There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don't know. But there are also unknown unknowns. These are things we do not know we don't know.
Former US Defense Secretary Donald Rumsfeld on 12 February 2002.
My recent article Do Not Believe Long Term Oil Forecasts caused some good discussion over at Seeking Alpha.
My prior article drew attention to a Wall Street Journal article that commented on the long term oil demand growth with price implications. In my article, I commented that it is difficult projecting West Texas Intermediate supply and demand as well as oil prices beyond five years. I discussed why these variables are hard to predict without referencing much numerical data by requesting that readers begin thinking of different scenarios. I wanted readers to think about possibilities rather than be anchored to numerical data. I also provided reference to Professor Bartlett's lecture that is recorded on YouTube. If Professor Bartlett's lecture is good enough for Jeremy Grantham, well known institutional investor and co-founder of GMO LLC, then it's good enough for me.
After investors thought of different scenarios, I further asked readers that, as investors, how might their views change toward various national oil companies such as: Gazprom OAO (OGZPY.PK), Petróleos de Venezuela, S.A., Petróleo Brasileiro S.A. - Petrobras (PBR); and oil sands companies such as: Suncor Energy, Inc. (SU) and Canadian Oil Sands Trust (COS-UN.TO); and large multinationals such as ConocoPhillips Company (COP), Chevron Corporation (CVX), and Exxon Mobil Corporation (XOM).
Please click through on the above charts to see larger versions..
As we can see from the historical WTI Prices chart, WTI began breaking free from its historical price range of $20-$30 per barrel near the year 2000. What about the future? Well, we can look at the CME Group's Light Sweet Crude Oil (WTI) Future's prices. And using the futures prices as a guide, I don't expect a return to a sustained price range of $20-$30 anytime soon.
Do professional consultants or forecasters have a different view? While I don't know all forecasts, I looked at oil price forecasts from GLJ Petroleum Consultants, a prominent and well respected oil and gas consulting company located in Calgary, Alberta. If you are interested, you can register at Sproule Associate Limited, another prominent and well respected oil and gas consulting company located in Calgary, to receive its forecasts. GLJ's forecast, dated 30 September 2009, has WTI nominal (as opposed to real) prices at $74.00 per barrel in 2010 and rising to $101.59 in 2018 and rising by $2% per year thereafter.
The challenge for creating long term supply, demand and price forecasts is that nobody knows the future. Setting aside the two Calgary consulting companies, if a consultant or forecaster provides you with a long term forecast, ask the following questions or requests:
- Is your price forecast substantially different from the WTI futures? Often the forecast is materially different. Ask the consultant to explain why. They will often tell you that the futures curves are a) wrong, b) change with time, and c) are heavily influenced by Wall Street types who are not using fundamental analysis to arrive their futures prices.
- If the consultant has strong conviction that its price forecast is correct and that the futures curves are wrong, then is it putting its money at risk? This is a rhetorical question meant to emphasize that few have strong conviction. In reality, this is an unfair question because the consultant would lose its credibility if it were playing the markets while providing price advice. It might, however, make the consultant worker harder when it has some skin in the game.
- Has the consultant's price forecast changed or is it expected to change? The answer is yes.
- Request to see the last two years worth of price forecasts. Note that the forecasts do change, often materially so.
- Request to see its price forecast from the year 2000. Did it even allow for the possibility that oil prices would be sustained at or above $70 per barrel by 2010? Most likely not.
- Ask the consultant to provide its methodology to arrive at its price forecast. This is just a general interest question. The reality is, it doesn't matter.
As we have seen from historical prices, futures curves, and one oil and gas consultant forecast, the prior range of $20-$30 per barrel for WTI does not look imminent. If prices are known fluctuate wildly, which would then change the future curves and consultants' forecasts, then why am I confident that prices won't return its prior range?
Last year, many oil companies had internal long term price forecasts of $70-$75 per barrel in real terms. Some might have been lower and others higher. And last year, I read that new greenfield oil sands develop projects required $70-$110 per barrel to achieve an economic return. While construction and operating costs have been reduced over the past year, they haven't been reduced much. Yet, many oil sands development projects by large and sophisticated companies are moving forward. Furthermore, look at the rate of returns most oil companies are enjoying at today's prices (they are not extreme), and then ask yourself what their returns would look like at sustained prices near $25 per barrel. Hint: it wouldn't be pretty.
It's interesting to watch the dynamics of senior executives of oil sands companies. As they plan and prepare for a new project, they all acknowledge that oil prices are volatile and that between now and the end of the project, there are likely going to be several stomach churning price drops. At this point, they are undaunted. Yet, when the prices drop, these same executives begin to reassess if they can scale back, postpone, or phase in projects over time. It's amazing how much influence short term prices have toward a long term outlook.
If you ran an oil company and believed that $20 per barrel prices were imminent and didn't want to play the futures market, then you would likely stop investing in new projects and wind down or sell existing production, fire all but essential staff, and just bide your time. When oil prices hit $20 per barrel, there will be many distressed assets available at fire sale prices. Moreover, many oil and gas companies will be shutting down, throwing their talented workers on the street. At that point, you could relaunch the company with better (lower costs) and greater (more production and reserves) assets than you had previously. I am unaware of any company embarking on this strategy.
As you do your own research and analysis, remember that the treadmill gets steeper as world production increases. What do I mean by that? Most oil fields (oil sands being an exception) experience a natural decline rate. For argument sake, let's assume that at some time in the future we have the following conditions: a) annual oil production at 100 million barrels per day; b) annual supply and demand growth rate of 1%; and c) a natural decline rate of 7% annually. Then, just to maintain production for the following year, an additional 7 million barrels per day of production must be found. And, another million barrels per day must be added as part of the supply growth. As annual production increases with the same decline rate, more reserves and production must be found.
I am neither in the bearish camp that says the sky is falling nor in the bullish camp that says we have plenty of oil at affordable prices. I believe we do have challenges in front of us. Furthermore, I believe we will have significant changes. It's best to keep an open mind and watch for signs that indicate abrupt changes are about to take place.
One last closing comment: I am glad that I do not provide long term oil and gas price forecasts—there are too many known unknowns and too many unknown unknowns.
Disclosure: I am long shares in Canadian Oil Sands Trust, Suncor Energy, and Exxon Mobil as well as long and short puts in Exxon Mobil.
On Sunday, 18 July 2009, I photographed Fish Creek in Fish Creek Provincial Park, which is located within Calgary. And, if you click on my Flickr profile link, you will be taken to Flickr where you can see more of my pictures.
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