Oil: Supply Side Pressures Provide Plenty of Medium Term Price Support

RelevanceDevelopment of one of the world’s most important new oil fields will be delayed by a further three years and require almost double the investment initially anticipated, Eni, the Italian oil group operating the field, said on Friday. Kazakhstan’s giant Kashagan oil field will now produce its first oil at the end of 2010 and hit peak production by 2019.

Kashagan, discovered in 2000, lies in the northern part of the Caspian Sea, in a particularly harsh environment. The field is estimated to have 18 billion barrels of oil reserves and was originally scheduled to be on stream in 2005.

This news comes on the back of a series of well documented project mishaps reported by IOCs in recent years. The IOC’s ability to find, develop and produce new oil in sufficient quantities is under question and this, together with other supply side pressures, will lend support to prices through the medium term. The best hope for price relief is a relaxation of demand, perhaps prompted by a correction in BRIC countries’ economies.

AnalysisEni’s announcement concerning delays and increased costs in its giant Kashagan oil field neatly illustrates the risks facing oil investors. Other major risks that have yet to materialize include reserves downgrades, worsening fiscal terms and lower prices. Fortunately for Eni and its co-investors the latter seems increasingly unlikely, even for a project coming on stream in 2010 with peak production forecast in 2019. A number of factors on the supply side are conspiring to improve price support. In the absence of relief on the demand side, prices are set to remain robust through the medium term. Supply factors include:

  1. The increased difficulty IOCs are experiencing finding, developing and producing new oil in significant quantities. That new discoveries are in technically and more politically challenging locations is manifested by the poorer growth projections reported by some of the majors and others. The problems encountered in Kazakhstan are the latest in a series, including delays to Thunder Horse in the GOM and a doubling in cost of Sakhalin LNG.
  2. Unconventional sources of oil, such as shale and sands may offer some hope, but the risks are high. A recent Wood Mackenzie reports claims that there are a potential 3,600 billion barrels of unconventional oil reserves (c.f. world consumption of 30bn bbl/year). However this oil is very expensive to exploit, the technology is largely unproven, and engineering resources are scare. This oil also requires a lot of energy and water to produce.
  3. That leaves the issue of the contribution by the Middle East to increased supply. Given its dominance of oil reserves, its potential would seem to be high. Leaving aside political will and the actions of OPEC, there is growing concern that the Middle East may not be able to deliver, even if it wanted to. Perhaps the most pessimistic in this respect is Matt Simmons, the respected energy banker. In “Twilight in the Desert” he articulates the fear that production from Saudi Arabia may have already peaked.

Finally, it is important to distinguish between supply of oil and the total reserves of oil available. While growth in oil production is an issue, what is not questioned is that we have many years of reserves available. So why do oil companies find it so difficult to grow – why is the industry elated by low single digit growth rates, when other industries can gallop along at 50%+ a year? The answer would make an interesting future White Paper, but it is partly due to history (i.e. low growth has been the norm for many years); partly due to a feature of the industry (high risk with significant capital outlays); and partly due to politics.

26 February 2007

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