What Mr. Crude Oil Sees Ahead: High prices until demand is destroyed, but no peak!

Goldman Sachs analyst Arjun Murti predicted the recent spike in oil prices, so it’s worth looking at his recent interview in Barron’s (subs. req’d):

IN 2004, ARJUN N. MURTI, A TOP ENERGY ANALYST AT GOLDMAN SACHS, published a report predicting “a potentially large upward spike in crude oil, natural gas and refining margins at some point this decade.” It was a controversial call, with crude around $40 a barrel at the time. But it was right on the money.

Four years later, crude is trading around 139.

Murti sees energy in the later stages of a “super spike,” in which prices rise to a point where demand drops off. In a note last month, he wrote that “the possibility of $150-to-$200-per-barrel oil seems increasingly likely over the next six to 24 months”….

Barron’s: What do you make of Friday’s big surge in oil prices?

Murti: There have been a number of bullish fundamental data points recently that contributed to the rally. These include further declines in U.S oil inventories announced June 4, the announcement of a decline in Russian oil production in May, and recent comments that Mexico expects further meaningful declines in oil production over the rest of this year.

Longer-term, what’s driving crude to such high levels?
Spare capacity throughout the energy complex seems very limited, whether for OPEC crude oil, natural gas or refining. In all of those areas, capacity is limited. And it’s getting very difficult for companies and countries to boost supply — something that became increasingly apparent to us over the first half of this decade.

Our view started shifting, from one of “It is easy to grow supply,” which was the perceived view of the 1990s, to “It is going to be more difficult to grow supply.” That’s partly because some oil-producing regions, like Mexico and the North Sea, are declining. The Lower 48 states in the U.S. are very mature.

There are growth areas, such as Brazil and Angola. But when we add up all those pluses and minuses, non-OPEC supply looks like it is not going to grow very much.

So, essentially, there is constrained supply, along with increasing demand?
Demand has been consistently growing. On the supply side, we don’t subscribe to the peak-oil view. We don’t think the world has run out of oil.

We do think that the places that have large quantities of recoverable oil, notably Saudi Arabia, Iraq, Iran, Venezuela and Russia, aren’t on track to grow their supply aggressively. It is growing at a very moderate rate, and so the remaining oil resources are concentrated. And, to some degree, high prices are disincentivizing some of these countries to either open up their industry or spend the money themselves.

What actually is keeping them from producing more?
These countries don’t need the incremental revenue. They’re getting the revenue through price; they don’t need it through volume. It means they have sufficient capital to try and develop their oil industry on their own. With high prices, they don’t need Western capital. Venezuela, where Western companies’ assets have been expropriated, is a good example.

You’ve made the distinction in your research that while the world’s oil supply is barely growing, if at all, there is a lot of oil that’s not being taken out of the ground. Take Russia, for example. Why aren’t they producing more oil?

In a lot of the key oil-exporting countries, the government is the key driver of whether their oil fields get developed. Relative to 10 years ago, Russia is in a very healthy position.

So, logically, there is less incentive for Russia to massively grow their supply and bring down oil prices. Frankly, that’s true for a lot of these countries.

In terms of your super-spike scenario, what phase are we in?
We are getting closer to the end game here, where despite eight years of rising energy prices, supply looks like it is going to barely grow this year. We have been bullish, but we didn’t expect such a slow growth rate of supply. And demand outside the U.S., Europe and Japan has been more resilient than we expected.

What markets are you referring to?
That would include China. The Middle East is a big demand driver, though it is often underappreciated. In aggregate, Middle East demand is about the same size as China’s and it’s growing at about the same rate. Demand from Latin America is also increasing.

Let’s talk about the possibility of crude hitting $200 a barrel. If we get there, how does it play out?
Our view has been that the price will keep going up to the level where it meaningfully reduces demand. This is Economics 101; we need more supply or less demand. And because there are various political and geologic constraints on growing supply, we’re left with looking for the price at which demand is reduced. We’ve never thought we knew what that exact number is. But we’ve tried to look at the 1970s, notably the economic impact of gasoline prices that ultimately led to a reduction in demand.

How does the current situation compare with the 1970s?
In the 1970s, you had a traditional supply shock. You took a bunch of oil off the market, and the price rose very quickly in a short period of time. That led to lower demand that proved sustainable, because the market worried that the supply wouldn’t come back. It has been, up until the last three or four months, a much more gradual increase — and therefore, people have generally been able to get used to the price. And it’s allowed demand to be more resilient than even we thought it would be.

