HYDROCARBON MAN
By John Myers

Just because the US Army has pitched its tents in the Iraqi oil fields, that doesn't mean that Iraqi oil will soon be flooding world markets or the price of oil is heading to $12 a barrel. Quite the contrary.

Indeed, one of the biggest post-war surprises is that the oil price has jumped back over $30 a barrel. I can't say we're surprised. We have stated repeatedly that the bull market in oil has little to do with Iraq specifically. Although, the politically volatile Middle Easy certainly plays a big role in the oil price trend.

Removing Saddam Hussein from power doesn't change the fundamental fact that the world is drawing down its oil reserves at a record pace. Nor does it change the fact that politically volatile Middle East nations continue to control the lion's share of the world's oil supplies. Since most of the rest of the world is rapidly depleting its domestic supplies of oil, the world has become more dependant than ever on Mid East oil. Forward-looking investors should be looking to invest in oil and gas companies with substantial North American reserves.

To predict what will happen to the world's oil supply, you need only look at a single oil field. Whether you are talking about Prudhoe Bay in Alaska or Leduc in Alberta, maximum production of a given field is achieved some years after initial discovery as the field continues to be developed with additional step-out wells. But, after half the recoverable reserves have been pumped from a field, there is a rapid decline in the field's oil reservoir. It becomes less and less economical to pump oil from the field until a breakeven point is reached - a point where the expense of operating the oil field equals the revenues produced by the field.

The physics that apply to a single field also apply to a region or an entire country. Consider the continental United States. The rate at which new oil was discovered hit its peak in 1957. By the early 1960s, the nation's total proven reserves reached its all-time high. Less than a decade later, U.S. production peaked. Production was relatively stable until the mid-1980s and then began to fall precipitously.
Year after year the Americans have made up the shortfall in oil production by importing foreign crude. But what happens when the world's output begins to fall?

Unless we find oil on Mars, there will be no outside source to make up for dwindling production. It will be then that the price impact of dwindling supplies will meet surging demand - a formula for incredible profits in oil and gas stocks.

Global oil reserves have not increased since 1990. In fact, over the past four decades, wildcatting has yielded fewer results. In the 1960s, the industry discovered 375 billion barrels. In the '70s, 275 billion barrels and in the '80s, 150 billion barrels were discovered. Fewer barrels yet were discovered during the 1990s.

At one time, the world was blessed with somewhere between 1.8 trillion and 2 trillion barrels of oil. But beginning with the first flowing oil well in April 1861, that endowment has been consumed. By the end of 2002, humankind had pumped and burned about 900 billion barrels of oil, or about half of the total amount of oil the world has to offer.

Perhaps this year - and certainly no later than 2005 - world production will hit its apex. That means that over the second half of this decade world oil output will begin to decline - just as global oil demand is surging.

Each year the world pumps and burns 26 billion barrels of this non-renewable resource. That means that every four years, more than 100 billion barrels of oil-five times the total reserves of the United States-are consumed.

But world demand for petroleum is expected to soar by 56 percent, or 43 million barrels per day (bpd), over the next two decades due mostly to strong demand for transportation fuels. According to the International Energy Agency, global oil demand would jump to 119.6 million mb/d in 2020 from its current level of 77 million mb/d. But even today, oil is being burnt at a torrid rate.

The implications are serious for what Daniel Yergin calls a "Hydrocarbon Society." Despite the advent of the microchip and explosion of the Internet, petroleum is the primary economic engine powering the world. And even as world oil output peaks and then tapers, there is little evidence that the necessity of oil, and the demand for it, will wane.

" Hydrocarbon Man shows little inclination to give up his cars, his suburban home, and what he takes to be not only the conveniences but the essentials of his way of life," wrote Yergin in his best seller, The Prize. "The people of the developing world give no inclination that they want to deny themselves the benefits of an oil-powered economy, whatever the environmental questions. And any notion of scaling back the world consumption of oil will be influenced by the extraordinary population growth ahead."

Of course, not all oil-producing nations will experience a reduction in output at the same time. As I mentioned, in the United States production began to fall in the 1970s. Mexico and North Sea production are now in decline, and few expect a major discovery in those regions.

The only other major non-OPEC oil region is Russia. But new oil discoveries in the former Soviet Union have been in decline since the late 1980s. The expectation by most oil executives is that we are on the verge of declining Russian oil production.

With reserves of around 650 billion barrels, the Middle East is the only major oil-producing region in the world that is not yet close to its oil reserve half-life.

Until recently it has been oil production from non-OPEC countries that has kept oil prices in check. But as production in these regions enter into decline, more power falls to OPEC, particularly Arab OPEC.

In 1988, Saudi Arabia was happy with an OPEC benchmark price of $20 a barrel. But given the falling value of the dollar as measured by the CPI, it takes $31 to buy the same amount of goods and services that $20 bought in 1988. So even if Mid East OPEC would accept the kind of pricing policy that the Saudi's implemented 15 years ago, they would insist on $11 more a barrel to keep pace.
Trouble is, Mid East OPEC wants nothing to do with the conservative pricing that the Saudis instituted in the late 1980s. Here's why: Most Mid East nations expect maximum oil production to happen within a decade. Under such a timetable - they want to maximize short-term revenues. That means a more aggressive OPEC pricing policy.

Fifteen years ago, world crude demand had slowed to a crawl. At the same time, millions of barrels a day were being harvested from the Soviet Union and the North Sea. Saudi Arabia understood that if it set OPEC prices too high, the cartel was certain to lose market share.

Not much chance this will happen today. World oil demand is growing by more than 2 percent annually. The only region rich enough in oil to satisfy this demand is the Middle East.

In the 1980s, Saudi Arabia was getting arms and financial assistance from the United States. In turn, the Saudis exercised their influence to keep oil prices affordable. Following the War on Iraq, that type of goodwill towards the United States no longer exists in the Middle East, or even in Saudi Arabia.

Rather than making life easy for the United States, most of Arab OPEC would like to see things get more difficult... and that means higher oil prices.

Sincerely,

John Myers, for The Daily Reckoning

P.S. The bottom line is we could see another three or even five dollar correction in crude prices. But low oil prices are not part of the future. In fact, I am as convinced as ever that we are headed past $50 a barrel oil by 2006. My advice: don't buy any gas-guzzling SUVs. Do buy oil stocks with significant domestic production.

Editor's note: John Myers - son of the great goldbug C.V. Myers - is the editor of Outstanding Investments. Our man on the scene in Calgary, Mr. Myers has his fingers on the pulse of natural resource profits - including oil, gas, energy and gold. To review his current strategy, please click here:After Iraq... America's Next Crisis! http://www.agora-inc.com/reports/OST/Riches/