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$100 Oil Isn't as Outlandish as You Might Think

If you came here to find out when oil will reach $100 a barrel, I'm sorry to disappoint. The thousands of factors that go into the price of oil at any given time make it hard to put a timestamp on prices. Demand can wax and wane with global economic growth, and supplies can't always react fast enough to keep prices consistent. Plus, since the word of OPEC carries such gravity with the global market, those without a

-style door into the minds of OPEC ministers have no chance of knowing what prices will do over the next few weeks or months.

What I can say, though, is that there some are situations brewing in the oil market that could lead to much higher prices. Here's a look at what's going on in the oil market that makes $100 a barrel closer to a reality than an oil investor's pipe dream and what investors can do to prepare for that situation.

Image source: Getty Images.

3 million barrels per day have to come from somewhere

The life cycle of an oil reservoir means that producing oil is very much a "three steps forward, two steps back" kind of situation. After a new reservoir is tapped, producers will poke and prod it with several wells until it ramps up to a certain production level. It then plateaus at that production rate for a time until it starts to fall as the reservoir depressurizes. Over the years, we have learned to extend the life of reservoirs with techniques such as water injection, but those techniques can only delay the inevitable.

According to the International Energy Agency, reservoirs that supply approximately 51 million barrels per day (mmbpd) of the world's current production rate of 98.9 mmbpd are in the decline phase of their production life. While the decline rate can vary depending on the type of production, the average across all of these reservoirs is about 6%. That means that to maintain today's production, producers need to bring 3 mmbpd of production into service every year just to maintain current supply rates. That's before we satisfy growing global demand and production decline from places facing political issues.

Sobriety after the hangover

From 2007 to 2014, oil producers were drunk on $100 oil. Fears of "peak oil" and the possibility that we won't be able to find enough oil to satisfy our needs led to outlandish capital spending budgets on projects that were barely economical at prices anywhere less than triple digits and helped incubate the development of shale in the United States. Once many of those megaprojects went live and producers found the secret sauce to extract shale oil, though, it led to a rush of supply that crashed prices all the way to less than $30 a barrel.

With so little cash coming in the door, companies slashed their capital spending budgets to the bone and didn't sanction new projects. Many were able to at least sustain themselves by boosting production from existing sources or from the projects still under construction. However, many avoided sanctioning new exploration or development work like a person swearing off alcohol after a bad hangover.

However, that queue of new development projects has been drying up quickly, and now there is a situation where the number of projects set to go live over the next few years is paltry at best. According to private equity company Burggraben Holding, production capacity additions from scheduled projects under construction are between 1 to 1.5 mmbpd each year from 2019 to 2022. Those numbers mean we will need to find and develop a lot of oil production over a short amount of time just to maintain current production rates.

Image source: Getty Images.

Shale the savior? OPEC the overseer of oil prices? Maybe, maybe not

Those production capacity additions exclude two key swing factors in today's oil market: Shale production growth and OPEC tapping its spare capacity. Shale oil in the U.S. has proven to be incredibly resilient at low prices, and prices where they are today have producers seeing dollar signs. In less than two years, shale producers have increased total U.S. capacity by 2.5 million barrels per day.

I don't doubt shale producers' ability to increase output at a breakneck pace, but that isn't the limiting factor to the U.S. supplying the global market. What will restrict oil production from the U.S. will be how quickly companies can lay pipelines and build export terminals. We're already seeing a situation emerge where U.S. crude oil prices are as much as $10 per barrel less than international prices because there isn't enough takeaway and export capacity to keep pace with production growth in the oil patch. With transportation being the limiting factor, it will take longer for shale to move its product to the global market.

So what about the 800-lb. gorilla that is OPEC? It could surely step in and put a lid on outrageously growing oil prices, right? While, again, I can't say with any certainty what those within the organization are thinking, one thing is more certain. The lever it can use to control prices -- its spare capacity -- isn't as big as it once was.

OPEC's total spare capacity -- the amount of potential production it has at the ready -- is a closely guarded secret. According to Robert McNally's book Crude Volatility: The History and Future of Boom-Bust Oil Prices, the best guess we have is that total OPEC spare capacity is somewhere between 2 and 3 mmbpd. That sounds like a lot, but 3 mmbpd doesn't mean what it did 20, 10, or even five years ago. Total spare capacity is about 3% of global production. Over the past 60 years, the only other times spare capacity was that low was during the Gulf War in 1990 and height of the peak oil panic from 2005-2007. The smaller the percentage of global production OPEC's spare capacity becomes, the harder it is to dictate prices.

Brent Crude Oil Spot Price data by YCharts.

What's an investor to do?

Again, I didn't take Professor Trelawney's divination class at Hogwarts, so I can't predict when oil prices will hit $100 a barrel or if they will get there at all. Based on the natural decline of existing sources, the lack of capacity additions over the next several years, and the slightly limited ability of today's swing producers to make up for shortfalls elsewhere, there is a path to getting to triple-digit oil prices.

Keep in mind, though, that the remedy for high oil prices is high oil prices. It's not hard envisioning a situation where producers get wasted on high oil prices again and start spending lavish amounts of money on new developments. So for investors today, it seems like an opportune time to invest in companies that will benefit immensely from higher international oil prices and those companies that will be the direct beneficiaries of increased capital spending. Just don't wait until prices have hit those astronomical prices to invest because it could preclude the next epic price crash.

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