ASPO-USA’s Steve Andrews recently hooked up with Matthew R. Simmons, chairman of Simmons & Company, Int’l, for a lengthy interview.  In Part 2, Matt challenges current conventional wisdom about the degree of on-going demand destruction and other issues.

 Question:  What are the big differences between the demand drops post-1978 and today?

Simmons:  They’re as comparable as the Crimean War and the Vietnam War.  I recently heard Leo Drollas and Ed Morse presentations in which they lamented that “we should have learned from 1979 that high oil prices kill demand: they always have, they always will.” I have told people over the last few months that today has no earthly resemblance to what happened in 1979.  When oil prices were still rising in 1979, the world was seriously rolling out the only new form of energy in the 20th Century-atomic energy.  It had been building for 15 years and that wasn’t in response to $30 oil.  In 1979, we were still bringing in oil from three of the last great frontiers, all discovered in 1967-69: Western Siberia, the North Slope of Alaska, and the North Sea. High oil prices kept those expensive projects afloat. 

Crude oil demand grew from 46 million b/d in 1970 to its then-all-time high of 62.7 mb in 1979.  The enormous swing in price-from $2 a barrel to $35 a barrel, from 1970 to 1979-didn’t slow demand.  By 1983, demand did drop to 53.3 million b/d.  The four major demand reduction drivers were fuel-switching to nuclear, fuel-switching to coal, vehicle efficiency and off-shoring heavy industry.  So only a fraction of the decline in demand came from what everyone has said for two generations: “high oil prices worked…consumers changed their habits.”

With respect to demand today, some of the OECD countries are now very mature and haven’t been growing their populations or economies.  Japan and parts of Europe are pretty gray, pretty mature, so we shouldn’t be expecting robust growth in either their economies or in oil demand.

 Over the course of the 12 months preceding the price collapse, when we had oil going from $70 to $145 and backing off to $120, we had only a deminimus change in a few of our key demand markets for oil, even though we were capping off a decade-long rise of 15-fold in oil prices. That’s a little reminiscent of the 1970s, when oil prices rose 10-fold, though demand rose until the end.  The higher that oil prices went last year, the more that people who had staked their careers betting this would never happen said “supply is going to soar, and demand must be falling.”

Along came June-July-August numbers out of the EIA, which are the only sort-of-reliable near-term estimates we have on demand.  People started to observe that we’ve finally seen a crack in gasoline demand, starting to decline year-over-year.  All sorts of stories started circulating how gasoline demand has finally turned down for the first time since 1990. 

In July in Maine, which is peak tourist season, many of the gas stations we passed were down to one pump in operation.  When I asked why, I was told their supply was being allocated, restricted.  At least one of the distributors had small gas stations on credit watch, since they were lending them product to the tune of $400,000, leading to large exposure for skinny margins.  So they were limiting supply to avoid write-offs from dealers that might go bust. 

In the spring of 2007, I spoke with Linda Cook at the EIA event in April.  I said that with gasoline stocks at such unbelievably low levels, we need to be concerned about potential shortages leading to a panic that people would respond to by  topping up their tanks, which could dry the system dry in two or three days.  I asked her if they had ever considered this, and the need to possibly print up rationing tickets.  She did, and said she was laughed at-“Linda, you’re hallucinating.” She said she had been noticing that at service stations in the Beltway area, when she looked at the last purchases on the pumps, a lot of them were at $5 or $10, rather than filling up.  People were driving around with just-enough gasoline in order to avoid having to pay for a full tank.  Last summer, AAA reported that they had a 17% increase in their use of tow trucks for people who had run out of gas.

Then came September, and we had the big collapse, because we had two back-to-back hurricanes.  Right after Ike hit, Houston was without power for the better part of two weeks.  Refineries, with their own generators, were without power just long enough that we had service stations with outages that spread all across the south, as far up as Maryland.  Only the Atlanta part of the story was covered, other than by local news, because the national news was being totally dominated by failures of Lehman Bros., AIG, Merrill Lynch, etc.  Had we not had the financial meltdowns, those other stories would have been covered, then motorists would probably have topped up their tanks and we would have run out of gas. 

