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With talk of the oil price hitting unthinkable highs, Tom Sieber laughs in the face of black gold reaching $200 a barrel

Don’t believe the hype, because there is no doubt that $200 oil is a pipe dream put up by the head of Opec to fuel the fear that is already stalking a tight market. Believing this madness is buying into an extremely bleak vision of the future, where your most valuable possessions will be a tin hat, Kalashnikov and a huge stockpile of tinned beans, and where Mad Max is your nearest neighbour beyond Thunderdome.

Make no mistake, a long-term oil price of $200 a barrel is an insanity. Petrol has already hit £5 a gallon, and even though much of that can be attributed to tax, an oil price of $200, even based on the most primitive of calculations, could see us closer to at least £7 or £8, pricing thousands of motorists off the roads.

What if we’re wrong, and $200 a barrel becomes reality? Well, it probably won’t matter that much since we will all be far too busy bolstering our bunkers. That is what we are talking about here; $200 oil is simply not an option, let alone a sustainable one.

Yet Opec president Chakib Khelil is not the only voice to sing from this apocalyptic hymn sheet, even if he is the one stealing all of the headlines. Charles Maxwell, for example, a proponent of the peak oil theory (see box, page 16) and senior oil and gas analyst at US broking firm Weedon & Co, predicts that the oil price will hit $300 by 2020, surmising that by then the world’s reserves will have rapidly begun to dry up.

It is not altogether surprising that such figures are being bandied around. The price of oil has been on a spectacular upward curve over the last 12 to 18 months, even by its own highly volatile standards.

In the beginning

At the beginning of last year the price was less than $60 and, as I write, it is at $115, just off record highs close to $120. Looking even further back you could have bought a barrel of oil with a ten dollar bill around the end of the millennium.

Unsurprisingly those with direct involvement in the industry are more likely to offer a bullish take on the price. Jeremy Eng, managing director of Ascent Resources, says: ‘Russia has started a decline in oil supply – people say it is because of Gazprom taking over all the assets, but there is more to it than this.

‘It took from 1950 to 1982 to go from nothing to drilling in 300 feet of water. It then took 25 years to go down to 9,000 feet of water. I can’t see there being oil in deeper water than this. All the big regions are running out, like Brazil and West Africa.

‘You may find the odd small discovery, but nothing big. We looked at Liberia a few years ago, but geology isn’t right for making big discoveries. Brazil’s had some recent big finds, but I can’t see there being too many more.'

All dried up

Eng raises some important points and certainly the factors he’s talking about are responsible for the price reaching $100. In a sense he is right, we are not seeing discoveries of the scale seen in the middle part of the twentieth century, but as technology improves companies are able to extract more hydrocarbons from an asset than ever before.

There is certainly no question in our minds that the ultra bulls are badly off the mark. And it is not as if we are long-standing bears on the oil price, in August last year we forecast $100.

Why then has a respected figure like Khelil introduced the possibility of such an increase? It is tempting to say he has picked the next obvious target for the oil bulls – it is a nice round number and it certainly has impact. $100 was the first barrier, breached earlier this year, why not $200?

While it may have got him noticed, in some senses what he says is immaterial because the real power in the cartel lies with Saudi Arabia, as Stephane Foucaud, analyst at broker Fox Davies, observes: ‘There is only one player that counts in Opec, that is Saudi Arabia. They are the ones with the spare capacity. A statement from their part could be taken with more concern.’

Opec would come under increasing pressure to pump more crude if the price of oil even started to approach such inflated levels and they would not want to see a price anywhere near that in the long term – it would certainly run the risk of seeing the black stuff supplanted by alternatives.

Even Khelil doesn’t say that the oil price is supported by the fundamentals of supply and demand, suggesting instead that the price is hurtling higher on the back of short-term supply shocks and dollar-based speculation.

Price before a fall

A recent report from US investment bank Lehman Brothers addresses the level of speculation that was built into the oil price. It notes that: ‘The oil market has been behaving as though a set of new fundamental factors will continue to support rising prices. However, based on our analysis of physical markets and financial flows, we expect oil prices to weaken significantly through the rest of this decade, after peaking in 2008.’

