Oil spill to upset crude's price balance

Peter Tertzakian, Calgary Herald, May 3, 2010--Maybe I was the only one on the flight from Florida to Texas last week feeling the irony of the situation. Hugging the Gulf of Mexico coastline for most of my otherwise routine business trip, I thought of the contradiction below: The jet fuel that was being consumed to coincidentally fly me over the disastrous BP oil spill probably originated from an offshore oil well in the nearby region.

To be sure, such events remind us, implicitly, that we live in a conflicted society that goes to the ‘ends of the earth’ to drill for the oil that promotes the way we “live, work and play,” under a long shadow of environmental, geopolitical and economic consequence. No doubt, the widening BP oil slick, reportedly spewing uncontrollably at a rate of 5,000 barrels per day from the ocean floor, will heighten our sense of this inner societal conflict. The markets will feel the conflict too, likely pushing oil prices higher over the near term, and triggering bigger changes longer term.

Oil prices in the $75/B to $85/B range over the past nine months have led to a quiet, multi-party balance. Consumers within this price range are not quite screaming at the pumps, governments have been tending to other matters, and oil producers have been content that their financial hurdles are being met at the cost margins, even at the ends of the earth. The worsening ecological disaster in the Gulf of Mexico upsets this balance.

A stronger oil price over the next 12 to 24 months was already looking probable, but now the time fame is likely going to come forward as markets perceive costlier and scarcer supply sources. Yet rising price will also reinforce the ultimate consequence of this disaster, which will be a redoubled effort by fully industrialized economies like the United States to try to “get off oil” over the longer term. Potentially significant advances toward that effort – whether it’s the adoption of direct petroleum substitutes, efficiency gains or the mitigation of demand – now have greater chance to accelerate as early as mid-decade. Such a ‘break point’ in the oil complex was already percolating; gauging the magnitude of this environmental disaster over the next few weeks will dictate how much faster the agenda of long-term change accelerates.

Aside from oil sands, offshore drilling is where most of the world’s incremental oil barrels now come from, and it’s those higher-cost marginal barrels that set price. Indeed, a large fraction of the world’s growing oil needs since the early 1990s has come from the discovery of new, deep offshore reservoirs. The trend, which is global, is best illustrated with data from the US Gulf of Mexico. Figure 1 shows the components of US monthly oil production between January 1981, and the end of 2009.

Top line oil volumes peaked in the mid-1980s and then started a long declining trend. The United States has been producing commercial quantities of crude oil for over 150 years, so it’s no surprise that onshore oil fields, the top wedge in Figure 1, would ultimately succumb to maturity. Onshore scarcity, geopolitics and new technology facilitated migration to deep offshore resources in the early 1990s, with production volumes from the Gulf of Mexico rising in the latter part of the decade (the bottom wedge in Figure 1). The sharp dips you can see in recent years are hurricane disruptions. But note how offshore US production really began to ramp up in the last couple of years, leading to the first overall rise in domestic America oil supply since the 1980s. Unbeknownst to most, the US has been a significant contributor to new oil supply over the past 18 months or so.

It’s no wonder the Obama administration, and other constituents who are determined to “get off foreign oil,” were eager to open up hitherto protected areas of offshore exploration. The volume increases from environmentally sensitive regions like Alaska and Florida are potentially significant contributors to the nation’s oil supply, if not the world.

Of course now there is a halt to offshore oil exploration in restricted areas. Drilling in areas already open for business will continue, but with heightened attention to safety, greater aversion to risk, more regulatory scrutiny, and more opposition from those affected – for example, fishermen. All of these factors translate into greater exploration and development costs and longer lead times to production. Of course this tragedy in the Gulf of Mexico won’t stop oil drilling in the deep waters off the shores of Brazil, Africa, India, China and even the North Sea to name a few of the extreme regions that the industry explores. But these places are not cheap to drill for each of their own circumstances, whether for technical, environmental or political reasons.

A seemingly insignificant 5,000 barrels per day of rogue oil, on 86 million barrels per day of global consumption, is going to cause a lot of change sooner than expected. We shouldn’t be surprised, because history shows that the way our society consumes its energy, and the way that our society is supplied its energy, always changes due to factors we least expect.