EIA’s weekly data in September was total junk because nobody was around in the Gulf Coast to measure it.  In late October, by the time they released their monthly report for September, it showed a gasoline decline of 11%.  People were saying, “high prices started this avalanche, but it’s cascading.”

At the recent Yamani Conference, Paul Horshnell, who does a fabulous job, said that we’ve seen the worst of the demand destruction in the US, which clearly had to be impacted by the hurricanes.  But when you look at the IEA’s demand drop for 2009, two-thirds is coming from the US, based on the assumption that the third quarter wasn’t an aberration but a trend.  Yet if you look at gasoline consumption over the last five months, gasoline consumption is up 2%, then down 2%, then up again.  Diesel fuel is still down about 10%, but most of that is exports.  Then jet fuel is down 10%. Relative to the price collapse, you would expect a major drop as opposed to the modulation we’ve seen.   It’s more or less unchanged, vs. a headline story.

But what I’m now sure of is that, in North America-in the only easy place in the world to stop drilling-we have stopped drilling.  Hopefully we’re getting towards the bottom of the decline, but the decline has been savage.  Around the rest of the world, we’re slowing down every planned project that is supposed to be getting started, and a lot of things needed to complete ongoing projects are being put on hold.  There is an enormous effort by the major oil companies to use this low-price environment to finally get oil services inflation under control.  While there is a lot of lip service going around that their budgets remain unchanged, the fact of the matter is that they’re killing their contractors. BP apparently sent out a letter to all their suppliers saying “BP has a large budget for this time of year, but if you want part of it drop your costs by 30%.” 

Question: Even with all the storage topped up and all the so-called floating storage…?

Simmons: The latter is a bunch of BS.  First of all, to play that game, it would basically mean that for the idea of possibly capturing some found money, you somehow airlifted oil out onto a tanker and you figured that somehow or other you’ll deliver it at Cushing. The near-month price for WTI was the only month that had this sharp contango; the others were way higher.  Do you know how much it would cost to store 80 million barrels? Over $5 billion. It’s an extremely expensive game to play, which is why no one does it, other than in the minds of oil traders.  Every time the price collapses, you gotta have a reason for it. 

Our finished supplies of gasoline are down to 89 million barrels.  We’re back to where we generally are after a long savage hurricane.  So we better hope that motor gasoline demand is way down because our stocks are very skinny.  Stocks of crude are back where they were in April-June of 2007.  They are on the high side of the historic averages, but for the last five years we’ve bounced around the lowest levels we’ve ever had.  Back in 2007, we weren’t saying we’re drowning in oil. 

If we don’t see a snap-back in prices for three to six to nine months, we should start preparing ourselves for a very large loss in supply, and brace ourselves for a shortage, unless suddenly demand does start to plunge, which so far it hasn’t done.  If oil prices just stay unchanged for 18 months, or just bounce around with no confidence, then the industry will say, “Oh, that was a mistake, we need to start drilling!”  The lag time in getting started is another 18 months.  In 30 months, we could find crude oil supply-which was 72.2 million barrels a day in the fourth quarter, according to EIA estimates-down to 66.5 million b/d, with worst case at 59.6 mb/d.  That’s obviously an utter catastrophe. 

So, the difference between today and 10 years ago, when we had the “Asian flu,” is that the rig count recovered very quickly back then so we only had about 9 months when things could have really started to hurt.  It snapped back so sharply.  Also, back then we didn’t have decline curves nearly as vicious as we do today.  The market in 1997 was tight as a drum until about the end of the year.  It started weakening as 1998 progressed and then the surprise collapse grew momentum.  In September 1998 I remember talk of stacking rigs, but six months later we were off to the races. 

[Footnote: in December 1998, the EIA forecast that demand and oil prices would remain lower-the $14 range was cited-through 2007, thanks in large part to the Asian flu.]