Where Will the Price of Oil Go From Here?

Oil is at $98.50 this morning — the highest in a month. That release of strategic reserves is working out like gangbusters, eh?

West Texas Intermediate Crude, price pe

Heck, Barron’s had a cover story a few days ago about oil reaching $150 by next spring. It cited some of the same data we cited four months ago, about “spare capacity” — or lack thereof.

“Spare capacity,” we pause to remind you, is the ability of oil producers to jump-start new oil production within 30 days and keep it up for at least 90 days.

According to Morgan Stanley, “spare capacity” will be tapped out in two years… and that’s based on figures before the war in Libya took that nation’s 1.5 million barrels per day offline.

Even with conservative demand assumptions, spare capacity disappears by 2013

The realities of shrinking spare capacity are becoming more evident by the day. To wit…

The International Energy Agency warns that unless OPEC can raise production by 1.5 million barrels a day — about the same as that lost Libyan production — global demand oil demand will start to outrun available supply between now and year-end.

Thus, “If there is not enough supply to match the 89 million barrels of oil the global economy is expected to burn every day,” says former CIBC World Markets chief economist Jeff Rubin, “world oil prices have only one direction to go.”

“With no obvious end in sight to the Libyan conflict,” Mr. Rubin continues, “and sectarian violence against oil fields and refineries suddenly on the rise in Iraq ahead of the scheduled U.S. troop withdrawal, the prospects are not promising for OPEC to increase supplies.

“This is even more evident given the region’s largest producer, Saudi Arabia, has little more to offer other than unwanted sour, heavy oil to add to the global supply mix.”

It’s not that the Saudi sheiks aren’t trying. Production in the kingdom rose nearly 4% last month, to 9.7 million barrels per day.

Thing is, only half of that increase hit the international market. The rest went to Saudi Arabia’s own refineries for “power generation and water desalination plants during the peak summer season,” according to an IEA report out yesterday.

Two more factors spurring oil demand: power shortages in China and Japan. Because of drought in China, hydropower plants can’t generate as much electricity. Diesel generators are making up the difference.

Diesel is also making up the difference in Japan after the Fukushima disaster. Two-thirds of the country’s nuclear capacity is offline… and won’t be coming back online anytime soon.

Thus, oil stands to be a profitable play for some time to come — even if what passes for a “recovery” in the United States ends up stalling out.

How to play it?

“About one-fifth of the domestically produced oil in the U.S. comes from Alaska,” observes Chris Mayer, who’s been examining the investing possibilities. “But these assets have been in long decline. Production of crude oil is down more 70% from its high in the 1980s.”

Annual field production of Alaskan crude

With existing fields declining, and Washington keeping new fields off-limits, Big Oil is bailing on Alaska — or at least some of its historically prolific regions.

Chevron, for instance, decided recently to dump its holdings in the Cook Inlet area. “The decision comes as production from Cook Inlet oil and gas fields is declining,” reports the Anchorage Daily News, “typically, a period when big energy companies lose interest in their investments and smaller operators jump in.”

For those smaller operators, there’s a surprising amount of oil yet to be tapped. “Nearly all of the operating oil and gas fields in Cook Inlet derive from exploration done in the 1950s and 1960s,” explains Petroleum News.

Then the giant Prudhoe Bay field was discovered and everyone ran off to work there instead. “As a consequence,” the trade publication goes on to say, “only limited exploration of Cook Inlet has taken place in more recent decades.”

That’s not the only incentive for a small operator to work over a place like Cook Inlet.

“Some 80% of state revenues depend on oil and gas extraction,” says Chris. “It employs thousands of people. Those people in turn support shops, restaurants, and the whole wheel that is a community.

“So the state government created some sweetheart deals for oil and gas companies to spend money here. Among these goodies is a 40% state refund on money spent for drilling and exploration costs — paid in cash to the operator. There are other laws in place that could refund as much as 20% of other costs and 25% of net losses incurred.”

“For a small operator looking to get a sweet return on a moderate-sized pot of money, Alaska is like the El Dorado of oil and gas.”

Addison Wiggin
for The Daily Reckoning

The Daily Reckoning