APS Energy Group: Alternative Fuels Overtake Conventional Oil In Many Markets.

"What is happening to world oil prices and the global economy now", notes a report by the APS Energy Group, "seems to be yielding implications which, put together, could have as big - if not bigger - an impact on mankind than those of World War II. This impact could change the way we do things, if world crude oil prices remain above an average of $25/barrel - in today's US dollars and at today's inflation rate - through the next two years".

The report says high oil prices since late 2002 have caused the emergence of two irreversible trends: (1) World demand for energy is strong and is no longer as dependent on the strength of the global economy - with demand for oil in 2004 rising by almost 3%. (2) A worldwide shift to alternative fuels has begun and can only accelerate. Alternative fuels have become more competitive than at any time before, thanks to technology.

"What is also irreversible is OPEC's resolve to keep preventing the average market price of conventional crude oil from falling below $25/barrel in today's US dollars and at today's inflation rate. This resolve keeps getting stronger - or more stubborn - as the real cash value of the US dollar keeps falling".

Today's economic cycle - in Wall Street terms of defining the old economy - "is the cycle of commodities rather than the cycle of equity". This means "it is the cycle of speculators", led by hedge funds which are huge, having shifted away from company stocks and bonds to conventional oil, metals, etc.

However, the report says, the first of the two new trends is not in favour of conventional oil which has become too expensive despite the fact that it is still about $35/barrel cheaper than its 1981 cash value adjusted to inflation and exchange rate fluctuations. Nor is the first trend in favour of natural gas, which still depends on the value of conventional oil.

On the other hand, it adds, if and when the speculators switch from conventional oil to alternative fuels - a development which is not likely to materialise in the near future - "the market value of conventional crude oil would fall quickly to at least half its current price".

The report says this could either hasten or delay the day when world production of conventional oil has reached its peak. The difference between these two scenarios for conventional oil will depend on "the speed of progress in technologies which already have made alternative fuels competitive".

The real cash value of alternative fuels in current US dollar terms and at today's rate of inflation in the US - on average for the whole range of alternatives available in markets on both sides of Suez - "is in the range of about $20-35/barrel".

It is in view of the above reality that both OPEC and non-OPEC exporters of conventional oil have made a grave mistake - from their perspective - since late 2002. That was when Venezuela went on strike causing its oil production to stop and OPEC quietly froze its $22-28/b price defence mechanism. OPEC then let the market price of its conventional oil exports rise as a result of a tight supply situation.

So while high oil prices may affect the global economy in the short term, the report says world demand for conventional oil will begin falling considerably from 2005. While no one knows when - or if ever - high prices for conventional oil will cause the next global economic recession, "no one can predict what will happen to mankind as a result of the two new irreversible trends". This is simply because "the two trends are beginning to create new fundamentals and new factors to the world's economy and geo-politics which are not known to any of us today and on the basis of which the future could, perhaps, be completely different from the one forecasters of the global economy have pictured most recently".

Coal gasification processes, which produce clean fuels (gas and liquid), belong to only one of many categories of alternative sources of energy that have become competitive. The world, including China and the US, has huge reserves of coal which can be converted to clean fuels. A number of companies have developed such processes. Shell's proprietary coal gasification process is one of them.

Of the many categories of alternative sources of energy including renewables examined, APS Energy Group's report focuses on synthetic crude oil. It noted that already since late 2002 synthetic crude oils from bitumen in Canada and Venezuela had become cheaper than conventional oil. Now production of synthetic crude oils from bitumen exceeds 800,000 b/d, and should reach more than 3.5m b/d by 2014. It says this forecast is conservative as it is limited to Venezuela (now producing 500,000 b/d and to reach 1m b/d before 2014) and Canada (now producing more than 300,000 b/d and to reach well over 2.5m b/d by 2014). There are several other countries in the world which have fairly large bitumen, or tar sand, resources which can be developed at top speed, because the price incentive is so high - now a net profit of about $16-18/b.

Yet, synthetic crude oil and nuclear energy, combined with other alternative fuels, did not constitute a new trend until front-month WTI rose above $50/b at NYMEX in recent weeks. "This trend has just become irreversible", in terms of market structure and global economics.

The cost of producing synthetic crude oils in Venezuela's Orinoco bitumen area and in Canada in recent weeks averaged about $16-18/barrel - i.e. less than half the market price of the heaviest and most sour among conventional crude oils. This is why President Hugo Chavez recently decided to raise the royalty on synthetic oil (syncrude) E&P ventures from 1% to 16.7%. But the way Chavez announced his move will have negative implications for the reputation of his populist regime.

The report forecasts that, if other countries exploit their bitumen resources, with multi-nationals and smaller investors using technologies developed in Canada and Venezuela, world output of syncrude may reach between 5m b/d and 15m b/d by 2014 - depending on a conventional heavy crude oil price average of $25/b (in today's US dollars and at today's inflation rate in the US) in the lower output case, or $35/b in the upper production case. It says even this forecast is conservative as "bitumen extraction technologies are bound to improve and cut costs further, which means syncrude production by 2014 could be higher in both cases".