The Right Price

T?he record-high oil prices of 2008 and rapid decline in tandem with the global financial crisis underscore the volatility inherent in pricing the world’s supply of oil. These extreme fluctuations also point to the importance of securing and marketing this supply at prices that are affordable to world economies yet strong enough to continue to attract the massive investments required to develop increasingly more expensive new resources.

The entrance of millions of new consumers into the global markets, particularly in developing countries such as China and India, is generating demand that may lead to depletion of existing, low-cost resources in a few decades. Meanwhile, consumption of hydrocarbon resources is increasingly believed to be affecting the global environment adversely.

It has become clear that security of energy supply and environmental preservation are interrelated issues, representing two of the most critical factors in sustainable economic development and the improvement of quality-of-life standards across the planet.

It is unlikely that a technological breakthrough capable of promoting a large-scale substitution for fossil fuels will occur in the short term. All projections indicate that oil, natural gas and coal will continue to be the main sources of energy in the next two to three decades, with oil remaining the predominant fuel source.

According to the Energy Information Administration (EIA), daily oil demand will grow to around 120 million barrels by 2030, representing 41% growth in current world consumption. Obviously, this will depend on economic growth, gains in energy efficiency and the contributions of renewable sources, particularly biofuels, wind and solar energy.

The EIA’s projections also indicate steady growth in demand for natural gas, particularly in developing countries. However, it seems that the transportation of gas from the main producers to the large consuming centers, traditionally accomplished via long pipelines, will increasingly be conducted through LNG (liquefied natural gas) tankers.

?All projections indicate that oil, natural gas and coal will continue to be the main sources of energy in the next several decades.

And, with the proliferation of liquefaction and regasification terminals around the world, it is likely that increasingly larger amounts of gas will be traded on the spot market. This will radically alter the long-term relationships between producers and consumers and will likely affect the gas markets, with a potential impact on the price of gas. It is reasonable to expect that, as gas becomes a quasi-commodity like oil, its price, currently a little more than 50% of that of oil in terms of energy content, will approach the price of other liquid fuels. A recent diversion of an LNG cargo from Texas to Asia, where gas was fetching higher prices, illustrates this trend.

?In light of forecasts for energy demand—particularly oil—the key factors world economies face are the existence and availability of enough reserves, and the development and delivery of those reserves at a pace commensurate with the demand growth.

?There seems to be a consensus among specialists that there are enough oil and gas resources to meet the projected demand for many decades, particularly when the potential for discoveries in new frontiers and non-conventional resources are taken into consideration. The combination of new technologies and higher prices is expected to render profitable the massive investments needed to develop non-conventional resources, such as coalbed methane, gas shales, oil sands, oil shale and the ultra-deepwater oil and gas reserves being discovered around the world. Additionally, advanced enhanced oil-recovery techniques may substantially increase the resource base from existing oil fields at competitive costs and in a fairly short term.

?Current proven oil reserves amount to around 1.3 trillion barrels; another trillion barrels of conventional oil remains to be discovered.
Bottom, natural gas demand will enjoy steady growth, particularly in developing countries.

?According to the estimates of various research entities, approximately 1 trillion barrels of oil have been already consumed; current proven oil reserves amount to around 1.3 trillion barrels; another trillion barrels of conventional oil remains to be discovered; and, if oil prices exceed certain minimum thresholds, 1 trillion barrels of non-conventional resources may become available to the market in the short- and medium term.

?The recent pre-salt discoveries offshore Brazil, massive oil resources from Canada and Venezuela, and the existence of vast prospective provinces that remain unexplored due to their location in environmentally sensitive, remote or politically unstable regions lend credibility to these estimates.

?The existence of sufficient gas volumes is also well established. The main issue with the gas supply-and-demand balance relates not so much to the availability of reserves, but rather to the resources’ geographic remoteness from the main consuming markets. It is for this reason that huge gas accumulations, like the Camisea in the Peruvian Amazon region, Alaska’s Prudhoe Bay and the resource in the Canadian Mackenzie Delta, have barely begun to be developed. Actually, one of the main opportunities for the energy industry resides exactly in the monetization of large, stranded gas accumulations, both associated and non-associated with oil.

?If proved oil and gas reserves appear plentiful, the pace at which these resources will be developed and brought onstream remains uncertain. Even though the current world’s reserves-to-production ratio is about 42 years for oil and 62 years for gas, the existing production capacity barely exceeds the current demand. In the case of oil, for instance, OPEC members’ idle production capacity, which hovered around 7 million barrels daily in 2002, has been reduced to only 1- to 2 million in the past few years.

