Supplying the Demand Ahead

At the start of 2011, all indications were that the slowly recovering economy would gradually lead to increased demand for petroleum products, even amid supply concerns, and that oil prices would remain fairly steady through the end of the year.

Three months into 2011 and a few things are still consistent with early projections: demand is still moving steadily higher and while the global refining industry is in a state of overcapacity, demand will all-too-soon move to suck up any extra supply. But then there’s the current state of oil prices, which have moved right past the US$100-mark at press time.

Last year, 2010, was really a year of recovery for the global petroleum industry, moving out of the tumultuous downturn of 2009. Hart Energy’s World Refining and Fuels Service Outlook Through 2030 (WRFS) noted that “there will be near-term overcapacity in the first half of the coming
decade [but] carbon-related policies that support biofuels and conservation will limit demand in the second half of the coming decade.”

The International Energy Agency (IEA) reported in February that world oil supply as of January 2011 was 88.5 million b/d on higher OPEC (Organization of Petroleum Exporting Countries) crude and NGL (natural gas liquids) output. At the same time a year ago, IEA indicated global oil supply had fallen to 85.8 million b/d.

Meanwhile, global oil product demand came in at 87.8 million b/d in 2010, according to the IEA in February, 2.8 million b/d higher than 2009. That figure should continue up to reach 89.3 million b/d in 2011, IEA stated. And the impacts of developing nations, China in particular, is playing a significant role there.

“Globally though, we’re still very much in a recovery phase,” said Rick Chimblo, chairman of EOR Energy Services, Inc. and former chief geophysicist at Saudi Aramco. “My concern on the supply and demand, or more importantly on the economic recovery of the world, not just the United States, is if that price of crude oil goes up too high, it’s really going to slow the recovery, because it’s a cost – it’s an energy cost, it’s needed.”

State of demand
While petroleum product demand in the western world is relatively stagnant, for developing countries, particularly those in Asia, demand is booming. It’s all about growing populations and their escalating need for energy.

Conrad Barnes, manager of Hart Energy’s Pricing Service, said “it’s going to be a demand-driven year, increasing gasoline prices in the U.S. will be something to monitor closely, but middle of the barrel growth is still looking strong. Refiners will have to continue to maximize operations with significant spare refining capacity in the system, especially in the OECD [Organization of Economic Cooperation and Development] countries.”

“Strong global economic growth at the close of 2010 created the second biggest demand spike in the past 30 years,” the largest since 2004, according to Ernst & Young’s (EY) Oil & Gas Quarterly Report released in January. EY also foresees demand increasing through 2011 as the market improves, albeit less dramatically than in 2010.

WRFS reported that between 2009 and 2030, “China is by far the largest factor for the growth of the Asia Pacific … account[ing] for 67% of the growth in the region. The product demand growth in China alone, 10.61 million b/d, will exceed total growth in any other individual region.”

China will be the demand leader for several reasons, including strong expected GDP growth during 2011 as well as the approximately 400,000 b/d of new refining capacity that will be added in 2011, according to Deutsche Bank’s Commodities Outlook, published January 11, 2011.

Dr. Petr Steiner, director of Refining for Hart Energy, noted that India and Brazil will also be driving the demand picture along with China.

“Brazil is currently one of the fastest growing countries and at the same time actually pushing their crude oil production,” he explained. “The Indians and Chinese are buying fields and refining assets in East Africa – in Kenya, Sudan, Chad – and the Chinese are also getting involved in Russia with some different deals. They know they will have demand, and they know that they need crude, which they don't have.”

What’s really going to drive the demand for refined products in the developing world are distillates, Steiner said.

As Chimblo said, after all, “there’s no real demand for oil itself. The demand is for the refined products. And without refineries, the oil itself has no true value.”

So while gasoline demand will head up as demand for passenger cars grows in China and India, which is linked with economic growth, distillates are powering the world’s trucks – which move goods and really move the economy, Steiner explained. “So increased demand in distillate will not be so much dieselization of the passenger car market in Asia as it will be the economic growth,” he said.

According to WRFS, demand in North America, Europe and OECD Asia Pacific countries will be essentially flat, seeing a less than 0.1% annual decline. So nearly all growth in demand will come from developing nations. But globally, WRFS projects demand will escalate to 113.48 million b/d by 2030, a 33% increase from the 85.07 million b/d seen in 2009.

Changes to demand are really going to depend on the current economic situation. While some industry analysts say that the recession is over, it’s not official.

