oftwominds-Charles Hugh Smith

Oil Down $16 to $130, Everything Wonderful Again: Not

I hate to pop the balloon about how everything's wonderful again now that oil has collapsed from $146 to a mere $130/barrel--no, scratch that. I delight in popping that nonsensical bubble.

Before we allow euphoria to lift us to a heady height so great we're ready to believe Lehman and Merrill and all the other "players" are suddenly whole again, let's look at a chart.

As a proxy for the oil sector, let's use the XLE:

Here we see a number of interesting points:
1. XLE just touched key support.
2. Every time XLE pierces its 200-day moving average and the Bollinger Band on the downside, a sharp rally to a new high has followed.
3. The downside breaks are very sharp and very short. The XLE can drop 20+% in a few weeks, and then bounce back within 6 weeks as it extends to a new high.
4. The MACD is at an extreme--even lower than when the XLE touched a "death of the Oil Bull" low in January 2008.
5. The uptrend is still intact.

Based on this chart, I would expect a rally from 75 to 85 in short order. Let's just say the chart makes me skeptical of calls for the end of the Bull market in petroleum.

The "recession-Lite" scenario that's getting a lot of airplay nowadays is based on the idea that demand for petroleum will plummet in a recession, leading to a collapse in oil prices.

I highlighted the fatal flaw in this fantasy in Saturday Quiz: Demand Destruction of Gasoline in the U.S. (July 12, 2008): reducing demand for gasoline 3-5% in the U.S. is supposed to deliver a crushing knockout blow to oil prices, but that works out to a meager 300-500,000 barrels a day in a world that produces 85 million barrels a day.

Meanwhile, what nobody mentions when recounting this rosy scenario is that oil exports to the U.S. from Mexico are falling at 30% per year--and the U.S. gets 20% of its imported oil from Mexico and Venezuela.

Frequent contributor U. Doran sent in this link from the Association for the Study of Peak Oil & Gas-USA: Peak Oil Is A Done Deal .

Bottom line: Saudi Arabia and Russia, which together pump about 23% of the world's oil, are both in depletion decline. So are Mexico, the North Sea, etc.

Simply put: every time the "Oil Bull" is declared dead, as it was in January, it rises with extraordinary alacrity to new heights. The reason is not gol-durned speculators but supply and demand--even as demand inches downward, supply is declining even faster.

Let's put "demand destruction" in the U.S. in its proper context. 300,000 barrels a day is chump-change in a nation which burns 21 million barrels a day. if supply were increasing by leaps and bounds as it was in the 80s, fine, then you could have a huge demand-supply imbalance in favor of supply. But by even the most optimistic estimates, "excess capacity" (all in heavy crude few can refine) is about 1.4 million barrels a day--a razor-thin margin.

I have predicted one last "head-fake" decline in oil prices, but it's going to take serious reduction in demand, on the order of 4-5 million barrels a day globally, to get that drop.

It takes a long time to locate, drill, pump and process new reserves of petroleum. I was fortunate to receive a report from a working petroleum geophysicist, who due to the nature of the business, prefers to remain anonymous. His report is a real eye-opener. Read on:

I am an exploration geophysicist working for a large oil company. The quiet consensus in the industry is that yes, we are at peak oil. (emphasis added, CHS) Such an idea was not even discussed even a year ago, but now it is a silent consensus.

I also agree with your assessment that a serious downturn can cause the oil prices to go down temporarily for the last time. Worrying thing is that it is a "perfect storm" coinciding with a large economic downturn and with the long-term trends of an aging population and of global warming. Weakened immune systems from aging, stress and poorer nutrition and the disturbed ecosystems may also cause some super-virus to spread.

However, it is crucial to make the transition to the new world (petroleum-less, older, changed climate) as slow as possible so that we can adapt. Otherwise it's finally the day the guys at survivalblog.com have been yearning for :-) I will do my best to prepare myself and my newly-started family, but ultimately it comes down to chance. Was it you who posted the story about Aaron Schwartz, the smartest man in the 20th century, who foresaw Hitler's rise and moved with his family to a quiet Pacific island called... Guadalcanal?

