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In the month that Forbes magazine rated Shell for the first time as the world’s largest company in terms of revenues, further evidence emerged from the International Energy Agency (IEA) that the nexus of power continues to shift from international oil companies (IOCs) to the national oil companies (NOCs), and that this may have a profound effect on future oil supply.

The problem, says the IEA’s chief economist Fatih Birol, is that it is becoming technically harder and far more expensive for IOCs to find new production. In its latest publication, the Medium-Term Oil Market Report 2009, published alongside Natural Gas Market Review 2009, the IEA sees a continuing upward trend in the oil price but this, says Birol, has a potentially profound impact on world economic recovery if it increases too quickly and strongly.

“In 1973-74 and again in 1979-80, we had two major oil price shocks and the basic economic rule applied: the higher the price, the higher the investment and therefore the greater the increase in production capacity,” says Birol. “But with the last sharp price rises, which saw a $147 peak in July last year, this effect has not been happening.”

“In its latest publication the IEA sees a continuing upward trend in the oil price.”

Indeed the IEA has found that between 2000 and 2008, sharply higher upstream spending did not result in a proportional increase in supply. This was in part because labour, equipment and servicing capacity shortages led to higher costs, compounded by slippage on complex projects and tightening fiscal and access terms to new properties.

“There are two-and-a-half main reasons for supply inelasticity which are going to affect the geopolitics in the years to come” explains Birol. “The first is that most oil reserves in the areas that are not dominated by the key oil producers are in decline – in some cases in steep decline. The fields are mainly run by IOCs. The money going into those fields is mainly to slow down the decline in production.

“Unlike after the previous two oil price shocks, this time higher upstream spending has not resulted in a proportional increase in supply.”

“The second reason is that, since the private sector has no access to major producing countries because of constitutional prohibitions, they are now investing in much more difficult and complex fields, such as deepwater offshore. These are by definition more expensive in terms of production costs. That is why you are seeing higher investment but a disproportionately low increase in production capacity. The half reason is that there are many areas that are much lower cost, such as the Middle Eastern countries, and they have not yet – except for Saudi Arabia – increased their own production capacity significantly.”

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IOCs’ E&P spend is now down by a hefty 21%. It reflects caution about new investments upstream and downstream. However, warns Birol, given the long lead times to bring new fields into production, the elasticity between supply and demand is, at least in the short term, low.

He adds that the lack of refining capacity in OECD countries, since many IOCs sold off rather than invested in upgrading their older refineries, will compound the inelasticity.

“This may turn out to be a problem, mainly in the OECD countries,” says Birol. “If you look at them, with one or two exceptions, one of those being Turkey, there has not been a single refinery expansion. I believe the bulk of new refining capacity will need to come from the Middle East and from India and China. If this extra capacity does not come through we will have difficulties in terms of products. And OECD reliance on imported crude will be aggravated by a lack of products as well.”

“IOCs’ E&P spend is now down by 21%.”

Birol notes how, compared with the previous price shocks, OECD countries no longer rely on oil for power generation and heating. “We therefore expect that almost all the growth in oil demand will now be coming from the transportation sector – cars, trucks, jets and ships – where you do not have major alternatives to oil,” he says. “You cannot put coal into the tank of a car nor wind in a truck – at least for the next 15 or 20 years.”

Nabucco, the EU gas lifeline?

As Birol spoke to World Expro, four EU countries and Turkey were finally preparing to sign the Nabucco pipeline deal to transport up to 31 billion cubic metres of gas from the Caspian and Middle East, 3,300km to Europe.

“In terms of the gas sector, this is currently the most important project in size, geopolitics and economics,” says Birol. “It is important in terms of energy security because it will be the first alternative to the Russian lines to Europe. The economics speak for this project and there is a strong political will behind it from the producing, transit and consuming countries.”

Although supplier deals and transit fees for Turkey have yet to be fixed, Birol says that he hopes that the full contract will be complete soon.

While warning that abnormal economic conditions make macro-economic forecasts difficult, Birol believes that a continuing weak US dollar with improving recovery prospects could boost crude prices. In any event he repeats his assertion that the era of cheap oil is over. “When we look at the forward curve today it shows prices will come to $70 or $80 towards the end of the year and maybe even higher next year.”

However, even with higher prices, there are few areas outside of Opec where IOCs can boost production. “We have offshore West Africa, offshore Latin America, Canadian oil sands and the Caspian,” explains Birol.

“Most of the oil reserves in the areas that are not dominated by the Opec producers are in decline – in some cases in steep decline.”

“These require not just higher prices but also good, reliable investment frameworks. In the Caspian, there are the geopolitics and the necessary pipelines. Canada’s oil sands have serious environmental and production challenges to overcome, before reserves equivalent in size to those of Saudi Arabia could be exploited.”

Offshore Brazil development faces delays, says Birol. “They are very complex fields and you need sophisticated technology there to boost production. At present nobody is jumping, even at such lucrative investment opportunities. However I believe that in a couple of years, there will be growing interest in deepwater Brazil because it is one of the few areas that capital can, at least at a certain level, flow in freely without major impediments.”

And higher prices may even actually reverse the old formula that they encouraged production, asserts Birol. Dominant oil producing countries may feel that strong prices might not necessarily boost output.

“This is because for them what is important is not how much they export, but how high their revenues are. If they have higher prices from the same production, what is the incentive to increase production as much as the consumers want?”

“The bulk of new refining capacity is expected to come from the Middle East and from India and China.”

Birol concludes that everything will depend on how the dollar evolves, and on economic growth, especially in key countries such as China and the US. “If we have signs of recovery globally, if China grows 8-9% this year and the next with the help of the stimulus packages, if the US demonstrates that it is on the road to recovery and if the dollar continues to be weak, then I think we have every reason to expect that oil prices will be even higher than current predictions. But there is one
issue that is very important. Higher prices now may be a major problem for the oil importing countries’ economic recovery, both within and outside the OECD countries.

“They will contribute to growing deficits,” Birol continues. “Economies are still fragile. Too high an oil price has the potential to slow down or even strangle recovery throughout the world. The need to recognise the consequences applies to the producing states as well, because they need healthy consuming countries to be able to sell their oil and gas, and invest and recycle their earnings”.