“We’re going to see demand increase slowly over the next I would say 12 to 18 months. I think if the recovery is not hampered by any other catastrophic event or by unduly priced crude oil, $100/bbl plus for a long period of time, I think that scenario of 12 to 18 months will hold true,” Chimblo said. “After that, I think we’re going to start seeing probably certainly by the end of 2012, beginning of 2013, I think we’ll be getting our second wind and demand will get back onto the track that it was in 2006, 2007.”

While current global refining capacity is sufficient to take the world up to about 85 million b/d, perhaps 86 million b/d, very few new refineries are being built to make up for rising demand, Chimblo explained.

“But there has been some change in the way that some major refineries operate so they can handle more and different, more complex oils, and still give the world the resulting refined products that they need,” he said. “But if we start going back to the direction we were heading in global demand back five, six, seven years ago, I’m going to be concerned again about global refining capacity. I think that’s going to be the bottleneck again – we just don’t have enough to meet future predicted demands.”

Status of supply
So the other question is where all this much-needed crude is going to come from. While the vast oil reserves in the Middle East, for example, are still a long ways away from drying up, the need for additional reserves to meet demand is escalating, so getting crude from as many sources as possible is the game today.

The CIA World Factbook indicates that figures as of January 2010 show Saudi Arabia leads with total proven reserves of about 264.6 billion bbl, with Canada in second with about 175.2 billion bbl.
So plenty of crude oil is still out there. Plus, production capacity is also going to grow in Russia, Brazil, the Caspian region, Saudi Arabia and Africa, Steiner pointed out.

“There is currently kind of a waiting game between OPEC and non-OPEC countries,” Steiner said. “Since non-OPEC [oil-producing] countries are not bound by any quotas, they are currently leaders on the market.”

He also said that not many people realize Russia’s role as an oil producing country, pointing out that in 2010, Russia produced on average 1.5 million b/d more crude than Saudi Arabia.

“Russia was at about 10 million b/d, Saudi Arabia was at about 8.3 million b/d,” he said. “So the Russians are, of course, trying to develop their fields. They opened new pipelines early last year in order to get as much East Siberian crude down to China and the Asian market as possible, which puts a lot of pressure on the Middle East because the Siberian crude oil is in some cases slightly better quality than the Middle Eastern crude oil.

“So Middle Eastern crude is sometimes being replaced by crude delivered by ESPO [Eastern Siberia Pacific Ocean] pipeline, and the Russians are counting on it by granting different taxation regimes on exports of that crude in that region.”

Steiner explained the WRFS notes that Russian production is still growing and may reach a plateau by around 2015, at which time the industry will need to see whether production from the oil fields can be kept at current levels or even improved. The size of investments in exploration and production will be the key factor.

Discoveries in South America and Africa are also lending to the supply picture, as Brazil is looking to produce from their discoveries offshore in the sub-salts and just recently, in December 2010, Ghana began producing oil, Steiner said.

“There's a lot of West African crude coming on the market too in the next two years, and then there are question marks like Venezuela, Iran and Iraq. Iran is still selling crude, Japan is buying crude from Iran, India is buying crude from Iran, China is buying crude from Iran – there's a lot of business there,” Steiner added. “And regarding Iraq – can they ramp it up and be one of the major players? Probably. Iraq, even as an OPEC member, is currently not under OPEC quotas, so now again it's a waiting game as to when OPEC will step in and require Iraq to adhere to quotas.”

The average quality of conventional crudes around the world in terms of sulfur content and API really isn’t going to change too much, Steiner explained. He continued, “but we will have much more of the streams of the light condensates, LPG [liquefied petroleum gas] and NGLs. At the same time, on the other end we’ll have the heavy crude coming in from Venezuela, Brazil and Canada. What we are seeing is the arrival of so-called ‘dumbbell crude,’ where we have light ends, heavy ends, but missing the middle part, from which the distillates are produced; Which might be a problem, since distillates will be the main demand driver.”

In recent years, unconventional crudes such as those coming from the Canadian oil sands or the shales across the United States have been right in the middle of the supply discussion. Both are new sources of crude, though crude from the Canadian oil sands is far more difficult to process than conventional sweet crudes, while the lighter shale crudes can go right into today’s refineries. Both are an answer to both rising prices and product demand.

“Horizontal directional drilling and hydraulic fracturing technologies, first applied to produce natural gas and now adapted to oil, are revolutionizing the U.S. supply outlook,” said Greg Haas, editor of Hart Energy’s Refinery Tracker. “New supplies of light sweet unconventional oil from the onshore Bakken, Eagle Ford and Niobrara shale formations rose from almost nothing five years ago to around 500,000 b/d in 2010. U.S. refineries are already equipped and refining this new light sweet unconventional oil. This technology and supply revolution may soon go global as well.”

