What's the Right Price for Oil?

Last year — 2008 — started out so well for the world’s energy industry. The price of oil was in the $90s and low $100s per barrel, not exorbitant. That is, the price of oil was high enough that people were beginning to change their usage habits, but the price wasn’t bad enough to break the banks (so to speak). The worldwide pace of well drilling was strong, but not unsustainable with the existing fleets of onshore and offshore rigs. Meanwhile, across the world, the oil patches were booming.

What a difference a year makes. By about March last year, the price of oil began to spike upward. Eventually, in July 2008, it reached $147 per barrel. And then the price broke. Oil prices slid down into the $100s by Labor Day. Between late September and late December, prices dropped as low as $33 per barrel. Now in January 2009, oil is hovering around the low $40s per barrel, $100 less than back in July, only six months ago.

We had a wild ride in 2008. And I believe 2009 will give us some new shocks. First, we are seeing significant companies in the domestic gas drilling business, like Chesapeake Energy, scaling back their drilling programs. And we’re seeing eye-popping fourth-quarter losses from key industry players like Conoco-Phillips (lost $31.2 billion in the last quarter) and Shell (lost $2.8 billion in the last quarter). We will see more reports like that, of operating losses, diminishing reserves, reduced earnings, write-downs and even some shotgun weddings (if not bankruptcies). Remember how Congress spent much of last year licking its collective chops over how it was going to tax those horrible so-called “windfall profits” of the oil firms? Well, not anymore, eh?

Also, watch how fast the drilling and oil service industry decelerates. Oil companies that lose money also scale back their capital expenditures. Conoco-Phillips and Occidental are cutting back. We’re seeing layoffs in key parts of the oil service sector. Companies like Schlumberger, Halliburton and Baker Hughes have announced personnel cutbacks just in the past week. And Rowan, a large offshore driller, is canceling new rigs. Across the oil patch, the hiring boom of the past couple of years has halted, while the average age of the current work force just gets older by the day.

With less drilling going on, we will soon start to see tighter output for both oil and natural gas. In Russia, oil output decreased by a seemingly small — but telling — 1% toward the end of 2008. You can expect a larger drop from Russia for 2009. Mexican oil output dropped by about 10% in 2008, and is on track to drop even more in 2009. According to figures recently published by the International Energy Agency, about 58% of world oil output comes from just 800 oil fields. And most of those oil fields are in the “mature” category. They were discovered in the 1950s-70s and are past their respective output peaks. So the macro view is grim, out beyond two years or so.

Markets work, right? Yes, basically. That’s the idea, anyhow. Unless, of course, they don’t work very well. And if something doesn’t work very well, does it still work? A stopped clock tells the correct time twice a day, right? But what if the clock just stops and starts whenever it gets banged around? To use another cliche, is that any way to run a railroad?

Let’s try to figure this out. What’s the difference between oil at $100 in January 2008, $147 that July, $100 in September and $33 in December? Has global demand been changing all that much? (Hint: Worldwide demand was not rising all that much in the first half of 2008. And demand is down over the past six months, but not by large factors.) Is the current oil price — in mid-January 2009 — in the low-$40s per barrel the “right” price? Can we believe the market?

One key thing that has changed in recent months is the oil market’s perception of the future. The marketplace is predicting lower oil usage as the world recession unfolds. So oil prices tend to fall with the release of bad economic news. But that perception is just plain myopic. Look at both the amount and the composition of the oil for sale. We’re seeing falling oil prices in the face of flat (at best) world output. And total world oil output includes increasing volumes of natural gas liquids (NGLs) and tar sands from Canada.

Let me translate that for you. NGLs are evidence that the oil industry is blowing down the world’s gas caps. And tar sand “oil” is the capital-intensive stuff with low energy return on investment. Tar sands use a lot of water and energy and come out at great capital cost and environmental cost to the North American landscape.

Ask yourself a couple more questions. In the near term, will worldwide economic contraction lower the use of oil? Yes, probably. And in the medium-to-long term, will depletion lower the worldwide output of oil? Yes, as well.

For now, lower oil demand is trumping stagnant supply. Oil prices are down. Near-term issues are beating out the medium-and-long term issues. But the longer oil prices stay low, the more damage will be inflicted on the world oil and drilling industry. More rigs will not be built. More wells will not be drilled. More prospects and fields will not be developed. More personnel will not enter into an aging industry work force. More of the current infrastructure and human capital will just run down.

In short, we are setting ourselves up for a period of severe volatility in oil prices. When demand starts to recover, supply falls below some not-yet-defined volume or perceptions change about the future of oil availability… prices will take off.

The Daily Reckoning