oil production capacity has peaked. Meanwhile, other prognosticators predict a 30% increase in energy demand in the next couple of decades. This confluence of supply being unable to meet demand will spell nothing but trouble that I don't see any easy way to avoid.
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