In fact, heavier “unconventional oil production from Canadian and Venezuelan sources is expected to more than double between 2009 and 2030,” WRFS stated.

“When oil started clearing $40/bbl, $45/bbl, unconventional oil sources became viable. And yes, we will continue to produce them and there’s tremendous reserves right here in the United States,” Chimblo said.

These new supplies of oil will do several things to the petroleum industry. For one, it could move the center of oil resources back to the Western Hemisphere, “because between North and South America alone, most of this unconventional oil far exceeds any of the reserves, for example, in the Middle East,” Chimblo said.

But there is still that question of whether refineries are going to be able to handle the heavy crudes.
“Now you’re compounding the refining problem because if you had all wonderful oil, light sweet crude, low sulfur, refineries would just blow and go, and they’ll just refine all the refined products that we could possibly need globally,” Chimblo explained.

Heavier crudes bring challenges to refiners, as they’re more paraffinic, have higher sulfur and other minerals that need to be removed, Chimblo said.

But one of the ‘benefits’ of refineries not running at full capacity in recent years, leading to today’s overcapacity, is the fact that refiners are taking the time to do much-needed maintenance work – which includes upgrades.

They’re not necessarily to increase capacity either, Chimblo pointed out, and are instead focused on upgrading existing units to more modern ones so that these existing refineries will be able to process crudes more efficiently and also so they can take in a whole range of crudes.

“The consolidation the last 2-1/2 years helped significantly,” Steiner said. “We lost more than half a million barrels per day in Europe, there was a significant drop in capacities in North America and Japan also dropped nearly half a million b/d. And many more rationalizations are still planned to happen in OECD countries. So in those regions, there was overcapacity, demand went down, but at the same time there was construction in India and in China, and even in Europe and the U.S. there was some expansion.”

Total operable refining capacity in the U.S. is 17.59 million b/d, 645,000 of which remains idle, making for a total utilization rate of 88.4%, according to Energy Information Administration (EIA). WRFS pointed out that before the economic downturn in 2009, refining capacity in the U.S. typically ran above 90% – so things still aren’t quite back to where they were.

The American Petroleum Institute indicated in February that U.S. crude oil production in January 2011 was 5.243 million b/d, compared to 5.446 million b/d in January 2010, and that U.S. production of NGLs in January 2011 was 2.05 million b/d compared to 1.91 million b/d a year earlier.

Meanwhile, non-OPEC countries will be adding about 1.5 million b/d of crude production as of 2010 and an additional 4.7 million b/d between 2010 and 2015, according to WRFS.

“The additions will exceed requirements, resulting in a decline in OPEC production. OPEC production in 2015 is projected to be below levels of 2009. Between 2015 and 2030 OPEC production requirements will again increase and production will increase by 10.14 million b/d,” the report stated.

Additional data from IEA show that non-OPEC world oil supply estimates for 2010 “remain at 52.8 [million] b/d, while the 2011 outlook is nudged up 0.1 [million] b/d to 53.5 [million] b/d on higher North American output.” Meantime, OPEC crude supply was at “two-year highs in January at 29.85 [million] b/d … [and] OPEC effective spare capacity stands at 4.7 [million] b/d.”

Fickle prices
On top of the current state of supply and demand around the world, crude oil price volatility is even more evident now than ever.

The effects of geopolitical tensions on crude prices kicked off 2011, as rioting – at times violent – in Egypt against then-President Hosni Mubarak’s regime began on January 25. The unrest continued until Mubarak finally stepped down February 11, pressuring oil prices up into the high $80s to low $90s amid questions about potential supply disruptions resulting from the protests because of Egypt’s critical location near other oil producing countries.

Shortly after tensions in Egypt finally came to a close, protests against Libyan leader Muammar el-Qaddafi began February 15, causing the markets to respond with even more fear of supply disruptions, as Libya currently produces about 1.6 million b/d, according to WRFS.

As a result of that initial turmoil in Libya, WTI set record highs in late February, with final full week of the month ending with WTI at $97.88/bbl, $11.68 higher than the week before – the largest weekly gain for WTI in more than two years.

To add to matters, tensions are also brewing in the Middle East, and as a result of that added conflict, oil prices finally shot up to break $100 March 2, closing at $102.23/bbl and marking a new 30-month high.

