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WHY OIL COULD HIT $180 A BARREL .

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Why oil could hit $180 a barrel
Just when crude is becoming more costly to extract and process, producers in three key countries are short of cash. And without that money, recent finds won't do much good.

By Jim Jubak
April 22, 2008
Yikes! Oil at $117 a barrel. It has to go down from here, right?

Wrong. In the short term -- say, the next two years or so -- we're looking at bad news about global oil supply that could take the price of a barrel of crude to $180.

Needless to say, today's $1.20-a-litre gasoline would look cheap if oil prices hit $180 a barrel. At that price for a barrel of oil, gasoline would cost somewhere north of $1.90 a litre.

The good news is that's about the price, experts now say, that would send global consumption tumbling and oil prices into retreat, as drivers scrambled to find ways to conserve.

Of course, experts once thought $1-a-litre gasoline would lead to a drop in consumption. The latest forecast from the International Energy Agency calls for global oil demand of 87.2 million barrels a day this year. That would be an increase in consumption of 1.3 million barrels a day from 2007 -- despite a U.S. economic slowdown and soaring oil prices.

So why do I think oil prices will keep climbing for two more years at least?

A terrible coincidence of geology and geopolitics. Just when oil is getting more expensive to produce, the oil industries in three key countries -- Mexico, Russia and Nigeria -- find themselves short of cash. And without that cash, oil production in these countries, and global oil production in general, is headed into a decline.

The Russian oil industry, for example, announced that production had fallen 1% in the first quarter of 2008. According to the Russian energy ministry, oil production for the full year could be lower than in 2007.

Any decline would mark a huge turnaround. Russian production has grown steadily over the past 10 years, and in its supply-and-demand projections the International Energy Agency has been counting on growth in Russian production of 5% by 2012 to offset big declines in older fields in the North Sea and Mexico.

The International Energy Agency now estimates that worldwide production from older existing fields is now falling each year by about 4.5 million barrels a day. To stay even -- let alone to meet rising demand from the new automobile drivers of Moscow, Shanghai and Tehran -- the world has to increase annual production by 4.5 million barrels a day.

You'd think that would be easy when oil is selling for more than $115 a barrel. But it's not.

What's the problem? Geology and money. But mostly money.

Government is in the way
Russia's older west Siberian fields are in decline, following the path of such fields as the North Sea. Russia has promising fields in eastern Siberia, but developing those is expensive. The fields are hundreds of miles from anywhere, making it costly to get workers and equipment to the fields and then support them in one of the world's more hostile climates. And then there's the additional cost of getting the oil and natural gas from remote wellheads to market.

How expensive is expensive? Leonid Fedun, the vice president of Lukoil (LUKOY.O), Russia's largest independent oil company, recently estimated that Russia needs to invest $1 trillion over the next 20 years to keep production in the range of 8.5 million to 9 million barrels a day.

It's never easy to find $1 trillion in investment capital, but the Russian government has made it hard for its oil industry to attract even a small part of that capital. The Kremlin has structured taxes so that most of the extraordinary rise in oil prices flows into government coffers, not oil-company profits.

When oil rises above $27 a barrel, the Russian government takes 80% of any additional revenue in taxes. That means at $67 a barrel, an oil company gets just $8 more a barrel in revenue than at $27. If the price climbs to $107 a barrel, the oil company's revenue increases by just $16 a barrel from what it was at $27 a barrel.

That may delight U.S. consumers who believe oil companies are making obscene windfall profits from soaring oil prices, but it hasn't made companies eager to sink their money into developing new oil in Russia.

The production decline in Russia would be serious enough if it were an isolated problem. But it's not. The same conjunction of geology and geopolitics is crimping production in Nigeria and Mexico, for example.

Paying less than what's fair
In Nigeria, a third of the country's oil output by 2015 is at risk, energy advisers to Nigerian President Umaru Yar'Adua have warned, because the government hasn't been paying its share of the costs of joint ventures -- about $3 billion to date -- with Royal Dutch Shell (RDS.A.N), ExxonMobil (XOM.N), and Chevron (CVX.N). If the government's failure to pay jeopardizes the joint ventures, Nigeria can kiss plans to double its production goodbye. Instead, total oil and gas production will fall 30% by 2015.

