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The Case for Higher Oil Prices

When I was in Calgary last year visiting several oil and gas companies, the CEO of one of Canada's best run junior oil and gas companies looked across the conference table and said something that stuck in my mind: "Get ready for $50 oil!" Such a bold prediction, made when nearly every Wall Street and Bay Street analyst was lowering his 2004 oil price prediction, underscores the massive divide in opinion on the future price of oil.

There is a growing belief among the geologists who study world oil supply that world oil production is soon headed into an irreversible decline. The geologist who has most eloquently laid out the argument for higher oil prices is Dr. Colin J. Campbell. Dr. Campbell, author of the book "The Coming Oil Crisis," holds a doctorate from Oxford University and spent decades working as an international exploration geologist for major oil companies. After a long career in the oil industry, Dr. Campbell worked for Petroconsultants, based in Geneva, Switzerland. At Petroconsultants, he was instrumental in assembling what has become widely recognized as the world's leading hydrocarbon database. Dr. Campbell is now a Trustee of the Oil Depletion Analysis Centre ("ODAC"), a charitable organization in London that is dedicated to researching the date and impact of the peak and decline of world oil production due to resource constraints, and raising awareness of the serious consequences.

I found Dr. Campbell's thesis on the future of world oil production in a speech he gave to a German university in 2000 entitled "Peak Oil: A Turning Point for Mankind". (To watch a replay of this speech go to the following URL: http://www.globalpublicmedia.com/SECTIONS/ENERGY/oil.depletion.php and click on the RealVideo presentation. The beginning of the lecture might be a little blurry.) Below is a summary of his findings.

Dr. Campbell believes worldwide production of conventional oil will head into permanent and irreversible decline in the 2005 to 2010 timeframe.

The term "conventional oil" is used to refer to oil that is produced from conventional reservoirs and does not include oil from tar sands, polar areas, deepwater areas or oil from coal or shale. Conventional oil accounts for 95% of all oil produced today and will remain the determining factor in world production for the foreseeable future. According to Dr. Campbell, world oil discovery peaked in the 1960's and has declined steadily since. We are now to a point where we produce four barrels for every one we discover. Clearly, this is an unsustainable situation since long-term discovery and production must mirror each other to some degree.

Dr. Campbell is also far from sanguine about the current state of world oil reserves. He provides significant evidence that oil reserves are being grossly overstated by OPEC. Dr. Campbell notes that the two most used estimates of world oil reserves, which are prepared by the Oil and Gas Journal and the BP Statistical Review, are flawed. Both publications rely on reserve estimates provided to them by governments and industry and make no effort to verify accuracy. The below table (data from the Oil and Gas Journal) supports Campbell's view that OPEC's reserve figures are not based on any reliable estimate of total recoverable reserves. Notice how several countries report the same reserve figures for several consecutive years. Constant reserves figures are very unlikely considering that production and discovery would have to match each other exactly.

OPEC Reserves (In Billion Barrels)

Campbell contends that OPEC reserve estimates are politically motivated. Kuwait is an excellent example of what is wrong with the way OPEC countries report reserves. The country reported a gradual decline in its reserve base from 1980 to 1984. This should be expected from a mature producing country. However, in 1985 the country reported a 50% increase in reserves with no corresponding discovery. The Kuwaiti government increased its reserve estimate due to the implementation of an OPEC production quota system that set country production levels based on country reserves. Kuwait was not alone in increasing its reserve estimates for political reasons. In 1988, Abu Dubai, Dubai, Iran and Iraq all significantly increased their reported reserves for political reasons. Even OPEC heavyweight Saudi Arabia reported a massive increase in reserve estimates in 1990 for similar reasons.

While OPEC has consistently overstated their reserves, Campbell contends that industry has understated its reserves. The pressure on companies to understate reserves by the analyst community has created a gross misunderstanding of how much oil is actually being discovered. Campbell argues that most company estimates create the illusion of growing reserves when in fact; previously discovered oil is merely being reclassified into the proven category for reporting purposes.

[Note: At least one major oil company is not understating reserves. Royal Dutch/Shell (NYSE:RD) reported a whopper of a reserve write down in January. The company reported that its reserves were overstated by an incredible 20%. The company contends that it acted "in good faith" when preparing its reserve estimates. Such a large write down has attracted the attention of SEC Commissioner Roel Campos, who is considering launching an investigation into the matter].

According to Dr. Campbell, we are likely to face a sea change in the world's oil production capacity. Campbell maintains that peak production comes close to the midpoint of depletion. According to Dr. Campbell's estimate of the world's oil endowment, we are right at the halfway mark.

How might this crisis unfold? Dr. Campbell makes it clear that the crisis will not look anything like the oil price shocks of the 1970's. Instead, Campbell refers to those politically motivated disruptions in supply as merely "tremors" compared to the "earthquake" that is about to hit the oil consuming world. The first phase of the crisis, which has already arrived, will bring about price shocks. In the nearly three years since Dr. Campbell made this prediction, the world has witnessed several rounds of high oil prices. However, the onset of chronic shortages will begin around 2010 when the Middle East will be required to supply 50% of total worldwide oil production. More importantly, it is at this time the Middle East will have reached its production midpoint and will head into decline also.

Clearly the scenario laid out by Dr. Campbell is not a pretty one. However in every crisis lies opportunity. Astute investors should recognize the implications of declining worldwide oil production and adjust their portfolios accordingly.

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