2005 oil outlook: is this the year when demand outstrips supply?

World Oil, Feb, 2005 by Matthew R. Simmons

What was the biggest oil story in 2004? I posed this question to all the Simmons & Company oil experts this year. The suggested list of topics varied enormously, which spoke to how many key oil events occurred last year. Oil prices in 2004 were on almost everyone's list. The "scandal of proven reserves" also got many votes. Dwindling spare productive capacity, sky-rocketing tanker rates, historically unprecedented spreads between light/sweet crude oil and heavy/sour oil, soaring oil demand and simply "China" and "Yukos" all got votes, along with flattening non-OPEC oil supply and even "Peak Oil"--a topic that received more media attention, during 2004, by a substantial margin than ever before.

What this myriad of stories actually represents is part of a far bigger mosaic for what is emerging in global oil markets as 2005 gets underway. It appears that we are entering a new oil era that could bear little resemblance to the behavior of past oil markets.

But many scoff at this suggestion. Scores of oil experts still are sure that 2004 was an aberration and believe, some with passion, that 2005 will finally see a return to normality in oil markets. This belief presumes that growth in oil demand will slow in conjunction with a significant supply response. Obviously, this combination of events could occur, but it is hard to find any factual data to support how demand could stall while supply soars. Unless one or the other (or both) happen, the oil markets should remain tight or tighten further than in 2004.

I began writing World Oil's Outlook for Crude Oil story 11 years ago. At the time, crude had collapsed from $21 per bbl six months earlier, to about $13. Conventional wisdom assumed it would stay at these low levels for years to come, but a rebound to over $20 per bbl took a mere six months. Over the course of the next 11 years, I have watched conventional wisdom turn out to be wrong at almost every turn. Throughout the past decade, many oil market observers have continuously predicted that growth in oil demand would be low. Most also believed that a surge in new supplies was just around the corner and that the cost to find and develop oil would steadily fall, making a further weakening in oil prices likely.

Over this 11-year period, oil prices did occasionally collapse. Twice the collapse was quite violent. Each time oil prices collapsed, a choir of oil pundits would proclaim that this was a normal economic adjustment. After every collapse, which became increasingly brief, the subsequent rise got steadily higher.

In 2004, oil markets finally began to shatter conventional beliefs. The widely held belief that $30 oil would cause a recession failed to pan out. The idea that high prices would soon induce a surge in new oil supplies never materialized. The theory that sustained growth in global oil demand was unlikely suddenly shifted to a more ominous question: Is oil demand growth now becoming a runaway train?

The notion that finding and development (F&D) costs would steadily fall also now seems illusionary. While F&D costs stayed in a $5 to $7 per bbl range throughout the past decade, the total exploration and production capital expenditures rose from a steady $55 billion to $60 billion in the first half of the 1990s to over $124 billion in 2000. The sole reason that F&D costs per bbl stayed low was the rise in reported proven reserves.

Until Shell Oil's stunning reserve reclassification in 2004, few industry observers ever questioned the accuracy of the industry-wide reserve additions that always seemed to exceed current production.

In hindsight, few companies actually enjoyed any significant production growth commensurate with their reported proven reserve gains. This anomaly suggests that lower F&D costs might have come primarily through abnormally low drilling and servicing costs, a reduction in the number of appraisal wells drilled, and a substantial decrease in conducting coring analysis and other expensive well testing. These factors reduced F&D expenses and led to an overstating of proven reserves. With less drilling data, it was easy to assume reserve additions were higher.

A key issue the industry needs to address in 2005 is how proven reserves are booked. We also must decide whether enough testing is being done to justify an aggressive booking of reserve additions by many companies relative to what they end up producing.

Were 2004 oil prices abnormally high, or did this price change signal a new era in oil markets? Were these high oil prices due to fear factors that encouraged many speculative hedge funds and commodity traders to bet on rising oil prices because of supply and demand factors? Or, were prices high because oil inventories tended to be quite low? Is the industry running out of spare capacity? If so, how quickly can capacity additions be created? If a fear factor was one of the culprits, how much of this fear was justified?

There are a variety of data points which shed some light on these seemingly rhetorical questions.