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Lou Gagliardi is Hedgeye's Managing Director of Energy Research.  The following is a note he published yesterday in response to Daryl Jones' note "Could the Turmoil in the Middle East be Bearish for Oil?"

At Hedgeye, we emphasize risk management; that entails encouraging different perspectives and in-house debate to ensure our clients are presented with a breadth and depth of thoughtful research. In the pursuit of that goal, my colleague Daryl Jones, our Macro Managing Director, this past Friday wrote a compelling and thoughtful view titled “Could the Turmoil in the Middle East be Bearish for Oil?’


In the spirit of debate where reasonable men may disagree, I will present a counter view.

Daryl is right; “fear” is driving the price of oil in the markets. But it is a credible fear. As I wrote this past Friday, “The market has seized upon the reality that these Mid-Eastern regimes are vulnerable and could collapse, and to which political wind is uncertain. Who will control these significant global energy supplies is still unknown. This new realization breeds uncertainty in the market.” That uncertainty breeds oil price volatility.

Whether these political regimes collapse or not, and to which political view, is not my focus here, nor is whether political liberalization could actually support growing production. Indeed, incremental production can grow under any political persuasion. Political liberalization will be good for the people of the Mid-East, and for international relations. It will calm the oil markets and remove much of the “fear” premium recently baked into oil prices. It can also create a more positive environment to grow global production supplies. But political liberalization will NOT over the long run be a catalyst for lower crude prices. Why? Because incremental production from Mid-East is “insufficient” to arrest global crude oil production decline and meet growing global consumption. The next three charts highlight these points.

First, the major global crude oil basins are in significant decline: Mexico, Venezuela, U.K., Norway, Nigeria, Alaska North Slope, U.S. lower 48 conventional, and Canadian conventional.

Counterpoint: Middle East Turmoil is Bullish for Oil  - lg1

Global crude oil consumption continues to outstrip global production: global consumption since 2000 has averaged about 1.1% per annum; global production has grown at about 0.7% per annum.

Counterpoint: Middle East Turmoil is Bullish for Oil  - lg2

Lastly, the major global oil basins in decline are the major global crude oil exporters: since 2004 the combined average drop off in production for only the UK, Norway, Mexico, Nigeria and Venezuela has been over 622,000 b/d per year, or 3.1 MM b/d in total production lost, and increasing.

Counterpoint: Middle East Turmoil is Bullish for Oil  - lg3

On closer examination, Russia is not a clear example of what Iraq can do with production growth; its growth will depend on its reservoirs and the laws of physics. According to the BP Statistical Review of World Energy and the IEA, Russian oil production peaked in 1987 at 11.484 MM b/d, reached a low of 6.114 MM b/d in 1996, ramped up to 9.287 MM b/d by 2004, and hit 10.150 MM b/d in 2010 – a 1.5% per annum increase from 2004 to 2010. As I wrote in an energy note on Jan 7th, “Can Russia Maintain Oil Production at 10 MM b/d?” Russia has struggled to return to its production level of 10.45 MM b/d in 1990, and twenty years is a long time; Russia has never returned to Soviet era levels. Indeed, since 2005 Russia’s year-over-year crude production rate has steadily declined, as seen from the graph below.

Counterpoint: Middle East Turmoil is Bullish for Oil  - lg4

Why has Russia struggled despite its “political liberalization”? Recall Yukos and Mikhail Khodorkovsky as a prime example that Russia’s “democracy” is not exactly comparable to western standards.  First, Russian oil fields were opened up to Russian bureaucratic cronies, not to the Western Multinationals (IOCs). Secondly, Mother Nature, or the natural laws of physics, has hampered growth. Once Russian fields were privatized, albeit to Russian insiders, economic incentives became the production drivers; Russian fields registered a significant uptick in production growth as secondary recovery techniques were applied to Russia’s aging Western Siberian fields. The rate of production growth began to increase in 2000, peaked in 2003, and the rate of growth has declined ever since. The difficulty in sustaining an increasing rate of growth is due to the natural rate of decline in oil and gas fields, and economics. The marginal cost of investment begins to erode the marginal return from mature Russian fields, even at high oil prices.

These are the same issues that Iraqi production growth faces today. First, as to claims that Iraqi production could eventually hit 12 MM b/d: since 1965 the highest Iraq production has ever been is 3.489 MM b/d in 1979; no country produces at 12 MM b/d, not even Saudi Arabia (today at ~8.9 MM b/d). The last country to come close to 12 MM b/d, Russia, fell short by roughly 500,000 b/d and has taken over twenty years since 1990 to get back to 10 MM b/d.

Furthermore, higher production that leads to lower crude prices is not in Iraq’s national interest, and the country knows this. Their goal is not to maximize production, but to maximize revenue.  The dilemma the Iraqis will run into is dealing with a“mutually exclusive” choice: you maximize production or you maximize ultimate recovery, you cannot have both unless you alter the laws of physics. When you run the reservoirs hard to speed up production, in the long-run you impair reservoir pressure and limit ultimate resource recovery; and that, in the long-run, limits ultimate revenue as barrels are lost.

In the initial years, Iraq will see a significant uptick in production as the Russians did, coming off a low base and as the dramatic effect of secondary enhanced recovery techniques kicks in. But successive increases in growth rates will become increasingly difficult to maintain, as natural reservoir decline accelerates due to falling pressure. Increasing capital investment to increase reservoir pressure and arrest natural decline will run into the wall of the laws of diminishing returns, as the cost of the incremental barrel exceeds its incremental return.

Today, Iraqi production is at 2.7 MM b/d with 2.75 MM b/d targeted at the end of this year. To hit 12 MM b/d within a decade demands a ~16% per annum compounded growth rate, and if they could attain it, it would require massive inflows of capital. Most of the Majors have avoided Iraq’s initial offering of licenses, due to unprofitable terms. This is a prime example of“Resource Nationalism.” Will Iraq invite the Majors back by offering better terms? They may, but, that means less for Iraq which they will seek to offset through higher oil prices. Iraq will get higher prices through production cutbacks – basic supply/demand/price levers. Greater capital investment will flow to Iraq only if commensurate returns increase, and that demands higher oil prices.

Understanding what is at stake for Iraq and many of the other oil-rich Mid-East nations cuts to the heart of the issue. Higher production is to whose benefit? The West? Or the local people, for whom it is intended? The road through greater oil wealth lies through less oil supply, which drives prices higher; even the Iraqis understand this, despite public relations statements to the contrary.

In conclusion, supply will remain increasingly constrained due to natural global decline, higher costs, inadequate infrastructure, accelerating demand from the developing world, continued geo-political tension, and “national self-interest”; combined these catalysts will limit global oil production and inevitably fuel higher prices.

From the Oil and Gas Patch,

Lou Gagliardi

Kevin Kaiser