WHAT KANGAROO COURT CREATED OUR OIL AND GAS MARKETS?

GEOPOLITICS

MARKETS

ECONOMY

SUPPLY

DEMAND

Australian American Chamber of Commerce Houston January 29, 2009 Houston, TX By: Matthew R. Simmons, Chairman Simmons & Company International

The Turmoil In Global Oil And Gas Markets Is Ridiculous
■ Market structure for how we run world’s most important business must have been created by a kangaroo court in the Billabong.

■ USSR’s central planning did a better job than the “free market” system did for oil and gas.
■ We now have a turbulent market for oil, and worse for gas. ■ Left unchanged, it could destroy the global economy.

Chaos In Current Energy Markets Is Serious And Getting Worse
■ But, it all did not have to happen this way. ■ The flashing signs of trouble ahead began two decades ago. ■ But, few wanted to listen to the “naysayers” and many wanted to hear from the optimists. ■ So, the kangaroo court ruled in favor if the optimists. ■ Let’s go back to a year ago and see what happened.

2008: Oil’s Annus Horribilis
■ 2008 started out so “bright” for oil markets:
– Rigs were fully employed – Oil price was high but not exorbitant – Oil regions were booming
“1992 is not a year on which I shall look back with undiluted pleasure. In the words of one of my more sympathetic correspondents, it has turned out to be an 'Annus Horribilis'. I suspect that I am not alone in thinking it so. Indeed, I suspect that there are very few people or institutions unaffected by these last months of worldwide turmoil and uncertainty.”

■ But, then came “volatility”:

– Prices spiked from $96 to $147 by early July (+53%) – Prices took a breather through mid-September – Then, prices plunged 74% in next 3 months

The Big Question As 2008 Came Crashing To An End
■ Why did prices spike so high? ■ Why did oil prices then crash? ■ Many pundits answered by observing:
– Prices spiked because of speculation – Prices collapsed because:
 Speculators went AWOL  Oil demand began to plunge  Oil gluts quickly emerged

The Spike And The Collapse Were Asymmetric
■ The “spike” topped off a 15 fold increase from under $10 in 1998 to $147 in 2008. ■ The 3 month plunge took oil prices back to where they were in November 2003. ■ Were both anomalies? Will we ever know?

?

“January 2009 Was Not A Good Month”
■ Oil price collapse came to an end. ■ But, price volatility continued to create chaos. ■ And, almost all major supply advances slowed or were stopped. ■ North American rig count plunged. ■ Rumors of oil glut grew. ■ Rumors of vast amounts of oil stored on tankers grew rapidly. ■ And, reported oil inventories stayed tight in many key regions.

What Is A Fair Price For Oil?
■ Oil prices will stay at $5 for a decade or two.
(The Economist cover story March, 1999)

■ “$27 oil price is fair.”
(British Petroleum’s Lord Browne – October, 2004)

Maybe oil is so plentiful that it has no fair price!
Multiple Quiz
 Fools Gold?  Just another commodity?  World’s most precious natural resource?

■ “$30 - $45 oil price is fair.”
(Shell’s John Huffmeister – January 6, 2008)

■ “$75 oil price is fair.”
(King Abdullah of Saudi Aramco – December 2008)

Nothing Goes Straight Up!
■ Oil price 15 fold rise had many retractions. ■ But each dip soon became a new high. ■ These are “normal prices.” ■ When inflation adjusted (CPI) the picture altered.
2008

1990

Why Did Prices Rise 15 Fold In A Decade?
■ 1997 – 2007 fundamentals changed:
– Demand grew by 12.7 MMB/D – Crude oil production grew by 7.3 MMB/D – Gap was filled by:
    Increased natural gas liquids “Other liquids” Refinery processing gains Occasional stock liquidation

■ OECD total petroleum stocks: 12/1997: 2,615 million (56 days’ use) 12/2007: 2,566 million (52 days’ use) ■ Along the way, speculators often shorted oil contracts.

Why Did Crude Supply Not Keep Pace With Demand Growth?
■ E&P spending grew from less than $100 billion to $400 billion in the decade. ■ By 2008, every quality drilling rig (and other oil service assets) were employed. ■ Technology gains allowed deepwater/ultra deepwater exploration. ■ Seismic advances and reservoir simulation modeling allowed greater amounts of trapped oil to be drained. But, all this still created “flattening” of crude oil supply in last few years.

