A Thirst to Quench, at a Good Price

Global oil prices are staggeringly high, but poised to decline in the future. For a global economy that remains heavily dependent on oil, this is good news.

Oil prices are poised to decline. This is no black magic, but the result of geopolitical and industrial facts. The WTI blend of crude oil (the main American blend) has now reached 105 US dollars per barrel while the European Brent blend has topped at 125. The turmoil in the Middle East has left its mark on oil prices for the past few years – after all, one third of the world’s crude oil is produced in a conflict area. The costs of the current Iranian tensions are written directly into the numbers: The difference between spot prices for the WTI blend (what you pay for a barrel now) and “future” prices in five years (what you pay now for a barrel you will receive in 2018) is at a staggering 30 US dollars. The longer you are willing to wait, the cheaper your oil will be. As a rule of thumb (if we neglect the impact of inflation and financial turmoil), 30 US dollars per barrel would then constitute the “cost of the crisis.” We may also term it “fear speculation”: Investors may be hoarding paper oil not out of mere greed but due to the risk of a possible conflict outbreak in the near future.

There are other factors to consider as well. Some oil-producing countries are either back in business or simply performing well. In Libya, some drilling operators have already reached pre-conflict production levels. Forecasts estimate that production might increase from today’s 1.6 million barrels per day to as much as three million barrels by 2020. The Iraqi oil industry is also doing well. In December 2011, the country reached a 20-year production high of three million barrels per day. Oil minister Noor Al-Maliki recently predicted a future national potential of 13 or 14 million barrels. That level might only be attainable if unexpected new oil reserves are found – which, like Aladdin’s lamp, would promise the fulfillment of Iraqi wishes for prosperity.
But even a more conservative estimate of seven million barrels per day would have a cooling effect on oil prices.

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In other parts of the world, oil production is also performing well. The pacification of Angola, after too many years of civil conflict, led to a production increase from 0,7 to more than two million barrels per day. Positive developments are reported from South America and Central Asia. Interestingly, the American Midwest is pumping like crazy – so much that “The Globe and the Mail” has bestowed the great title of Saudi America on the region.

And let’s not forget the role of natural gas. Shale gas has recently generated quite a bit of public attention. Different from “traditional” gas, which occurs in large and concentrated basins, shale gas is found in porous rocks dispersed beneath large landmasses. All you need to do is perforate the terrain with pneumatic and hydraulic systems, and dissolve the gas from the rock. The US has a lot of it. Americans rely on gas for 25 percent of their energy. Yet ten years ago just two percent of the US gas production came from shale gas. That has changed: By the end of 2011, shale represented some 30 percent of national gas production. This gas explosion seems to partially explain the enormous difference between the 125 dollars for the “European” Brent blend and the 105 dollars for the American WTI blend.

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But will US shale gas also impact European gas prices? Not directly. First, gas is different from oil. it is transported through complex and costly infrastructures – pipelines or refrigerated tanks – that have made gas a more localized commodity, even though markets are internationally connected.
In comparison, the oil market is more integrated on a global level. A gas butterfly flapping its wings in the US will not set off a tornado in Europe. A particularly strong oil butterfly might have an effect, but it would have to be a truly monstrous event. Moreover, we still don’t fully understand price relations between gas and oil. US investors have begun to purchase less WTI oil since they believe that, in the coming years, the oil/gas ration might shift and the country may need fewer barrels of crude. Call it “rational speculation,” if you will.

More than shale gas, it is actually unconventional oil that might set the pace of declining oil prices. After years of assertiveness by producing countries, which asked for up to 97 percent of the profits on extracting operations, investors have begun to look elsewhere. Oil contained in shale or stored in sand (“tar sands”) has the attractive characteristic of being located in stable regions of the world: The sleepy north of Canada, the deserts of Kazakhstan, and in the vast regions of Russia. Great quantities also exist in Venezuela, where Comandante Hugo Chavez pays for his domestic bills by exporting more than 40 percent of his oil to the US. We can expect a similar export economy around Venezuelan unconventional oil.

One caveat: If traditional oil extractions expand, there will be less room for unconventional oil. High extractive costs and the ecological impact of the unconventional must not be forgotten. Unconventional oil is serving as an “alternative source of supply” in a time of production constraint to avoid excessive price increases. As the situation calms down – as it will – shaking shale and sand to suck hydrocarbons may not be as fun as it used to be.

Stefano Casertano, The European


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