Where has the money gone that was supposed to go into the joint ventures? It's in the pockets of just about any Nigerian government official with any clout.

Mexico faces a similar shortfall in investment capital. The country's massive Cantarell oil field in the Gulf of Mexico is dying. Production fell 12% in 2006 and 18% more in 2007, according to data from the national Energy Ministry.

Mexico's total oil production, which peaked at 3.4 million barrels a day in 2004, fell to 3.08 million barrels a day in 2007. If trends continue, Mexico, the fifth-largest oil exporter in the world, exporting 1.9 million barrels a day, could become a net oil importer within 10 to 20 years.

Mexico does have ways to replace this production, but it will take money and technology. Developing the massive Chicontepec onshore field in eastern Mexico will require drilling 13,500 to 20,000 wells at a cost of $30 billion to $38 billion over the next 15 years, according to Pemex, the Mexican national oil company, because the oil occurs in isolated pockets.

And Pemex could install state-of-the-art pumping and separation equipment to separate the oil from the increasing amounts of water now pumped out of wells in Cantarell. That would help slow that field's production decline.

But Pemex doesn't have the money to invest in drilling all these wells or for buying this pumping and separation equipment. As in Russia, the government has used the oil industry as a cash cow. About 40% of total government revenue in Mexico comes from Pemex. And as a symbol of the country's economic independence from the United States, Pemex is prohibited from signing joint-production agreements that would let the company trade oil for the technology and investment it needs. So far, Mexican President Felipe Calderón has been unable to push a modest set of changes to the Mexican oil industry through Congress.

Questions of time and money
It's not as if the world's oil industry isn't finding new oil while production is declining in places such as Russia, Mexico and Nigeria. It's just that the oil that is being discovered is either very expensive to produce -- the production costs for oil from Canada's oil sands have crept to $65 a barrel, according to some estimates -- or is a long time away from market. Or both, as in Brazil's big recent oil discoveries.

For example, a new field, Carioca, might contain as much as 9 billion barrels of recoverable oil. (To put that in context, total proven U.S. oil reserves total 20 billion barrels.) Last year Brazil's Petrobras (PBR.N) announced the discovery of the Tupi field, with a potential 5 billion to 8 billion recoverable barrels. The country eventually could wind up producing 3 million barrels a day, as much as today's Venezuela or Mexico.

Eventually.

Getting oil out of Carioca will require oil companies to go beneath 6,500 feet of water, then drill through 9,800 feet of rock and sand, and then through 6,500 feet of salt to get at the oil. That's possible with cutting-edge technology, but it's mighty expensive and time-consuming.

Estimates of fully developing the Tupi field, which involves similarly challenging geology, run to about $50 billion. Count on a decade before these fields reach full production.

It's that gap between production declines that are continuing and visible now and production increases that are speculative and in the future that will keep upward pressure on oil prices.

In the short term, the oil market is right not to underestimate the ability of the governments of national oil producers to shoot themselves in the foot by starving their national industries of capital. We're likely to see a continuation of these self-defeating strategies among enough big oil-producing countries to keep oil prices climbing until global consumers finally say, "We can't take higher prices anymore." In that crisis, falling demand will break the upward trend in oil prices.

For a while, anyway. The logic of rising costs of production and falling supply from cheaper conventional sources of oil argues that oil prices could suffer a temporary correction on a fall in demand but that over the next decade at least oil prices will trend higher.

The only thing that ultimately breaks that trend is the production of alternative-transportation fuels in mass-market volumes.

Do you see that happening soon in most of the world? Especially in the big markets -- the United States and China -- that really count?

Until you do, the best strategy is to hang on to your oil stocks and buy more when the opportunity presents itself.

http://finance.sympatico.msn.ca/investing/jimjubak/article.aspx?cp-documentid=6956902

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