But if crude does hit $200 a barrel, what kind of prices will we see at the pump?

Oil at $150 to $200 a barrel would imply between $4 and $5.75 a gallon.

At which point you probably see a falloff in demand, right?
We are already starting to see a drop in demand in the U.S., but they are still having demand growth in the non-OECD countries, including China, the Middle East and Asia. The OECD [Organization for Economic Cooperation and Development] countries are mainly the U.S., Europe and Japan. The real question: At what point do the non-OECD economies slow down? The other thing about U.S. demand is, at what point do you have sustainable change in consumer behavior? So if the price temporarily goes to $4 [a gallon], but immediately falls back to $3, it’s likely that people will keep driving cars with poor gasoline mileage. But if people believe the increase in oil prices is more sustainable, they might shift to taking mass transportation, if available, driving hybrids or taking the other kind of actions that are necessary to reduce demand on a sustained basis.

Do you see a sustained drop in demand at $200 a barrel?

That is the big question. We have always assumed that, at some point, you get a sustained drop in demand. Our long-term oil forecast looking out 20 years is [for crude] to fall back to $75 a barrel, or some lower number. The questions are: How long do prices stay high? How sharply do they rise? And do people truly change their behavior or are they just temporarily driving less? It’s an unknown at this point.

I agree with much of this, especially the near-term price forecast and the statement “the price will keep going up to the level where it meaningfully reduces demand.” But I do think we are getting near the peak of conventional oil and that unconventional oil resources will not come on fast enough — either because of underinvestment or climate concerns or both.

I don’t see how crude oil falls back to $75 or less in 2028 — unless we truly began the WWII-scale effort needed to avert climate catastrophe — and would be happy to take a bet with anybody on that, though I can’t imagine anybody, including Murti, taking that bet.

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18 Responses to What Mr. Crude Oil Sees Ahead: High prices until demand is destroyed, but no peak!

  1. John Mashey says:

    I don’t see how crude oil falls back to $75 or less even if we do all the things we need to do to avert both economic & climate catastrophe.

    “On the supply side, we don’t subscribe to the peak-oil view. We don’t think the world has run out of oil.”

    That’s a pretty strange comment: no oil expert I know thinks the world has run out of oil. Oil experts who are friends and think we’re at/near Peak production include an ex-Vice-Chairman of Chevron and an ex-Chariman of Shell, and I find it harder to ignore what they say.

    As in previous posts, I’m fond of the work of Ayres & Warr on modeling economic growth as a function not just of capital, labor and {total factor productivity, tehcnology progress, or the Solow Residual … i.e., we don’t really know}, but incorporating

    work = efficiency * energy used

    and getting very good fits for various economies. They key problem is shown on the last page of Ayres, projecting USA economy under peak oil and various efficiency assumptions.

    I.e., GET REALLY EFFICIENT, or see US GDP peak and then start falling, while we’re rebuidling the world’s energy economy around renewables over the next bunch of decades.

    Note that this is a *far different model* than the models used for BAU cases in most studies of cllimate+economy [IPCC, Stern, MIT, NRDC, Nordhaus, for example.] The latter happily predict BAU 2-3% GDP CAGR indefinitely, i.e., Peak Oil+gas seem irrelevant.

    This seems especially strange in those cases where someone argues for low carbon taxes, as higher ones would do damage, but doesn’t include any effects of Peaks … but hten, I’m not an economist.

  2. John McCormick says:

    Consumer choices—-

    This from an auto dealer friend in the business of helping customers downsize:

    They come into the showroom to look over fuel-efficient cars. Soon, the discussion comes down to 34 mpg or better cars. The customer settles on a Honda Civic. Then the conversation shifts to credit checks, trade-in, payment plan etc.

    The customer has a Cadillac Escalade parked out front and the salesman is reluctant to take it is as a trade. He agrees to give less than the Blue Book for the 2005 vehicle. They haggle and a trade-in offer is agreed.

    Then they start to pull the numbers together and discover the customer still owes about $14, 000 on the Escalade. That is added to the loan amount for the Honda Civic and soon the customer sees the monthly payments going above $500 and the credit risk rises accordingly.

    Finally, the customer rethinks the deal and settles for the Escalade because the efficiency delta is about 33mpg. Customer’s 12K miles/yr at 18 mpg and $4 gasoline is $220/mo. The Civic at 51 mpg and 12K miles/yr and $4 gas is $80/mo. So the savings would be $142/mo in gasoline costs.

