The greatest honor in the blogosphere is to be quoted by another blogger. I will now return the favor to my friend at Buyside Notes who has done an excellent job of expanding upon my Kashagan piece, to show all of the many reasons that oil prices will not be declining any time soon. I have found his writing to be very informative and highly recommend that you sign-up for his research at www.buysidenotes.com.
I’ve heard some very smart people speculate that oil prices will decline as new supply comes online – mainly related to shale oil. This just isn’t the case.
– Harris Kupperman, Adventures in Capitalism
Harris is 100% right. And I’m going to prove it to you.
Let’s start high-level. There are 3 factors that influence the price of oil:
- Demand – driven by per capita consumption and population growth
- Supply – driven by new discoveries and spare capacity
Diving into each and doing simple math will lead you to the same indisputable conclusion I have come to: the era of cheap oil is over.
Before I lay out my thoughts, I think it’s best to start with the thoughts of someone much smarter than me – John Hess of Hess Corporation. In a 2009 speech, he offered 3 main points (source):
- Fact No. 1: Eighty-five percent of the world’s energy comes from hydrocarbons. While renewable energy will be needed to meet future energy demand and contribute to reducing our carbon footprint, hydrocarbons will fuel the world’s economy for decades to come. Renewable energy does not have the scale, timeframe or economics to materially change this outcome.
- Fact No. 2: Once the economy recovers, oil demand is projected to increase by 1 million barrels per day each year, as world population grows from 6.8 billion today to 9 billion by 2050. The introduction of higher mileage standards in the U.S. and the gradual phasing in of electrical power into automotive drive trains will only moderate growth in automotive fuel demand. That is because nearly one billion vehicles on the road today could grow to approximately two billion vehicles in the next 30 years. Keep in mind: The U.S. has 1000 cars for every 1000 people; China has 10 cars per 1000.
- Fact No. 3: Supply. We are not running out of oil. The issue is not our endowment of oil resources, it is the world’s production capacity. Additions from exploration last replaced annual production in 1987. The easiest oil has been discovered. Costs are increasing for new barrels, where wells can be drilled in water depths of over one mile to targets up to six miles deep, and discoveries can take over a decade to develop. Oil field declines are running at more than 5 percent per year. That means we have to add at least 4 million barrels per day each year just to keep production flat. Yet non-OPEC production is in the process of, if not peaking, reaching a plateau. The U.K. Energy Research Centre just published a report that there is a significant risk that worldwide production of conventional oil could peak before 2020 and enter terminal decline. If we do not act now, we will have a devastating oil crisis in the next 5-to-10 years.
Factor 1: Oil Demand
On the demand side, the one thing in John’s speech that immediately jumped out at me was this: oil demand is projected to increase by 1 million barrels per day each year, as world population grows from 6.8 billion today to 9 billion by 2050.
There are two points here. The first is that – absent a recession – oil demand will grow at a rate of 1MM barrels per day each year. Looking back at the past 3 years of data (a relatively stable period ex-Europe) demonstrates that John is right – global oil demand has increased an average of 1.2MM boe / d per year. Why has that happened? Because of the billions and billions of people in the developing world striving for a higher standard of living. As more people join the middle class, cars replace bikes and oil consumption increases. It’s that simple.
To provide some context around this burgeoning demand growth, consider this:
US daily oil consumption = 19MM barrels
US population = 318MM
Per capita consumption = 0.06 barrels / day
China daily oil consumption = 10.2MM barrels
China population = 1.365BN
Per capita consumption = 0.0075 barrels / day
A person in the US consumes 8x the amount of oil per day as a person in China. Compared to an Indian, it’s 20x. That is an absolutely staggering difference.
Truthfully, the US isn’t a great comparison to these developing economies – the wealth gap is just too wide. But I think Brazil is a useful comp. So let’s assume that the per capita consumption in only 3 countries – India, China and Indonesia – rises to match Brazil. What would that mean to oil demand?
It would mean additional demand of nearly 30MM barrels of oil per day, 30% more than the world currently consumes.
Source, Buyside Notes: https://www.dropbox.com/s/9ecag3qap82qze5/Oil%20Data.xlsx
This point needs emphasis: if only 3 countries experience Brazil-level demand, the world will need to produce 30% more oil to meet that demand.
The second point I want to highlight from John Hess’ speech is on worldwide population growth. And to this point, he is being conservative. If you follow the work of Hans Rosling, you will understand that current demographic trends indicate the world population is a lock to hit 10BN people (to see why, watch minutes 10:30 – 13:00 of this video). This isn’t fantasy; it’s a virtual certainty.
So what happens to oil demand when you add 3BN people to the world’s population? Well, if you assume exactly the same per capita oil consumption as exists today (meaning no improvement from a growing middle class, no per capita GDP growth, no Brazil-level demand), the world will see a demand increase of 36.1MM barrels of oil per day. It’s a near certainty that the world needs 40% more oil.
But what if you combine these two trends – a population increase to 10BN and a Brazil-level per capita increase in India, China and Indonesia?
If you experience both a Brazil-level demand increase in India, China and Indonesia along with 3BN extra people, daily oil demand increases by 67MM barrels of oil per day. That is over 70% more oil than we consume today. And the implications for oil prices should be obvious.
Now you can begin to appreciate the last line in John Hess’ speech: If we do not act now, we will have a devastating oil crisis.
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