Saudi Arabia was able to rapidly ramp up oil production in the 1970s to meet global demand. This was particularly important given that US production peaked in 1971-72 and then began a gradual downtrend. The Saudis picked up the slack.

The fact that Saudi Arabia was able to increase its production by a factor of nearly five in only 15 years is amazing; such rapid and sustained production growth has not been repeated elsewhere. But what’s even more amazing is that it was comparatively easy to do. Giant oilfields, by far the most prolific ever discovered anywhere in the world, flowed easily in those early years and could be produced using relatively unsophisticated techniques. The country didn’t need a huge number of wells or more advanced horizontal drilling techniques and “intelligent” wells to produce its fields.

The same basic production pattern is evident in all sorts of oilfields all over the world. See “The Alaska Experience” below, a chart of Alaskan crude production below.

Source: Energy Information Administration

The big find in Alaska was the Prudhoe Bay field, discovered in the late ‘70s. Production ramped up quickly through the early ‘80s and then plateaued. Prudhoe Bay actually stayed at near-peak production for an unusually long period of time and didn’t peak until the late ‘80s because the operators were careful not to overproduce the field. By deliberately producing a field at less than full capacity, it’s possible to sustain high levels of production for longer periods of time. Overproducing a field can actually damage the reservoir and lower the amount of oil ultimately recovered.

While operators have used increasingly high-tech methods to produce Prudhoe Bay, it has seen declining production since that late-‘80s peak. The point is it’s easier to grow or maintain production on the left side of this bell-curve than on the right side.

Fast-forward another 25 years to the present day and Saudi Arabia is once again the focus of the global oil market. It produces roughly 13 percent of global oil consumption and, more importantly, is the only nation with at least a plausible claim of spare capacity, and has infrastructure in place to quickly increase production of oil to meet global needs or offset supply shocks elsewhere in the world.

It’s no secret that oil demand is booming. By 2025, the Energy Information Administration (EIA) projects global oil demand of more than 120 million barrels per day, up from approximately 80 to 85 million today. That’s a 50 percent jump in demand.

In this era of booming global demand, the importance of Saudi production can’t be overstated. The world is already depending on another turbocharged spurt of production growth from Saudi Arabia to meet future needs (see the chart below).

Source: Energy Information Administration

This reliance on Saudi Arabian supply is obvious from the EIA’s 2005 Annual Energy Outlook survey. The EIA is projecting only slight oil production growth from the industrialized world. Meanwhile, the developing world--including Russia and the former Soviet republics--is projected to kick in slightly higher growth.

But the real growth in production is projected to come from the Middle East. In fact, the EIA is projecting a near doubling in annual oil production from this region, a large chunk of that coming from the Saudis.

The Saudis have publicly supported this outlook. They’ve repeatedly insisted they’ll be able to increase their production capacity over the next few years to meet all that new demand. And historically the Saudis have lived up to this role, ramping up supply whenever necessary.

But several cracks have recently appeared in the Saudi miracle (for more information see my report, The Saudi Mirage). Rising demand from the developing world has meant that Saudi Arabia’s spare capacity is shrinking. Annual production stood at 9 million barrels per day in 1999 and grew to more than 10.5 million barrels last year. Spare capacity is simply mothballed wells (wells not flowing at full capacity). As oil demand grows, the Desert Kingdom has been ramping up production and that spare capacity has been shrinking.

By most estimates, the Saudis’ current production capacity is 11 million barrels per day. If they’re producing approximately 10.5 million, that means they have just 0.5 million in share capacity against closer to 2.5 million to 3 million just six years ago. With global oil demand at more than 80 million barrels per day, Saudi spare capacity now sits at less than 1 percent of daily demand--tight by any measure.

This is why any disruption in the global oil supply can lead to huge jumps in the price of crude. When spare capacity is large, and there’s a sudden drop in production somewhere in the world, the capacity cushions that supply shock. But when Hurricane Katrina hit and oil prices spiked, Saudi Arabia all but admitted it couldn’t make up for all the lost production.

Saudi Arabia’s entire oil industry is veiled in secrecy, and there are plenty of signs its oil reserve and production potential have been massively overstated. There’s plenty of evidence the Saudis are already experiencing high water cuts--they’re producing increasingly large amounts of salt water mixed with their crude oil. Rising water cuts are typical of more mature fields and make it more expensive to produce oil. This is also partly due to the country’s long-standing aggressive water flooding--injecting water into its oil fields to push oil towards the wells.

But even if we hold to the optimistic belief the Saudis can increase their production capacity, it’s abundantly clear this will require massive investments. It’s easier to increase production from relatively young fields than it is to ramp up production from more mature reservoirs. And Saudi Aramco has described some of its largest fields as mature on multiple occasions.

Bottom line: If it is possible for the Saudis to grow their production and capacity, the task will be neither easy nor cheap.

The Saudis are looking to boost their capacity from 11 million to 12.5 million barrels per day over the next few years. This would at least slightly widen that spare capacity cushion. To that end they’re already ramping up their drilling activity in a big way; the Saudi rig count now stands at a 25 year high (see chart “The Saudis Are Drilling”).

Source: Baker Hughes

The rapid rise of active drilling rigs since the late ‘90s is proof-positive that Saudi Arabia is working to enhance its production capacity. Eventually, the Saudis are expected to boost their total fleet of operating rigs to around 70 or 80 from the current 40. This would represent a more than tripling of the rig count since the mid-‘90s.

The real winners of this increased activity and expensive investments are the oil services stocks, more particularly the big, internationally levered names.

The obvious player in this space is Schlumberger, a well-established player in Saudi Arabia and across the Middle East. It specializes in technically complex services--exactly the sort of technology that Saudi Arabia is using to try to increase capacity. Schlumberger’s a leader in most of the fields in which it operates. More rigs drilling in Saudi Arabia means more business for Schlumberger.

Schlumberger, however, represents just the tip of the iceberg with regards in how to profit from the Saudi oil story.

Sincerely,

Elliott Gue, Editor
The Energy Strategist

© 2005 Elliott H. Gue
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