In late February, Saudi Arabia moved to utilize some of its approximately 4 million b/d of spare capacity to make up for supply shortfalls in light of the violence in Libya. The IEA on March 2 noted that “between 850[,000] b/d to 1 [million] b/d out of a total of 1.6 [million] b/d of Libyan oil production is currently shut-in.” So the Saudis are now “producing 9 million b/d, an increase of between 500,000 and 600,000 b/d, Saudi oil officials said,” according to the Wall Street Journal in a related report February 28.

If the unrest continues or spreads even more, “that would change everything in ways that cannot be anticipated,” said Dr. Philip K. Verleger, energy commodity market economist and David E. Mitchell/EnCana Professor of Management at the University of Calgary's Haskayne School of Business. “It could lead to a serious economic slowdown, which would put downward pressure on crude prices, it could lead to disruption of supplies which would put upward pressure on prices. This is just one of those big uncertainties.”

But as Chimblo pointed out in March, “this is a temporary thing … I don’t think what happens in Libya is going to be long term. The price of oil is going to cap itself out, especially once we resolve the situation in Libya.

“I think the reality of it all is that if we stay calm and the people making decisions within the oil companies for their one-year operating plans and five-year business plans and don’t have a major reaction, I think everything is going to be okay.”

Barnes explained that according to Hart Energy’s Pricing Service forecasts, crude prices will average about $84/bbl in 2011. “Obviously, the situation in the Middle East and North Africa has caused prices to shoot up, with Libya’s 1.6 million b/d of production at risk, and fear that turmoil will spread to other major producing countries like Iran or Saudi Arabia. We think there is anywhere between a $5-$15 premium baked into the market stemming from unrest in the region, but there is still a decent amount of oil out there in the form of both OECD inventories and OPEC spare capacity,” he said.
Deutsche Bank, on the other hand, expects crude to average above $95/bbl in 2011, moving up to $98/bbl in 2012.

So will crude ever go as high as say, $200/bbl? Opinions on that are mixed.

“Some countries are saying that $120 is okay too, that there's no need for OPEC additions if the crude oil reaches $120 because the dollar is weak and demand is there,” Steiner said. “We will have expensive crude, but we will not have $200 crude because in that case the price of the end fuels would be too expensive, demand would drop, alternatives will be much cheaper and it's just unsustainable to have high oil prices at that level. So that comes back to the notion of $5/gal gas – that corresponds approximately to $200/bbl, and that's not going to happen.”

Verleger also commented that “if we saw $5/gal gas, we'd see 14% unemployment, unless we have a lot of inflation. We're more likely to see $1/gal gas than $5/gal gas.”

Even so, Chimblo points out that $200/bbl crude “is not unimaginable,” particularly if speculation really takes hold in the marketplace once again, as it did in 2008 when crude soared up to nearly $150/bbl.

Moving forward

Total world oil supply is projected to reach 93.52 million b/d by 2030, up from 73.79 million b/d in 2010, WRFS noted. And with demand for petroleum products going from 86.42 million b/d in 2010 to 113.48 million b/d in 2030, under current conditions there is just not going to be enough supply to meet demand in the coming years. It’s going to take around 20 million b/d of additional supply to meet growing global demand by 2030.

But there is some hope if refiners can somehow expand and keep pumping out more products. WRFS pointed out that “anticipated refinery expansion projects will add 11.04 million barrels of crude distillation capacity by 2015, a 12% increase over end-of-year 2009 global capacity.” The report also indicates that the total increase in world refining capacity taking into account all planned expansion projects will be enough to meet demand by 2020 or so, but after that even more will be needed.

Chimblo said that with demand heading where it is, “if the refining capacity and the changes in the refining capabilities to handle, for example, [heavy] unconventional oil, if those come into play, and the end consumer is happy with the amount of gasoline and jet fuel and diesel and the price that they have to pay for it, then everything will stay on that trend of growth and recovery that we were looking at a few years back.

“But if we don’t meet the refining capacity that we’ll need to handle the 86-90+ million b/d, and therefore not give the consumer what they really want, which is refined products, then I think Wall Street will take over, the perception will be there’s a shortage and the commodity that they trade is crude oil, and therefore the price of crude oil will go up,” he explained. “Part of that might be a good thing in that it will make us conserve more, which we need to do because there’s only a limited amount of crude oil in the world – 1.3 trillion barrels is the last estimate roughly – and we’re not replacing it as fast as we consume it, nature’s not going to replace it, not in 100 million years.”
The reality is that petroleum products will still be by far the largest component of the fuel supply, even with the onset of biofuels and other alternatives. WRFS pointed out that “the contribution of crude oil to total supply will decline from 86% in 2009 to 82% in 2030.”

