Drawing on current futures curves and the investment threshold for upstream projects, the International Energy Agency (IEA) reported that not only does oil look extremely tight over the next five years, but it coincides with the prospects of even tighter natural gas markets.

The IEA’s “Medium-Term Oil Market Report,” which was released on Monday, forecasted supply and demand potential for crude and petroleum products over the next five years.

Despite an increase in biofuels production and a “bunching” of supply projects planned over the next few years, spare capacity by the Organization of Petroleum Exporting Countries (OPEC) will remain “relatively constrained before 2009” when slowing upstream capacity growth and accelerating demand by countries that do not participate in the free market Organization for Economic Cooperation and Development (OECD) pull it down to “uncomfortably low levels,” the report stated.

“But the oil market cannot be looked at in isolation,” the authors noted in the 82-page analysis. “Over the past 25 years there has been substitution away from fuel oil and toward natural gas. However, when natural gas supplies have been insufficient or there have been supply problems (such as those seen following Hurricanes Katrina and Rita in 2005, Russia in 2006), fuel oil has been the natural substitute.”

By 2010, this flexibility between oil and gas may be constrained, “producing upward pressures on all hydrocarbons,” the report stated. “Slower-than-expected GDP [gross domestic product] growth may provide a breathing space, but it is abundantly clear that if the path of demand does not change on its own, it may well be driven to change by higher prices.”

The authors noted that “substantially higher cash returns to shareholders stand in curious contrast to growing upstream supply tightness and essentially unchanged exploration and production (E&P) effort.” Nominal,” they said, “E&P expenditures are up, but higher costs have eroded their purchasing power commensurately.”

Other issues also are at work. In particular, the analysis noted the following:

“The potential effects of a combination of low OPEC spare capacity and slow non-OPEC production growth are of significant concern — all the more so when considered alongside tightness in other hydrocarbons — particularly the natural gas market,” the report stated.

The IEA’s “Gas Market Review 2007,” which was published in May, noted that gas output in IEA member countries is either on a plateau or, in several countries, declining at a rapid rate (see Daily GPI, May 7). At the same time, demand remains strong.

“While in the medium to longer term (post-2015), investment in coal and nuclear power could ameliorate matters, investment impediments may force investors back to gas,” the IEA stated. “Oil and gas price pressures look set to remain in the coming years.”

The sequential analysis in the IEA’s latest oil review suggests that while gas markets may look to fuel oil as an alternative, fuel oil supplies themselves will tighten.

“Ultimately this may lead to upward pressure on fuel oil and gas prices until electricity or industrial demand growth abates,” the authors noted. “Further, it raises serious concerns for gas market security, whereby the most cost-effective solution in many countries is to switch to fuel oil in the event of a supply disruption — fostering competition for supplies across the hydrocarbon sector.”

In the past three years, U.S. natural gas prices have dictated fuel oil demand, “but the increasing sophistication of the refining system is likely to foster a stronger price effect as demand fluctuates between the heavy and the light end of the barrel. Therefore, if natural gas supply growth proves lower than needed, there could well be a period of strong price competition between all forms of hydrocarbons.”

Cost inflation for raw materials, service and drilling capacity “shows some signs of moderating, although industry consensus points to a leveling in upstream costs rather than a substantial fall,” according to the report. “Healthy spending increases have therefore largely been absorbed by double-digit inflation, limiting any automatic feed-through of high prices into incremental discoveries and production. Nor has there been a discernable rise in exploration’s share of upstream spending, or in net reserve additions, despite sustained high prices, although access and regulatory uncertainty, borne partly of a spate of resource nationalism, partly explain this.”

Given the current tight labor and service markets, “any attempt to boost exploration activity presently might do more to fuel further inflation rather than generate extra oil,” the analysis found. “Delays in natural gas expansion are another factor that can be added to the list of potential impediments to higher oil supply.” And project delays are a “key drag” on non-OPEC and OPEC capacity growth alike.

“Overall, delayed new field start-ups accounted for 35% of shortfalls versus original OECD forecast for 2004, and 65% in 2005 and 2006. Slippage by project varies in severity from several months to several years. In extreme cases such as the Thunder Horse project in the U.S. Gulf of Mexico, delays have pushed back start-up of 250 kb/d of production from an initially targeted summer 2005, to a latest estimate of end-2008” (see Daily GPI, Sept. 19, 2006).

“Other projects may not face the same litany of problems as Thunder Horse, but as incremental non-OPEC supply becomes increasingly concentrated in technologically challenging areas, so cost overruns and delays will remain part of the industrial landscape.”

To read the report, visit www.oilmarketreport.org.

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