We are in a major oil correction, as we  predicted early July (with somewhat fortuitous timing). The reasons behind the drop is simple, oil got so expensive that where consumers feel the effects (which is really not everywhere due to distorting subsidies and taxes), it changed behaviour. A slow-down in world economic growth is the other argument. But that won’t last..

First, the case for the correction once more:

• Oil demand in the United States, the world’s biggest oil consumer, dropped by 800,000 barrels per day (bpd) in the first half of 2008, the steepest volume drop in 26 years. Some analysts say falling demand from developed economies in the Organization for Economic Co-operation and Development (OECD) could undermine gains from emerging economies like China that have underpinned the six-year rally in oil. “If that contraction becomes steeper, at some point it’s going to be hard to argue there is enough non-OECD growth to offset it,” said Mike Wittner, analyst for Societe Generale.
• “We’re at a major inflection point for the dollar which could help to deepen this decline in prices,” said Jarvis, adding oil’s sharp move would test OPEC’s preferred price floor when the producer group meets to decide on output policy.
• On Tuesday oil fell below $110 a barrel, a key support level identified by technical analysts who predict future price movements by studying charts. They have said the market could fall as far as around $60 a barrel before the long-term bull trend would be broken and there is strong support at $100.
• Iran has said $100 is the lowest acceptable oil price and called for the group to cut output by 1.5 million bpd by early next year. Fellow price hawk Venezuela has said around $100 a barrel is a fair price, while other OPEC sources have suggested a price floor closer to $80 a barrel because of concerns about the effects of high fuel costs on large consumer economies.
• There are fears that prices below that level would discourage investment in new production capacity.

So:

1. High oil prices and economic problems started to decline demand in some developed countries, most notably the US
2. That decline might offset structurally rising demand from developing countries
3. The rebound in the dollar is helping

However:

1. OPEC countries, at some point, will not stand by idle, and there is a new assertiveness and power supported by non-OPEC countries like Russia
2. Lower prices are a disincentive to invest in production capacity, and will increase demand in the developed countries again
3. Most importantly though is that demand is structurally increasing in developing countries
4. And production in many of the biggest oil fields are already declining (“economic peak oil”)
5. Most of world reserves are in awkward places with awkward regimes, with little incentive to invest or increase supply

We will provide some details for the latter points:

Demand from developing countries structurally increasing

• Oil demand from China increased from 3.4M barrels/d (1995) to 7M barrels/d (2005) (and further to 8Mb/d last June)
• Oil imports from India are expected to triple to 5Mb/d by 2020
• Even the US, the falling demand could be just a blip, as between 1995 and 2005 oil demand grew from 17.7Mb/d to 20.7Mb/d.
• Asia accounts for 60% of the world’s new oil demand. [moneymoring]

Supply might already have peaked

• At least nine of the largest 21 oil fields on the planet are in decline.
• In 2006, a Saudi Aramco spokesman admitted that its mature fields are declining 8% per year. It’s now clear that Ghawar, the largest oil field in the world, has peaked.
• The second largest, the Burgan field in Kuwait, started down in 2005. And Mexico announced that its giant Cantarell Field entered depletion in 2006. [moneymoring]

Reserves are not all they seem

• But as Sadad I. Al Husseini, a former VP of Aramco, said in October 2007, “Reserves are confused and inflated. Many of the so-called reserves are in fact speculative. They’re not delineated, they’re not accessible, they’re not available for production.”
• By Al-Husseini’s estimate, 300 billion of the world’s proven reserves should be re-categorized as speculative.
• On top of that, about 70 oil-producing nations don’t reduce their reserves to account for yearly production. As noted investor Jim Rogers says, “Despite consistently pumping 8 million bpd for over two decades, Saudi Arabia has repeatedly stated their reserves are at 267 billion barrels.”
• Organization of Petroleum Exporting Countries (OPEC) member nations even have economic incentives to exaggerate their reserves, as the OPEC quota system allows greater output for countries with bigger reserves. [moneymoring]

New production neither

• Even though we continue to hear about new oil discoveries, new oil reserves will be harder to find and extract.
• Take Kazakhstan, for instance. Its oil fields are slated to be the third largest in the world. The heralded Kashagan field should produce 1.5 million bpd at its peak. But technical problems continue to plague the project.
• In 2005, production was scheduled to start in 2009. A year ago that was moved to 2011 and now it’s been pushed back to 2013. And the projected cost has risen to a whopping $50 billion.
• Canada’s oil sands are another example. Production could reach 5 million bpd by 2030 in a “crash program,” but the oil contains contaminants such as sulfur and carbon that are difficult to extract and leave highly toxic tailings.
• Frankly, the most easy-to-extract oil has been found. Price increases have led to exploration where high technology is required and where it is much more expensive to extract the oil.
• We are replacing OPEC oil that costs $3 per barrel to produce with deep-water and other nonconventional sources at $60 per barrel and up.
• And that’s why the markets are predicting triple digit oil prices are here to stay. [moneymoring]

Political peak oil

• Summary: Robert Hirsch describes another form of Peak Oil: political peaking.  Perhaps the Middle Eastern nations can produce more oil to meet the world’s growing thirst — but will they?  Is it in their interest to do so?  Also, the focus of doomsters on shockwaves — instantaneous and large production cuts — ignores the more likely forms of slower political and geological peaking. [fabiusmaximus]

Many of the biggest reserves are in parts of the world with awkward regimes and under national control. Do these nations have much incentive to spend tens of billions of dollars to increase capacity, thereby reduce the price of energy, often their only or at least by far their most important source of income? No.

They do have an incentive to rake in the money and use that to solidify their regimes (Venezuela, Russia), or even worse, solidify that the group in power can continue to syphon of the state booty.

These are uncomfortable stylized facts about the energy markets and they will virtually guarantee that whatever correction we now have on the basis of weakening economies, it won’t last. High energy prices are here to stay. (We had an earlier entry on the topic, you can read here)