Chimblo went on to say that unconventional oil is absolutely going to be playing a major role in the supply picture, as it’s “an opportunity, for example, for the United States to become less dependent on imports. I think in order to do that, though, we have to change and be willing not only to modify existing refineries, we need to build some new ones closer to those sources. And that’s going to be a whole other EPA [Environmental Protection Agency] battle, so we’ll see what will happen there.”

“If oil prices stay high, things will change,” Verleger said. “The rate of change really is associated with the price of the nearest competition. Oil forced coal out. Right now natural gas is selling at 20% to 25% the price of oil. If it continues, oil is going to find it very hard to compete in the United States.

“When you see price differences of that sort that persist for very long, you start seeing big changes,” he said.

What lies ahead on the price side will be very much dependent on the current geopolitical environment and the state of the global economy.

“I think five years out it could be a potentially very different world in terms of how we are able to continue to grow out of the recession, what we see in terms of economic growth from the developed economies versus the emerging markets, and how those balance with one another,” Barnes said. “We are in a new price environment.”

He pointed out that 2010 was the second-highest average year for WTI, “only behind 2008 when obviously we had some significant amount of time well above $100 a barrel.”

Furthermore, “supplies are more difficult to get out of the ground, whether it's in deep water in the Gulf of Mexico or even offshore Brazil, or whether it's heavy oil sands in Canada,” Barnes said. “Those are expensive oils to get out of the ground, so even though we're above $90/bbl, we're going to need to stay at high prices to get ample supply out of the ground, otherwise you could potentially see another price shock.”

For right now, heading into the next two or three years, Chimblo foresees economic recovery globally, which includes the oil and gas industry.

Barnes added, “you'll see prices maybe come back a little bit, but in the longer term we’ll continue to see prices gradually rise. In terms of where we see prices five, 10 years from now, I believe our numbers indicate right now that we will be above $100/bbl nominal crude.”

And “if there’s not new methodology or new physical capacity [in the refining industry], what’s going to happen is between the pull from China and our own consumption on this side of the world, between Europe and the United States, that the price of the refined products, because it’ll be in short supply, because we won’t have the ability to refine the oil, that the price of the refined products is going to go up and transportation costs are going to go [even further] up,” Chimblo explained.

Running out?

So will the world run out of crude and completely overturn the supply/demand dynamic? That’s still up for debate.

“I don't believe that we will ever run out of oil because it's economically impossible. I have a hard time believing that anyone would pay something like $1,000/bbl to extract the crude,” Steiner explained. “Nobody will be producing it at that price, because nobody will be buying it for that price. So in the moment when crude oil reaches some high, let's say $150, for the sake of the argument let's say even $200 – there will be many other options to deal with it. Alternative fuels will become economically viable, there will be a drop in demand and what not to basically make the price of crude decline or to just kill the demand for oil and move to alternatives where possible.

“Oil will remain important until we really have those alternatives. If anyone is thinking that in 20 or even 30 years we will not need oil, that's simply not possible. We don't have the technology. But at the same time, the demand peak oil will precede supply peak oil in my opinion. We will not run out of oil, we will run out of demand for oil before we run out of supply of oil.”

One factor that needs to be accounted for though, Chimblo said, is replacement and recovery. The more oil drawn out of the ground, the less oil that’s in the ground, thus the less that’s available for future extraction.
“In some places there’s no replacement, there’s only depletion. It always comes down to the same thing – we’re depleting [oil reserves] every year. Now, that being said, what we never really talk about when we say that to the media is there’s another very complicated thing and that’s recovery factor,” Chimblo said. “Typically out of a very good reservoir, very nice porous permeable rock that’s willing to give up the oil easily, you might get a 40% recovery factor – what that means is 60% is still in the ground. So even when we’re all done, if there’s a way to go back in and recover another 5%, another 10% economically, we can extend the life of the era of oil.”

He added that if the recovery factor can be increased, the era of oil could be extended “beyond 90 years. But under existing conditions, we’re probably 50 or 60 years out,” Chimblo said.

One thing is for sure, crude is a limited resource in the sense that there will come a point, however distant in the future, that crude won’t be the main source of energy. But while crude is still the main energy resource, alternatives must be developed to help with meeting demand because it’s set to become so vast.

“If we don’t have alternate energy resources for everything from stationary energy needs – power your house, power a factory, power your computers, power the grid, whatever – to our transportation type needs for energy, not just our cars, but our airplanes and everything else, then the price of oil is just going to skyrocket,” Chimblo said. “And it could be catastrophic.”

Louise Poirier can be reached at lpoirier@hartenergy.com or +1 (713) 260-6419.