Did Oil Field Technology Not Work?
■ If so many new wells were drilled and so much money spent, was it wasted? ■ No. These projects were critical to offset accelerating decline rates from mature fields. ■ The big problem:
– All new discoveries were either small or in deepwater – All peak fast and decline fast

Long-Term Supply Trend Got Uglier By The Year
■ >800 super-giant, giant and large oil fields comprise 58% of world’s crude supply. ■ Other 42% comes from ≈70,000 small to tiny fields (average field production 440 bbls/day). ■ Foundations of world’s oil supply comes from 356 super-giant oil fields. Almost all are “mature” and past peak. ■ IEA’s WEO 2008 Supply Outlook laid bare some ugly facts.

“The Era Of Cheap Oil Is Over”
(IEA November 14, 2008)

Has Crude Oil Now Peaked?
■ Hard data argues that sustained peak supply reached in 2005. ■ Too many key producing countries are now in irreversible production decline.

■ Only a handful of key producers have some growth left:
– – – – Angola Brazil Sudan (?) Canada’s heavy oil (?)

Source: EIA Monthly Energy Report – March 2008

Detailed Peek Into Why Crude Oil Peaked In 2005
■ When only 9 key producing countries show any significant growth, bad sign. ■ When rest of world collectively falls by almost 5 MMB/D, terrible sign!
Major Increased Crude Russia* Azerbaijan Kazakhstan China* Brazil Iraq Kuwait* Angola Sudan Total Rest of world crude Net change
*Now in decline, too.
Source: Highly regarded confidential supply model.

2005 9,185 454 1,266 3,617 1,634 1,992 2,133 1,228 305 21,814 51,033 72,847

2008 9,520 895 1,412 3,810 1,822 2,374 2,314 1,847 480 24,474 46,396 70,870

Change 335 441 146 193 188 382 181 619 175 2,660 (4,637) (1,977)

------------- MMB/Day -------------

A New Look At Best-In-Class Supply Model
2005
Conventional USA Canada Mexico UK Norway Other Europe Australia New Zealand, Japan Russia* Other FSO* E. Europe China* Other Asia Brazil* Other LA Non OPEC, Middle East Non OPEC, Africa, Middle East OPEC Crude Other OPEC 5,877 1,358 3,333 1,600 2,506 743 452 25 9,185 2,162 158 3,617 2,658 1,634 2,273 1,845 3,682 20,702 9,037 72,847 NonConventional 2,219 1,698 429 240 463 58 89 28 443 Conventional 4,946 1,409 2,804 1,304 1,941 635 472 69 9,520 2,753 123 3,810 2,636 1,822 1,738 1,611 2,593 20,587 10,097 70,870

2008
NonConventional 2,579 1,832 368 222 530 84 77 31 471

-------------------------- MMB/Day -------------------------

356

448

4,628 10,651

4,959 11,601

Source: Highly regarded confidential supply model.

Between 2005 And 2008, A Lot Happened
■ All world’s drilling rigs were finally at work. ■ Prices went up at furious pace. ■ Technology advanced ways to bring out more oil flows. ■ E&P spending soared. ■ But, this did not impact rising decline rates for almost all important key oil fields. ■ And, it did not find any easily producible high quality crude oil.

Supply Growth Coming From Junk Crude (Crud)
■ In 2005, world’s NGL, bitumen, syncrudes and “other supply” totaled 10,651 MMB/D. ■ By 2008, these tough to process non-conventional crudes grew to 11,598 MMB/D. ■ These slivers of junk crude are hard to grow and harder to refine into light finished products. ■ They are easy to turn into asphalt!

The Supply Picture Is Not Pretty (And Explains $147 Oil)
■ There are no bright spots on supply horizon. ■ There are many flashing red lights indicating “all is not well”:
– Civil unrest in key oil producing regions – Fragile aging infrastructure – Accelerating decline rates due to oil field technology

■ Visible oil stocks keep getting “too tight.” ■ These all explain why oil prices rose 15 fold.

What Explains The Crude Oil Price Collapse?
■ Media and pundits say:
– Speculators left the game that created spike – Unraveling economy killed off demand – Gluts are now endemic:
 Tank farms brimming with oil  Super-tankers now floating oil gluts
Crude Oil Price History Jun – Dec 2008
$160 $140 $120 $100 $80 $60 $40 $20 $0

■ But, none of these “facts” can be proven.

7/1/08

8/1/08

9/1/08

10/1/08

11/1/08

12/1/08

Source: Bloomberg

■ Only clear fact: “Crude oil fell 74% in 12 weeks” (September 22nd – December 22nd).