?Conventional sources are expected to lead energy use for the next several decades worldwide.

?This low level of spare production capacity can easily be exceeded by production disruptions caused by natural or manmade disasters, political instability or terrorist attacks. For instance, when Hurricane Katrina struck the Gulf of Mexico, almost 1.5 million barrels of daily oil production were shut down overnight, and full restoration of output took almost six months.?

??Massive amounts of investment will be required to meet the projected growth in demand for oil and gas and to offset the production decline of existing fields. This will be achieved through a variety of new developments, including the development of existing fields and future discoveries in ultra-deep waters, enhanced-recovery projects and exploitation of non-conventional resources, such as the extra-heavy oil sands, oil and gas shales, and tight-gas reservoirs.

?According to the International Energy Agency, some US$20 trillion will need to be invested in energy through 2030, with US$4 trillion of that on oil and gas. Since the additional units of energy are becoming increasingly more costly to produce, it is inevitable that energy prices will have to stay at a sufficiently high level for this massive amount of capital to be deployed.?

?Even if financial resources are committed at the required level, the industry will face other serious limitations to production growth, including a lack of specialized personnel and shortages of drilling and production equipment and materials. Preliminary estimates indicate that the development of the pre-salt reserves offshore Brazil will cost more than US$600 billion and require hundreds of large offshore facilities and equipment, including drilling rigs, floating production platforms, shuttle tankers and supply boats. The vast majority of these elements are not currently available or may not exist. A consequence of such shortages is the significant cost increase that was observed during the past five years. This factor will make the development of new oil and gas reserves, already expensive because of their location in increasingly harsh and remote environments, even more costly.?

??Another hurdle to development of new resources are the political difficulties that the major oil companies face in gaining access to regions with potentially significant reserves. According to a study prepared by the Baker Institute, approximately 77% of the world’s oil reserves are controlled by state oil companies. Even though many of these are as technically and financially capable as any major international energy corporation, others lack the resources and expertise to operate in more challenging environments, such as ultra-deep water. This problem is made worse by politically driven restrictions imposed by governments on the exploration of vast areas that could help increase production in the relatively short term.

?This situation can be found around the world, including in the sedimentary basins offshore the U.S. East and West coasts, which, while not capable of delivering enough oil to replace all the current imports, would certainly mitigate U.S. dependence on foreign oil.?

?The petroleum industry has demonstrated time and again that there are no technological limits on the exploitation of oil and gas reserves in evermore challenging environments. All the indications are that resources in extremely remote, harsh or environmentally sensitive areas can be developed safely and in a socially acceptable manner. However, the cost of developing and extracting oil and gas from such new provinces will be orders of magnitude above the typical costs of conventional developments.?

??All of these factors lead to the same scenario. There are sufficient oil and gas resources to meet world demand for the next several decades. Stable demand and secure supply, however, can only be balanced at the right price. To be right, the price must be affordable and not hinder sustainable economic development. The price also must be sufficiently high to steadily attract the massive resources required for the exploration and development of new fields.

??The enormous volatility seen in oil prices during the past 12 months, clearly indicating that the market is struggling to strike the right price, has negative consequences for investments in the sector. The oil and gas industry does not benefit from either price extreme. Too high, and there is enormous market destruction; too low, and capital is withheld from the new developments.

?Over the long term, it is reasonable to expect that the markets will establish the right price. The problem is that the same average price can be obtained in an environment of high volatility, which makes life for producers and consumers much harder, or with markets trading at an intermediate price level, with less fluctuation, which is beneficial to all.?

?Before the first oil shock, that right-price average was attained with low volatility and at a price that reflected the existence, until then, of abundant and cheap oil and gas. Looking forward, a new threshold, at a much higher price, will have to be established by the market to rebalance the supply-and-demand equation. In a world in which new oil and gas reserves are going to be much more expensive to find and develop, and demand will continue growing, this new threshold will probably be in the range of $70 to $90 per barrel.?

?Except for very rare and short-lived periods, the petroleum industry has been able to supply the world with a source of energy that has been affordable and dependable for almost 150 years. It is likely that it will continue to do so. The industry is constantly developing new technologies and preparing to explore for and produce oil and gas, in increasingly challenging areas or conditions, in a safe and responsible manner. Oil for global sustainable development will be expensive, but there will be no shortage.?

?Renato Bertani is president of Thompson & Knight Global Energy Services, a subsidiary of Thompson & Knight LLP, which provides specialized services to the energy industry. He is the former president of Petrobras America Inc.