The two key catalysts behind the current spike in the oil price according to the report are firstly the large financial flows into oil and other commodities. On this it notes that ‘...enthusiasm that at times has bordered on manic, has retreated somewhat over the past month, with tougher margins and profit taking prevailing. It remains to be seen if new index investors such as sovereign wealth funds of countries with physical long exposure to oil, will remain “double-exposed” and undiversified if prices retreat even further.’

The second key factor it highlights is, as discussed, the weakness of the dollar. Fundamentally people are beginning to see oil as the new gold on a long-term basis – using it as a direct hedge against the dollar. The reality is that it doesn’t fit this category and in any case as Lehman Brothers point out: ‘We see further 2008 cuts of 100bp by the US Federal Reserve impeding dollar strength for a period; however, this could give way to room for the European Central Bank to cut rates by mid-year, and our FX team forecasts the dollar to gain slowly against the euro. A reversal of this hedge could indeed lead to a more significant oil price sell off.’

If the speculation factor accounts for the froth which the report says makes up around $20 to $30 of the current price, what is the real price as supported by the hard and fast realities of supply and demand? As we have already pointed out, $200 a barrel is just not supported by these fundamentals.

Demand for oil is certainly strong – and remains so among developing countries – but there is a limit and demand is likely to fall off some way short of $200 particularly in a slowing global economy.

‘We have already seen the negative impact of high prices on demand in OECD countries for the last two years, particularly in US,’ Foucaud says. ‘What has been maintaining the growth is the developing world. That is partly because of the subsidies provided by governments looking to keep the price of energy down within their countries.’

Theses subsidies would come under severe pressure at $200, and while China has long been held up by the bulls as being a major support for an increasingly high oil price, there are signals that this is changing.

The flame snubbed out

An important factor could be the Olympics as Blue Oar analyst Craig Howie points out. Beijing 2008 has been a key driver of economic expansion and traditionally host countries have run out of steam in this area once such an event is over.

And while demand is beginning to look a little bit shaky then the picture in terms of supply has improved.

Howie says: ‘At the moment we are modestly bearish on the oil price and could see the price going back to $90. Certainly short-term spikes are feasible but the reality is that we are still producing more and more oil.’

Refining capacity is due to be rapidly ramped up over the next five years at a rate which should out pace demand. At present the system is pushed towards full utilisation when the market is tight – this new capacity should ease concerns.

A wake up call

The major producing countries are also beginning to wake up to the higher prices and are acting accordingly. Saudi Arabia is investing a huge amount of money in bringing on extra capacity, Russia is relaxing its tax regime to encourage more exploration and in any case there is greater potential in deep water sources of crude – we have seen evidence of this in Brazil with some potentially huge discoveries just in the last year.

According to Tim Heeley, head of oil and gas at Daniel Stewart: ‘The way things stand at the moment there are no real choke points in terms of supply. Nigeria has got a few issues but Iraq is at the point of putting an extra half a million barrels into the market over the next few weeks. There is plenty of supply but that is not stopping speculators upsetting the oil price.’

Peter Hitchens, analyst at Seymour Pierce, adds: ‘The market it is tight at the moment but it would take a pretty major disruption to get us to $200. Even if that were to happen it would be a spike rather than anything else. You would get some major demand destruction coming through if it remained at that level. We don’t believe there is actually any great shortage of crude, it is just costing more to get it out of the ground.’

Hitchens is right, the oil is out there, it is just becoming more difficult and more expensive to access. The fact that projects such as the Canadian tar sands are only economic at around $80 a barrel could well sustain oil prices above $100 but not push them to $200.

Momentum and herd mentality have made it easy to get swept along with the oil price bulls over the last year or more but it is worth remembering how low oil has been in the past. While the days of $10, $20, perhaps even $50 oil may be behind us, it is important to retain perspective in the face of wild predictions that, while fashionable, are equally far fetched.

Peak Oil Theory explained

It is widely accepted that oil is a finite resource; and there are basic laws which describe the depletion of any finite resource:

• Production starts at zero;

• Production then rises to a peak, which can never be surpassed;

• Once the peak has been passed, production declines until the resource is depleted

These principles were first described in the 1950s by Dr M King Hubbert, a geoscientist who worked at the Shell research lab in Houston, Texas and the so called ‘peak oil’ theory has gained greater currency in recent years as prices have gone up. There are some who believe the peak has already been reached. Predictions on the effect a rapid decline in oil production would have vary, but most believe it would have catastrophic economic consequences.