Are We Missing “The Black Swan?”
■ Credit default swap index soared as crude oil plunged. ■ Credit freeze began when oil collapsed.
USD 3,500 Glencoore SR CDS 5 yr (USD) 3,000 WTI (USD/bbl) 60 40

80 2,000 100 1,500 120 1,000 140

■ This had to hurt traders’ ability to own oil contracts.

500

■ If any traders ever had to liquidate contracts, this would cause oil prices to temporarily fall.
0

160

■ Glencore (aka Marc Rich & Co AG) Energy Trading Credit default swaps illustrate the squeeze.

USD/BBL (Inverted Axis)

2,500

Are Current Oil Prices Now “Fair?”
■ NO! They are dangerously low. ■ Middle East producers now facing deficit spending. ■ Key projects have been postponed or cancelled. ■ Drilling rigs are being laid down. ■ New rigs are facing credit problems with shipyards. ■ Industry economics do not work at current prices.

What Do We Need Oil Prices To Be?
■ $100 - $147 oil prices did not increase crude supply. ■ It did not alleviate rig and people shortages. ■ It did not stimulate rebuilding a rapidly aging infrastructure. ■ It also did not cause catastrophic economic damage. ■ It began creating booming prosperity across the oil world.

Is There An Oil Price That Begins To Cut This Gordian Knot?
■ There is no hard data to shed light on this. ■ $150 oil with a permanent floor might help for a while. ■ But, this does not:
– “Find more” oil – Quickly build additional new drilling rigs – Recruit and train oil workforce

When Do Oil Prices Get So High They Really Hurt Economies?
■ Through 2007 - 1st half 2008, many key consuming regions paid retail prices for gasoline at $8 to $11 per gallon. ■ This translates to $378 - $462/bbl for oil and no economic pain was evident. ■ How the wellhead revenue for high oil prices gets reinvested is key to insure high prices help, not hurt, global economies.

Natural Gas Supply In Worse Shape Than Crude Oil
■ Conventional North American gas peaked decades ago:
– USA’s conventional dry gas peaked at 63 bcf/day in 1973 – Its output by 2008 shrank to under 30 bcf/day

■ Growing percentage of global gas tainted with sulfur and other toxic gases and metals. ■ Growing amount of gas is “wet gas” coming from gas caps of old oil fields. ■ Most global proven gas reserves have never properly been discovered.

Natural Gas Production Decline Rates Are Amazing
■ Since natural gas is a vapor, it can be produced at extremely high rates, but once it declines, rates can range from 30% - 65% per annum. ■ Tight rock gas can be fractured or acidized to create high flow rates for short periods. ■ Shale gas resource base is abundant, but:
– It is very energy intensive to get out of ground – Its decline rates vary by type of shale – Individual well flows are small

U.S. Natural Gas Prices Fell Further Than Crude Oil
■ By early 2008, gas analysts began predicting a coming glut of shale gas. This created heavy pressure on gas prices. ■ By end of year, natural gas prices were back to $3.50 to $5.00 range (BOE equivalent of $21 - $30 oil). ■ Gas rig count began to plunge. ■ Shale gas needs high prices to be economically viable.

Russian Gas Crisis Almost Froze Europe
■ On January 1, 2009 a bitter Arctic blast froze Russia. ■ Putin had a tough decision as high amount of their gas was committed to Europe (at high prices).

■ Russia did not have enough gas for peak winter in Russia and Europe, let alone Ukraine.

Source: CBCNews.ca – January 9, 2009

■ So, they closed their taps and Europe almost froze. ■ This problem was not political. It was mature Siberian giant gas fields in steep decline.

Russia’s “Big Three” Problems Will Never Get Better
■ Russia’s three top gas fields produce 65% – 70% of its gas. ■ All have peaked. ■ Urengoy is the “Ghawar” of global gas:
– It peaked in the mid-1990s at 305 bcm/year – By 2000, Urengoy’s production was 145 bcm/year – By 2015, production is estimated to fall to 70 bcm/year
410 360 310 260 210 160 Urengoy 110 60 10 1999 2000 2001 2002 2003 2004 2010 2015 2020 Zapolyarnoye Yamburg

■ Yamburg’s decline is close behind. ■ Zapolyarnoye came on stream one year ago and is just starting to decline.

Gas To Liquids (GTL) Is Outrageously Expensive
■ Shell’s Pearl GTL project is world’s most costly new energy project:
– Construction is ≈50% complete – Cost estimates range from $15 - $30 billion – It consumed 100,000 tons of piping steel, 100,000 tons of structural steel and 100,000 tons of steel equipment

■ It will produce 140,000 barrels per day of distillate plus high volume of sulfur and some condensate. ■ Its gas reserves are tough to produce.

