Why low oil prices now may mean higher oil prices later

By Kevin G. Hall

WASHINGTON — What until recently was a steep drop in global crude oil prices has sparked delays and cancellations of major energy projects across the globe. Experts fear that this pullback could provoke costly supply shortages just over the horizon.

"Energy investment worldwide is plunging in the face of a tougher financing environment, weakening final demand for energy and falling cash flows," the Paris-based International Energy Agency warned in a report late last month.

The IEA also warned that investment is being curtailed both on the supply side and the demand side, meaning that spending is falling on both drilling of oil and gas wells and on expansion of refineries, pipelines and power stations.

In the short term, falling prices are a boon to consumers. Experts, however, warn of problems if the U.S. economy — the world's largest oil consumer — returns to normalcy and the global economy resumes its torrid pace of growth.

If the ability to find and produce more oil is put on hold and the global economy roars back to life, last year's record oil prices could seem tame. Today's pullback in prices may be setting the stage for tomorrow's shortages.

One of the world's leading voices on energy trends, IHS Cambridge Energy Research Associates, reached a similar conclusion in a private report titled "The Long Aftershock."

CERA researchers believe that deferred or canceled projects will prevent 7.6 million barrels a day of expected oil growth from coming onto world markets in 2014.

"CERA estimates that 52 percent of the potential net growth in liquids production capacity from 2009 to 2014 is at risk of deferment or cancellation because of poor project economics or investor cash flow difficulties," CERA's report said.

The energy research group thinks that the projected additional new oil production capacity of 14.5 million barrels a day coming online through 2014 will be cut in half unless there's a sudden spurt in demand. This reduced production could spark supply shortages and price spikes.

"That's clearly something we should pay attention to," said John Felmy, the chief economist for the American Petroleum Institute, the trade group for oil producers.

The potential shortages, he said, argue for expanded offshore drilling to ensure future supplies.

Few markets are as volatile as oil. Over a period of 12 months, contracts for future delivery of oil soared from $70 a barrel to a record $147 a barrel in July. Then they collapsed over the next four months to less than $40. During the past month, oil prices have come roaring back to near $70 a barrel, even as inventories hover at record highs and demand remains at 10-year lows.

Before the big run-up in prices, deepwater drilling in the Gulf of Mexico and complex refining of western Canada's oil sands needed oil prices of $40 a barrel to break even. But as prices soared, so did production costs, and that break-even point stands somewhere between $60 and $80 a barrel.

In today's volatile price environment, projects are being put on hold or are being killed altogether.

"There are long-term projects, and you have to be confident about the price to make the investments," said oil historian Daniel Yergin, CERA's chairman, in an interview. "You've seen the oil sands are a very important and secure source of supply to the United States. And 70 percent of the projects from last summer have now been postponed."

Much of CERA's projected investment drop-off involves the oil sands region, where oil is literally boiled out of tar-like deposits. Canada is the largest oil exporter to the U.S. market, and much of it comes from the oil sands. Canada's daily production average for the oil sands this year is projected to be 1.3 million barrels.

However, warned the IEA report, falling prices and slumping demand have led to the suspension or cancellation of oil sands projects that collectively amount to 1.7 million barrels a day of lost production. Investment totaling more than $150 million has been curtailed, and these projects can't be profitable unless crude oil sells for $75 a barrel or more.

On a global scale, oil prices had risen for an unprecedented seven consecutive years as a growing world economy thirsted for oil and gasoline. Projects were planned across the globe to match growing demand and rising prices.

Then came September, when the near-crash of the U.S. financial system brought a global recession. Oil prices fell so far that large producers can no longer finance new projects out of their cash flow, the IEA's report said. Many are borrowing at a premium because of the global credit crunch and have scaled back or delayed projects.

For state-owned oil companies, such as those in Mexico and Venezuela, falling prices have meant more of their earnings are being diverted to social programs and there's less money to find, produce or refine more oil.

The IEA, in its recent report, asked, "Are we heading for a mid-term supply crunch?" The answer is still uncertain, the report's authors said.

"The outlook for spare crude oil production and refining capacity in the longer term hinges on how quickly demand recovers once the global economy is back on the road to recovery, how much further investment is scaled back in coming months and how quickly investment rebounds in the coming years," the IEA said. "The faster the rebound in demand, the more likely it is that capacity will be squeezed in the medium term," and the greater likelihood of high prices because of tight supplies.

The timing would be awful. Few economists believe the U.S. economy will return to sustainable growth before the end of 2010, and by 2011 the benefits of federal stimulus spending will wear off. An oil supply crunch that triggers high prices could kill recovery on the vine.

"Although it will take time for these changes to have an impact on total global oil supply, that impact could prove to be significant in three to five years," CERA's report concluded. "Slower growth in oil production capacity over the next five years could lead to the next period of rising oil prices, but much depends on the recovery of world oil demand."