In a recent report, Michael Lo, a CFA at Nomura, cited the potential for $220 oil in the near future. He based his analysis on the market's reaction to the first Gulf War in 1991. The comparison focuses on the loss of supply from Iraq in 1991 and the current loss of 60-70% of Libyan production increasing to a 100% loss, and unrest in Algeria leading to supply disruptions there.
The loss of the remainder of Libyan production seems likely. Even if the production isn't lost, but Qaddafi is deposed, the question of the validity of the current drilling contracts is likely to come into play. In other words, upward pressure on oil prices is likely to continue due to geopolitical uncertainty.
Add to that uncertainty the fact that, according to the International Energy Agency (IEA), global oil production for 2010 was 87.3 million barrels per day (MMb/d), which was .5 MMb/d short of global consumption of 87.8 MMb/d. There is no indication that supply will be able to fill that gap this year.
Finally, crude, as measured by the NYMEX contract, appears to have made a significant break out ...
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Although I don't have a chart of the Brent crude here, the action is similar, with the current price for Brent approximately $11 above the NYMEX contract.
I don't know whether we will get to $220, but higher prices seem like a reasonable expectation. Ultimately that will impact consumers and the economy in a negative way, as more and more disposable income goes toward heating homes and fueling cars.
But aren't we supposed to be working toward lowering our dependence on foreign oil, and shouldn't that help ease some of these pressures?
First the bad news. Remember how, in the early and mid-2000s, there was so much excitement about US oil resources in Alaska? In 2002, a US Geologic Survey estimated that there were as much as 10.5 billion barrels of oil in the frozen north. Shockingly, the scientific organization revised this estimate in October of last year to 896 million barrels, less than 90% of the original estimate!
According to the USGS, "This striking reduction reflects the results of exploration drilling, specifically (1) the unanticipated and abrupt transition from oil to gas just 15-20 miles west of the Alpine Oil field and (2) poor reservoir quality in key formations."
In other words, a big part of what they thought was going to be oil turned out to be gas, and the oil that is there is difficult to get to and of questionable quality. Even though we weren't aggressively drilling in Alaska, to see that massive potential wiped out is unnerving. It does explain why we haven't heard any recent calls for drilling in the 49th state.
The Gulf of Mexico
OK, there is a little more bad news. Since the BP disaster in the Gulf, production has held up fairly well, as shallow water rigs continue to produce. However, the remaining potential in the Gulf is mostly in deep and ultra-deep water resources -- over 5,000 feet. The moratorium on drilling these types of wells has been lifted, but the permitting process for new wells has been painfully slow. Nobel Energy (NBL) received the first post-moratorium permit to drill in deep water just this past week.
From an environmental perspective, slowing the permitting process makes sense since the Deepwater Horizon dumped an estimated 5 million barrels of oil into the Gulf, and the technology required to execute these wells is shaky at best. Nonetheless, it takes 5-6 years to drill and ramp up production, and the delays are going to crimp production going forward. According to the US Energy Information Agency (EIA), production in the Gulf is expected to decline over the next year or so, before estimated increases near the end of 2012, barring any weather related shut-ins.
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Finally a little good news. There are a number of shale formations in the US -- including Bakken, Eagle Ford, and Niobrara -- with some crazy potential. USGS estimates 3.5 billion barrels in Bakken alone, but the CEO of Continental Resources (CLR) put forth a recent estimate of 24 billion barrels of recoverable reserves in the region.
While the high end estimate is still less than 10% of Saudi Arabia's claimed 267 billion barrels, and Venezuela's recent claim of 297 billion barrels of reserves, US shale oil is a big boost to our national reserves, more than doubling prior proven reserve estimates of 21 billion barrels. Bakken is expected to be producing something on the order of 1.5 MMb/d within five years.
The biggest problem with recovering shale oil is that it is a nasty, dirty process. The conventional process, put simply, is this: the shale is mined, put into trucks and taken to a plant which heats the crushed rock to varying degrees to extract the oil and other fuels. There are a lot of carbon emissions associated with this process, as well as a number of other pollutants.
New technology in the form of horizontal drilling and hydraulic fracturing (fracking) has enabled better access to these reserves in what are called "unconventional" oil plays. Coupled with elevated oil prices, the technology makes extraction economically viable, but there are environmental concerns with this process as well.
Fracking involves injecting a combination of water, chemicals and sand into the wells to fracture or break up the formations at the site. The chemical portion of the mix can contain some known carcinogens -- like benzene -- and heavy metals, which can do serious damage to the water table. Best known are the examples in my home state of Pennsylvania, where fracking has been used to unlock natural gas deposits in the Macellus Shale region. The pollution of the water table has caused some local residents to have flammable water. Yes you read that right, you can actually light the water coming out of your tap.
There is an ongoing effort by some companies, like Slumberger (SLB) and Petrohawk Energy (HK), to experiment with more organic compounds in fracking fluid. But the bottom line is that, for now, neither the conventional nor the unconventional methods are environmentally friendly. In fact, New York state has a moratorium on fracking until May 15, 2011. Pennsylvania rescinded its moratorium this past week, and New York will likely follow suit in May.
Will it help?
Eventually, new permitting in the Gulf of Mexico and production ramp ups from shale regions are going to help reduce US dependence on foreign oil and hopefully reduce prices, but significant progress will take years. Additionally, reliable estimates for proven and unproven reserves are not really available; everybody is fudging the numbers a little.
For now, higher oil prices are here to stay as a result of geopolitical turmoil and demand/supply imbalances.
I don't know whether it will hit $220 per barrel, but a retest of the 2008 high, north of $145, may be in the cards. Long before it gets to that level, however, a real domestic and global impact will be seen. This could have devastating consequences for a US economy that is limping out of recession