    But, the monthly on the Civic plus the Escalade would be higher than the Escalade already being paid down. Customer is stuck with the Escalade.

    Not an unusual customer according to my car dealer friend.

    Choices have a lot to do with credit worthiness.

    John McCormick

  3. David B. Benson says:

    For reasons regarding global economy, hedge funds, peak oil, decline in the value of the US dollar and so on, I see no prospect of a decline in price for crude oil, measured in US dollars.

    I’ll just assert, without being an econometrician about it, that the price will continue to rise so long as new supply cannot keep up with new demand.

  4. hapa says:

    Choices have a lot to do with credit worthiness.

    this is exactly why the car of the near future is a higher-mileage honda fit- or yaris-like thing — cheap to build, buy, and operate — not a PHEV. nobody has the money to finance the new machine at a “premium,” as that car industry person was wondering about pricing hybrids — and maybe we won’t have that money for several years.

    and then we won’t have it again, when the second coming of the car gives way to the third, and becomes a similar home-budget albatross.

    the cycle of car payments is broken. the wheels of the middle period need to make financial sense all on their own.

  5. hapa says:

    oh, and, f*** detroit, and the government it rode in on.

  6. JCH says:

    If the new President aggressively banned many uses of gasoline, the barrel price would drop to less than $75 within a month.

    A large percentage of our gasoline usage is nonessential.

  7. John Mashey says:

    Note that gas prices are very akin to global temperatures: there’s a lot of noise atop a general trend. I’d be astonished if we don’t have short downward drops in either one now and then. Of course, unlike temperature, which can have both upward (El Nino) and downward (La Nina, volcanoes) spikes difficult to predict far in advance:

    – oil prices may have upward spikes (for many reasons), and then fall back.

    – but it’s hard for them to have temporary downward spikes of similar size, given that:

    “Another Al Ghawar has been discovered and will go into full production next month”

    doesn’t happen.

  8. Harold Pierce Jr says:

    ATTN: John M.

    Go check the estimate for Iraqi crude oil reserves. I remember reading not too long ago that it is now put at about 200 billion bbls. When the war is over, and it will be over soon, there will be a flood of Iraqi oil into the market.

    If Chevez is let go, then Exxon-Marathon can go back to Orinico Basin and start bringing up heavy crude oil. They put about 15 billion into that project and they want to get their money back one way or another.

    Go: and checkout some of the methods that are being developed for recovering these heavy crudes.

  9. Sriram says:

    The problem with both Mr. Murti and Harold Pierce Jr’s understanding of the peak oil theory is that “Peak Oil” does not describe the point at which the world has run out of oil, but rather the point at which half of the global oil supply has been extracted from the ground. The extraction of oil at relatively cheap margins (once initial technology costs are met) relies on high amounts of pressure within the wells to push the crude oil to the surface. What Hubbard’s Peak (the original estimate of crude oil supplies within the US) and other similar peaks of oil supplies indicate is the end of cheap oil due to higher input costs involved in its extraction.

    The mention of 200 billion bbls of oil under Iraq ground is easily misleading. I highly doubt all of this oil is recoverable, and even if that were (in purely hypothetical sense) possible, it would hardly last the world for more than 6 years given current consumption levels (and not accounting for projected rises in consumption levels, which are inevitable).

    As Joe’s argued here before quite often, it’s simply wishful thinking to continue fantasizing about all the untapped sweet crude lying unexploited beneath the earth or the various other possibilities for increasing the world oil supply. What is needed is a transition to clean, renewable energy sources and an end once and for all to our self-destructive oil addiction!

  10. JCH says:

    It’s highly unlikely ExxonMobil will ever get back into Venezuela, National oil companies like Petrobras are likely to pick up what ExxonMobil voluntarily left.

    Venezuela offered to repay their estimate of the ExxonMobil investment. ExxonMobil refused that deal, and took them to court. A European court froze 12 billion of Venezuela’s assets.

  11. Ric Merritt says:

    As a sober middle-aged person, I avoid blogospheric snark, but this target is just too fat to resist. John McCormick’s hypothetical “friend of a friend” who could afford a Cadillac Escalade in 2005 and couldn’t figure out why not to buy one deserves whatever he gets. Do whatever you want with that hunk of sunk cost, as long as you wake up and advocate a rational carbon policy.

