The key factor in forecasting global oil prices is demand from emerging markets and, more specifically, demand from Asia. For a closer look, check out the chart below.

Source: BP Statistical Review

Between 1999 and 2004, total global consumption of crude oil rose by just under 6 million barrels per day. The pie chart above breaks down that increase by region.

As you can see, the US and Europe accounted for only about 20 percent of that jump in consumption. While Europe and the US combined account for more than half of total world oil consumption, neither region saw a huge increase in consumption between 1999 and 2004.

The really big jump in demand came from the Asia Pacific region. The entire region, including Japan, China and India, accounts for less than 30 percent of daily demand for crude, but it accounted for well over half of the total jump in demand over the past five years.

Trying to forecast global oil prices is really a matter of trying to forecast the future path of economies in the region; Asia is where the marginal demand for energy commodities will come from.

As I've outlined in this journal on numerous occasions (see TEL, December 12, 2005, The Saudi Miracle), I’m not convinced global energy production can be expanded far beyond the current 80 million barrels per day. While it's quite possible that Saudi Arabia and Russia, among others, could push their production higher eventually, it would require massive investments and some years for this to occur.

Right now the oil markets are extraordinarily tight—there’s very little excess oil globally to satisfy growing demand. Only a pronounced drop—more than a mere slowdown in growth—will bring oil prices near or below $40 on a long-term basis. Only a drop of some magnitude would ease the tight supply/demand balance that currently grips the oil market.

It's premature to forecast a global recession at this time. As the global economy currently stands, I doubt we'll see oil prices at $40 in 2006. A moderation in global economic growth will be enough to temper oil and natural gas prices this year, but not enough to produce a collapse in commodity pricing. Bottom line: At this time, I’m looking for oil prices to average above $50 in 2006.

The one wild card is, of course, geopolitics. Even if demand for oil does drop, a major supply disruption or political instability in the Middle East could prompt another spike in pricing. This upside risk to oil prices looms just as large as the aforementioned demand shock from a global economic recession.

Supply And Reserves

Still other oil bears point to global oil reserves as a reason for oil to fall back under $40. This argument is not entirely logical.

Some contend that the world has "plenty" of oil and can increase production almost indefinitely. They reason that global oil reserves in some parts of the world--notably Saudi Arabia--are rising and, therefore, production should also be able to increase. After all, Saudi Arabia's reserve estimates of over 250 billion barrels of crude alone represent enough oil to cover nearly 10 years of global oil demand.

But there are two problems with this argument. First, the term proven reserves is a nebulous concept--there is no global standard or definition of what exactly constitutes reserves. Second, reserves and production aren't as closely linked as you might expect.

As to the first point, the first step in estimating reserves is to determine the physical size of the field. Once that's estimated, it's necessary to estimate the field's original oil in place (OOIP). OOIP is nothing more than a measure of the total oil in a particular field.

But it's not possible to recover all of the OOIP in a given reservoir. The recovery factor can be as little as 5 percent of OOIP to as much as 80 percent or more. The ultimate recovery factor depends on the particular geology of a given field, the type and viscosity of oil produced (how easily the oil flows) and the methods used to produce that oil. Further, if oil prices are higher, this may justify higher recovery from a given field.

Estimating reserves entails not only estimating the OOIP but also the ultimate recovery factor. Quite obviously, estimating proven reserves is far from an exact science; this is why reserve estimates are frequently changed and modified. When a company or nation adds proven reserves it quite often has little to do with finding new fields. Reserves often change because the estimates of OOIP or recovery factors are tweaked over time.

In fact, according to numbers presented in the BP Statistical review of World Energy 2003, global oil reserves rose by 367 billion barrels between 1982 and 2002. But less than one-tenth of those reserve gains came as a result of new drilling or exploration. More than 90 percent of the change in reserves over these years was due to changes in accounting for proven reserves as outlined above.

The chart below shows US reserves and production from 1980 through 2004. These are not actual figures; I set both consumption and production equal to 100 to better illustrate changes over time.

Source: BP Statistical Review

As you can see in that chart, US oil reserves fell roughly 20 percent from 1980 to 2004. But production from US fields actually fell by an even larger amount--by nearly 30 percent over the same period. Reserves and production also both fell even as oil prices rose from 2001 to 2004. But production, once again, fell far faster than reserves.

The following chart plots North Sea oil production and reserve estimates over the same time period. To estimate North Sea production, I used data for Norway and the UK, the two prime players in the region.

Source: BP Statistical Review

In this chart, we see quite the opposite trend. Oil reserves from the North Sea rose by roughly 20 percent from 1980 to 2004. Over the same period, production rose by well over 150 percent. That's a dramatic disparity.

Bottom line: There is no direct link between proven reserve estimates and production. Even if proven reserves in a given field increase it does not automatically mean that daily oil production from that field can rise at a similar pace.

When you consider the dubious nature of global reserve data and the uncertain link between reserves and production, it isn't logical to argue that rising reserves spell rising supply and falling oil prices.

© 2006 Elliott H. Gue
Editorial Archive

I'd like to make an announcement of a more personal nature. As long-time subscribers are already aware, for about a year now I've been working on a book with my colleagues Yiannis Mostrous and Ivan Martchev, The Silk Road to Riches: How You Can Profit by Investing in Asia's Newfound Prosperity.

We discuss Asia's tremendous growth potential and the integration of this fast-growing region into the global economy. More specifically, the book addresses some of the key themes that will power tremendous returns for investors over the next decade; energy, agricultural commodities and geopolitics are just a few of the highlighted trends.

The Silk Road to Riches is now available for pre-order at Amazon.com. For those interested in getting a copy of the book as soon as it's released, you can order it through Amazon by clicking here.

Asia, Geopolitics and Oil

Asia and the geopolitics of the Middle East are two themes we outline in great depth in my new book and that I frequently reference in The Energy Strategist; both clearly have great bearing on the global energy markets and on oil prices.

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