WHAT THE EXPERTS SAY

Kwaku Boakye-Adjei, analyst, Edison Investment Research

‘Supply and demand supports $60 a barrel, there is an instability and war premium of $20 to $30 a barrel, anything over $100 is driven by the dollar. But, as people think it is an issue of supply and demand, any small thing that affects supply and demand has a big effect. Every time we hear about a problem in Nigeria it has a disproportionate effect on the oil price. The dollar could tank in the third quarter of this year and oil could go through the roof.’

Tim Heeley, analyst, Daniel Stewart

‘It is like the housing bubble all over again. Everyone has gone to oil as a speculative market and speculation is the only thing that will take oil to $200. The general trend should be down based on fundamentals since there is no shortage of supply into the market. What you are finding is that as the oil price goes up, say on concerns about Iran, it does not come out of the price, and next time something happens it builds on that even though the initial catalyst has disappeared. Today’s price is ridiculous.’

Frank Jackson, commercial director, Aurelian Oil & Gas

‘I don’t think people understand what is going on in terms of reserves. We have lots of contrary reports saying [we’re] running out of oil and you pick up the paper the next day and [they] say they’ve got enough oil for 100 years. We are not going to get prices below $100 again but whether we will see $200 [I don’t know.]’

Brian O’Cathain, executive chairman, Petroceltic International

‘The International Energy Agency (IEA) is a lot more conservative [than OPEC]. It is not forecasting $200 a barrel. But most of the predictions of the IEA in terms of car demand are low. Car usage predictions for China, India and the Middle East [are] very conservative, if these regions move to anywhere like demand in the West then, given the lack of production, oil prices could go significantly higher. I think there will be a supply gap.’

Tony Alves, analyst, KBC Peel Hunt

‘It is very dependent on how consumption goes [as to whether we reach $200]. We are beginning to see America cut back a little bit. The real question is that Chinese consumption continues growing at 10% a year in the next few years. If that is the case I think the world will be hard pushed to provide to provide the supply. Looking forward the challenge of increasing global production is enormous.’

Peter Bassett, analyst, Hanson Westhouse

‘Saudi is clearly not using its excess capacity, which suggests Opec is trying to maximise prices in the short term.’

Aaron Close, managing director, Irvine Energy

‘$200 a barrel sounds over ambitious. It is possible, but not probable. Opec is really talking about peak oil, current thinking is that oil production will peak within next ten years. Any oil company who runs their business on the assumption of $200 a barrel is crazy. Production costs continue to rise and at current levels, oil could only fall to $40 or $50 a barrel before oil production become uneconomical.’

Jeremy Eng, managing director, Ascent Resources

‘Blaming the economy and the falling dollar for pushing up the oil price is a bit of an excuse. The world’s supplies are running out. To stop the overall decline in production, companies are working harder. Russia’s output is starting to decline, we’re probably at the end of the deep water oil in West Africa and Brazil. Saudi is under pressure with supplies.

If the oil price keeps rising, then you’ll see fields come onstream previously thought to be too expensive to work. But if the oil price falls, there will be problems as costs may not fall as well. Offshore working used to cost $20 a barrel, now it is closer to $70. There is a shortage of equipment, so many oil projects could become uneconomical if the oil price falls back.’

Tony Shepard, analyst, Charles Stanley

‘No one really knows where the oil price is going. Demand for oil in developing markets might be down, but it could be offset by strong demand from emerging markets. Net effect is small growth in demand on a global basis. The North Sea is running down on supplies, as are the old Alaskan fields. Oman is in decline. Saudi is one of the few places still capable of meeting demand. You could end up with a supply crunch in five years time.’

Dougie Youngson, analyst, Ambrian Capital

‘The $200 per barrel suggestion doesn’t help the market. We had this problem when people suggested $100 per barrel. The market starts to believe its own hype. At the moment, $200 per barrel is not realistic. I think there is just a lot of speculation and hype.’