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Wednesday, October 3, 2007

Goldman Sachs on the Marginal Price of Oil Being Over $70 Per Barrell

Last night I picked up comments on the Investors Village CWEI board comments on the latest Goldman Sachs report on oil. I felt I should share this report with you. If Goldman Sachs is right then our income investing philosophy will be rewarded because some of the largest dividend paying investments are related to the oil and gas industry.

However, I caution readers on Canadian Oil and Gas Trusts because they are more sensitive to Natural gas prices (except Canadian Oil Sands Trust) and unless the oil:gas ratio improves along with the rising price of oil then the Canroys will continue to struggle.

The Goldman Sachs report talks about a lot of the issues we've discussed. Most interestingly, they believe that the long-term price of oil is determined by the marginal cost of oil production. Marginal cost is defined as the average of the highest cost (or bottom quartile) producers. Their study concludes that marginal costs are now close to $70/bbl. Furthermore, there are no more than 4 million b/d of current production that have a cost greater than $70/bbl, meaning 4 million b/d of extra capacity costing under $70/bbl to bring the long-date price down.

The report is the best I've read. It is the most technical, most numbers based. I've included a couple quotes below. I think oil is going down over the next few days as the dollar has a little bit of a rally here. If it goes down enough, I might add to my already significant positions in preparation for what could end up being a long, hard winter.

Excerpts from the report;

"In July, we argued that a significant increase in Saudi Arabian, Kuwaiti and UAE production by the end of the summer was critical to avoid prices spiking above $90/bbl this autumn. Last week, OPEC announced that it would increase production by only 500 thousand b/d by November 1. We believe that this will be too little, too late, baring an outright collapse in demand, and now expect inventories to draw to critical levels this winter."

"Despite only modest demand growth this past year, anaemic oil supply growth, due to disappointing non-OPEC supply increases and OPEC production cuts, has pushed the market into a significant deficit, which pushed the oil forward curves back into backwardation, creating the first cyclical bull market since 2003 that will likely carry into 2008."

"The current structural bull market, or investment phase, has entered its sixth year; however, the industry has added very little new, low-cost, production capacity as it has run into technological and political bottlenecks that will likely take years to resolve, supporting our view that the investment phase will likely last another five to 10 years. Further, costs have continued to rise, pushing marginal costs closer to $70/bbl, leading us to raise our 5-year forward WTI forecast to $70.00/bbl from $67.50/bbl... "

"Crude oil production during these summer months was nearly 1.0 million b/d below the level a year ago, while demand was averaging more than 1.0 million b/d higher than the level a year ago. This sharp imbalance prevented the normal seasonal build in inventories and has even set the stage for a third quarter draw on stocks, which is a rare event typically associated with significant winter spikes... "

"Net, we now expect inventories to decline by 1.5 million b/d during the fourth quarter versus a seasonal norm of 0.5 million b/d, which will likely cause prices to spike above $90/bbl this winter as inventories are drawn down near critical levels. It is important to emphasize that the current market deficit is being driven more by supply shortages than by excess demand, which is why upside price risks are so high despite significant economic growth concerns. We estimate that during the fourth quarter, demand growth would need to be 1.0 million b/d below our forecast, nearly 1.25%, to create a balanced market with a normal fourth quarter draw of 0.5 million b/d... "

"Given the inability of non-OPEC producers to significantly expand conventional production, we have argued for some time that oil at the margin is no longer pricing conventional oil but rather non-conventional oil such as synthetic crude oil, renewable fuels, and synthetic fuels... "

"1. The energy, water, and labour bottlenecks in the Canadian tar sands are severe and will likely prevent significant scaling up of the supplies at an oil price of $70/bbl, while a substantial change in Canadian policies in order to incentivise the use of nuclear power in tar sands production, and facilitate immigration of much needed foreign engineers appears unlikely in the near term;

"2. The nationalization of the Orinoco belt assets by Venezuela has led to a sharp decline in non-conventional output and no further foreign input of capital;

"3. Biofuel production has substantially driven up agriculture prices, pushing the subsidized cost of many of these fuels anywhere from $65/bbl to $150/bbl with a further scale-up likely to push agriculture prices even higher and hence raise biofuel production costs;

"4. ExxonMobil abandoned its gas-to-liquids (GTL) project due to high costs, the Sasol GTL plant in Qatar has run into technical problems in the ramp-up phase, and the Shell GTL project is significantly over budget, all of which suggest that GTL is off the table at an oil price of $70/bbl...

"If OPEC wishes to push the long-dated oil price down, it would need to offset almost all of the high cost production. However, as the group only has 2.0 to 3.0 b/d of spare capacity at most, it cannot displace the high cost production that supports the long-dated oil price. Instead, it can only control inventory levels, which ultimately controls curve shape..."

"Over the past five years, volumetric exports from the (Gulf Cooperation Council) region have been flat as demand growth has absorbed all of the supply growth..."

"If Saudi Arabia, UAW, and Kuwait ramp production up by 1.0 million b/d, the world would be left with very little spare capacity, which is politically dangerous for the GCC countries as they would have less of a negotiating position that the spare capacity provides, and would be economically dangerous for the consumer countries."

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