It's possible to have a long career in petroleum as everyone either goes back to old wells to extract a bit more or drills a lot of dry holes looking for the elusive super-giant field which will save us all :-)

The strong job market for geophysicists has more to do with the fact that the oil industry downsized massively between 1983 and 2003 than with peak oil. Why? Assume you own an oilfield or hold a long-term lease on one. If you believe that the current price is just a cyclical high, then you will do all you can to explore the land to find oil, or to do extra surveys to find bypassed pockets in the reservoir, and get the oil to market before the price falls.

However, if you expect the price to keep rising, and rising, why would you work so hard today to find new oil / get some more now, when if you do the same amount of work a couple of years down the road, you will sell it for much more? And maybe more capacity will come on the market for drilling rigs and oilfield services, so you would not pay those outrageous prices to your service providers either. Companies do have to replace reserves (they usually have about 6-8 yrs of reserves in their portofolio), but they don't do much more.

BTW re: the dramatic capacity cuts, they were indeed amazing. In 1983 there were 730 land crews doing land seismic surveys in North America, and in 2003 there were only 37. These statistics were published by The Leading Edge (TLE), the monthly magazine of the 25,000-members Society for Exploration Geophysicists (seg.org). That's 20 x reduction in capacity, for God's sake!! How does one expect to find more of something with 20x less people?? Technology did not make much of a difference, as for land seismic the crews still have to go and plant geophones by hand.

Companies were downsizing entire departments. As late as 2004 you could read in "career advice" articles in TLE leading geophysicists saying that they are not advising their children to go into this field, that they should only do it if they really love it and they should expect to be out of a job half the time... Walter Lynn, SEG president 2001-02, was downsized from his company (PGS) the day after his president mandate was over (it's visible in his CV at http://www.lynn-inc.com/).

I spent the 2000-05 period working towards a PhD at a top U.S. university, and we were in contact with many companies. 2003 was the bottom; out of about 15 graduate students, only 2 or 3 got internships although most tried. That was in a leading research group in the field. Unemployment in geosciences as measured by the Houston Geological Society was above 10%. In 2004 an American colleague of mine graduated after working for 7 years for a PhD and he only got a menial job warranting a BSc with a company in Houston. You see, supply and demand.

In 2005 things turned around and I quit my PhD as soon as I got a job offer in hand, because I believed that by the time I would graduate (the last of my cohort "got out" 1 month ago) oil prices would be again at a low. In the early 2000s US produced only about 100 (yes, one hundred) graduates with decent BSc degrees in geophysics. China produced easily 20x more, and well prepared too, not some junk diplomas. In 2004 85% of the graduate students in the Petroleum Engineering department at Stanford were foreign. Now oil prices are high everywhere and they start to have good employment in their home countries as well...

My former research group is down to half the number of students... Things are not always what they seem, and the level of activity in the oil industry now is still FAR from a emergency-level, all-out effort, WWII kind of thing. The industry is still recovering from 20 years of capacity cuts!

In other words: additional capacity might well come online, but it will take an entire new generation of geophysicists/geologists and an effort which dwarfs current exploration levels.
Oil insiders also note that there are no spare rigs or drilling platforms lying about; every rig is already in use. So we have to construct, at enormous expense, an entire new generation of equipment.

Let's say this takes 10 - 15 years, which is what knowledgeable sources like Matt Simmons guesstimate. That means we can look for new oil flowing in about 2021.
All that new production will do, of course, is replace some of what's been lost to depletion in the next 13 years.



Maybe I'm wrong and oil is heading to $100/brl or less. If so, it's the final head-fake before Peak Oil strikes with a vengence:



Note: I will be away from my desk through next Tuesday, July 22.