  12. Finnjor says:

    In Finland we have no problems with peak oil, we burn peat. We have 100 000 square kilometers of peat bogs, over one meter deep in average. Makes 100 cubic kilometers material to burn. We are richer with peat than Norway with oil, believe or not. You know, peat is dirtier than coal, burt our peat barons say that peat is a renewable material, it only has a little longer life cycle, a few thousand years.

  13. Harold Pierce Jr says:

    Hello JCH

    The heavy crude oil in the Orinoco basin isn’t going anywhere, and Chevez isn’t going to live forever. The big majors are diamonds: they are forever!

    What clean, renewable energy do you recommend for boats, planes, trains, trucks, the military-industrial complex, steel mills, cement plants, glass factories, diamond and gold mines, etc? Ya know, all those really heavy hitters.

    The reason Exxon walked away is that they took all of their proprietory technology with them.

  14. JCH says:

    I’m an ExxonMobil shareholder. I’m fully aware of their capabilities. I’m very proud of ExxonMobil’s savvy. But you overestimate them.

    Some companies walked away from Venezuela; others stayed. Venezuela is getting ready to bring in partners in the Orinoco. The national oil companies come from countries that better understand why Chavez did what he did, and that do not share ExxonMobil’s revulsion at socialism. My prediction is they will partner with Chavez.

    Watching ExxonMobil’s new ad campaign, perhaps their new battery technology is going to accomplish those things. HIdden back deep in recesses of ExxonMobil’s capability storage facility is the information for the days when John D. had a fully globalized company that delivered its vast product array to global markets by sail-powered tankers and wheeled tankers pulled by horse teams. They’ll figure it out.

  15. Dano says:

    I respect Murti and what he has to say, but it simply isn’t in his company’s interest to discuss peak oil, hence the phrase “we don’t subscribe to the peak-oil view. We don’t think the world has run out of oil.”

    Of course “they” don’t think the world has run out of oil. No one does. But what do they think about peak oil?



  16. Greg N says:

    John McCormick’s Civic/Escalade scenario is rather muddled.

    It doesn’t matter who owns the 2005 Escalade – the original owner or someone buying it from the dealer second hand. For the rest of its life, the Escalade is going to be getting 18 mpg no matter how many times it is traded or exchanged.

    The Escalade is good for another 100,000 miles, say, and it will do all those miles with someone, because functional cars don’t get scrapped until they are near economic expiry.

    As Ric Merritt says, the Escalade is a sunk cost – in CO2 terms as well as personal financial terms. The decision was made in 2005, and it was a bad decision, a decision that cost the owner financially and cost the planet CO2-wise. Buying and selling existing cars makes no difference whatsoever.

    All that matters is the purchase (=manufacture) of new cars. If someone in the showroom is choosing between a new Civic or a new Escalade, then they are implicitly choosing which of the two cars the capitalist system should manufacture.

    The perceived high price of gas sends a clear signal to the buyer now. As John McCormick says, the Escalade will cost the driver $220/mo while the Civic costs $80/mo. With cost comparisons like these, the shift towards the manufacture of higher mpg cars is inevitable – these are the cars that customers in showrooms are demanding.

  17. hapa says:

    probly people will figure out how to convert the lighter XUVs to motorvate cleaner. the heavier ones that have little working capacity, they’ll probably end up scrap. made into part of a train maybe, or a turbine perch.

  18. john says:

    ok people its time for a reality check if they are punping oil out of the ground every day at eveyr sight and all refinerys are at full capcity it would be safe to say that there is plenty of oil ,but……according to a articel i read the united states reserve supply is very low hmmmmm that doesnt make sense if millions of gallons are being pumped out daily where the heck is it going????? and if we are using about 40 percent less this yr then last yr then that means less demand prices should drop but oh wait they want al countries to demand it less first i say bullsh** we are busting our butts trying to earn a living and making sacrifices to deal with making life decisions at the pump….also why in the hell is deisel higher then gas when it is a waste product i cant believe garbage costs so much ….and finally if president bush was all bout using alternative fuel sources yrs ago when he said it how come there isnt any fuel sites for them yet unless of course it was all talk just to make people like the idea
    i work 40 a week for 5 and i live three miles from work and go though 50 bucks a week in gas if it goes any higher i will have to quit cause it wont be feasable to spend that much and make so little only to put it back in the tank