Wednesday, July 16, 2008

Oil Supply - The Little Engine That Cantarell

Nobody can consistently predict where short-term oil prices are headed because they just can't know what new news is coming or just how trigger-happy the traders will be on any given day. The near-term fundamentals are only slightly less muddy. Clearly we're experiencing some degree of demand destruction as the global economy weakens, people drive less, and alternative energy substitution makes a very small dent. On the other hand, growth in China, Russia, and India is still robust with more and more people in these countries trading in their bicycles and rickshaws for cars every day. It doesn't hurt that Tata Motors is now mass-producing a $2500 car for the Indian market. Also, it was recently reported that the Russian car market is now the largest car market in Europe by sales, with a 41% year-over-year increase in sales in the first 6 months of this year.

As for supply, Saudi Arabia claims to be ramping production, but no independent verification of Saudi oil statistics exists. Aside from the recent large discovery offshore Brazil by Petrobras, there have been no super-major oil discoveries in over 30 years, so it's really difficult to argue that there's a meaningful amount of easy oil left to be found. Demand, of course, has grown steadily over these past few decades while the existing major discoveries from the 1970's and earlier have been gradually depleting. Additionally, who knows when Bush or Ahmadinejad will provide the next school yard shove and again inflame the fears of further Middle East turmoil and possible oil supply disruption.

The largest oil field in the world is the Ghawar field in Saudi Arabia. As mentioned above, no one outside of Saudi Aramco and the royal family really knows the true size of the field or its production trends. There are some prominent voices, most notably Matthew Simmons, who've raised serious questions about the sustainability of production from the field. I highly recommend his book, Twilight in the Desert. Whether or not Ghawar is actually in decline, it would be difficult to argue that the Saudis will be able to sustainably produce at rates much higher than current levels given what anecdotal evidence we do have.

Since we don't have good numbers with which to analyze Ghawar, let's turn to the second and third largest fields. Number 2 on the list is the Burgan field in Kuwait which began producing in 1946. In the fall of 2005, the chairman of the Kuwait Oil Company admitted that the field would only be able to sustain production of 1.7 million barrels of oil per day versus the 2.0 million they had hoped for. It turns out that production above 1.7 million barrels was actually damaging the field. Although production from Burgan may remain flat for many years to come, it certainly seems to have peaked.

Number 3 on the list is the Mexican super-giant, Cantarell, located in the Bay of Campeche in the Gulf of Mexico. The production changes in this field have been dramatic. The field was discovered in 1976 and began producing in 1979. By 1981, the field was already producing 1.16 million barrels per day. 14 years later the field was only producing 1 million barrels per day, and the Mexican government decided to make a major investment to further develop the field. This included drilling new wells, installing new platforms, and constructing the largest nitrogen extraction facility in the world in order to inject nitrogen into the field in order to help "lift" the oil.

The investment seemed to pay off. By 2001, the field was producing 2.2 million barrels of oil per day. By January of 2006 this figure had declined to a still healthy 1.99 million barrels, but the decline has accelerated since then. In December of 2006, production was down to 1.44 million barrels per day. The latest figures for May of 2008 show yet another tremendous decline to 1.04 million barrels per day. Given domestic oil demand growth and faltering supply, the day when Mexico ceases to be an oil exporter seems to be drawing near. (By comparison, some of the largest deepwater fields produce about 250,000 barrels per day, and the average U.S. well produces all of 10.5 barrels per day).

Yes, there is still plenty of oil out there, but the easy oil has largely (not completely) been tapped. Much of the oil that still exists is expensive to reach and produce. Even the recent mammoth discovery by Petrobras will cost untold billions to develop given the depth of water and the total depth at which the field lies. Sustained high oil prices will be necessary to warrant the investment needed to develop these more challenging reserves that exist in the tar sands, the oil shale, the deepwater, and the Arctic. Over time, rising demand and higher exploration and development costs will provide some strong price support to crude.

In the short-term anything can happen. We certainly should expect to see pull-backs, as we've seen over the last couple of days. a 20-30% retracement in the price of oil would hardly be surprising if a near-term production boost (from the Saudis) runs head-on into slackening demand and an easing of tensions with Iran. There are plenty of weak momentum hands in the energy play currently, and it wouldn't take much to shake them out. But with oil becoming more difficult and expensive to extract and with more people in developing countries wanting a piece of the "American dream," the intermediate-term (at least) outlook still remains bullish.

With that in mind, from an investment perspective, I have had and plan to keep a core energy position diversified across a number of favored energy securities and ETFs. When oil and and oil-related shares are sold-off, I'll continue to step in and augment the core position with an eye towards selling this "non-core" addition on the following run. I've been patiently waiting for this next opportunity to buy. Hopefully, George and Mahmoud will keep their mouths shut for a few days, and the sell-off in oil of the last two days will continue and provide the next good entry point. If a strong market rally accompanies this oil sell-off, I may be rebuilding my overall short (not in energy) position soon as well.

Disclosure: The Rubbernecker is long energy-related shares and short rickshaws.