Global Refinery Squeeze Is Another Bottleneck
■ Most of world’s key refineries are extremely old and not suited to convert heavy crude into light finished products. ■ Nameplate capacity is misleading as 10% – 15% of refineries need to be shut down at unspecified times. ■ Only a fraction of global refineries are “new.”

■ Average age of USA refinery complex is over 80 years.
■ Refineries wear out (and explode when run at full capacity).

High Prices Do Not Address Oil Industry’s Twin Cancers
■ Two “issues” threaten oil industry’s sustainability. ■ Both took decades to develop into twin cancers. ■ Neither has any clear, quick resolution. ■ Both could take decades to redress. The “Issues”
■ People Crisis ■ Rust

Unresolved People Crisis Will Cripple Global Industry

■ High percentage of current employee base of global oil industry will retire in next 5 – 7 years. ■ This crisis touches every aspect of the industry:
– – – – – – Rig hands Geologists Engineers of all disciplines Welders Manufacturing workers Executives across the face of industry

■ How quickly can industry recruit and train millions of employees?

“Rust” Is A More Serious Twin Disease
■ “Rust” is code word for aging oil delivery system. ■ It is all built of steel, which begins to rust on day one. ■ “Rust never sleeps” is timeless maritime phrase. ■ High percentage of “delivery system” from well bores, gathering system, tank farms, pipelines, tankers, refineries, rigs, other oil service assets and service stations tanks, etc., etc. beyond original design life. ■ The Band-aid Era is over. ■ The era to rebuild the entire infrastructure has to begin ASAP.

Conquering Rust Will Be World’s Largest And Most Complex “Project”
■ Replacing even 80% of global delivery system of oil will be more costly and complex than fighting WWII or Marshall Plan. ■ Total cost might exceed $100 trillion. ■ Manpower needs could exceed 500,000 to 1 million engineers, construction workers, etc. ■ Could the world run out of iron ore and steel in getting the task done?

Oil Prices Need To “Snap Back” Fast
■ The longer current prices stay low, the higher the odds rise the industry will destroy itself. ■ Industry leaders/stakeholders need to re-examine how little is known about what sets oil prices, the aging of industry key assets and the reality that oil has peaked. ■ Someone needs to abolish current extreme volatility before it destroys the industry.
Source: Upstream – November 28, 2008

Natural Gas Prices Should Scale At BTU Premium To Oil
■ Natural gas is world’s only source of instant heat. ■ In the winter, heat is a gift of God. ■ In severe cold, lack of heat quickly leads to hypothermia, which kills quickly. ■ Gas is scarce and should command a BTU premium to oil. ■ Post-Katrina, we briefly had close to BTU parity:
– $12.65 natural gas ≈$76 oil

2009 Will Be Year Of Extreme Challenge
■ If industry leadership keeps heads buried in sand, they deserve the blame for anguish this is causing. ■ New Obama Administration needs to get quickly educated on these key issues. ■ Easiest way to crush any economic recovery is to end up with oil shortage and sky-rocketing oil prices. ■ Natural gas might be worse shape than oil. ■ 2009 needs to be “Year of Enlightenment.”

What To Watch For As 2009 Unfolds
■ Watch how fast rigs working slow down. ■ Watch oil stocks getting tight. ■ Watch production starting to decline as drilling stops.

■ Watch OPEC cut too deeply into tight market.
■ Watch the horror of layoffs ending a nascent recruiting era. ■ Watch for sharp rebound in oil and gas prices when supply drops outstrip demand.

Does The Oil Business Have To Be “Boom And Bust?”
■ Is the industry fated to lurch between feast and famine? ■ With cost of new oil and gas projects so high, can anyone survive this volatility? ■ When reality sets in that oil supply really peaked, can this usher in a Brave New World in oil? ■ Or, does this exacerbate vicious volatility? ■ Is this oil industry still sustainable?

Not on its current course.

Can The World Adjust To Having Less Oil To Use?
■ Not on present global blueprint. ■ We are heavily embedded in an oil powered economy. ■ Mobility, agriculture, distribution of food, etc., all depend on plentiful and reliable oil supplies.

■ 90% of world population just starting down path America and Europe began after WWII.
■ We have a brief window to change current path. ■ Otherwise, future could be crazy.
Source: Oil & Gas Middle East , April 2008

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