The oil squeeze has just begun

Keeping up the pressure

Let me use Mexico's giant Cantarell oil field, the world's second-largest by production, as an example of the extent of the problem.

When Mexican fisherman Rudesindo Cantarell discovered the field named after him in the shallow waters of the Gulf of Mexico in 1971, the first well drilled was a gusher. The oil in the field was under so much pressure that this first well produced 36,000 barrels of oil a day -- compared with the average 200 to 300 barrels. By 1980, Mexican oil company Pemex had sunk more than 200 wells, and the Cantarell field was pumping more than 1 million barrels a day. Production peaked at 2.3 million barrels a day in 2004.

But serious problems were building up under the surface. As Pemex pumped more and more oil out of Cantarell, a highly concentrated field that covers only 70 square miles, pressure in the field began to drop. In 1998, Pemex started injecting nitrogen gas into the rocks in an effort to keep up pressure. Still, more and more water seeped into the field and found its way into Pemex's oil wells.

Technology investments go only so far

That's a common problem in older oil fields, and oil companies have dealt with it by buying and installing expensive pumping and separation equipment to divide the water from the oil in the flow from a well. Some of the oldest wells in Texas can deal with flow that's 99% water.

But Pemex didn't have the money to invest in this basic technology. The capital budget of the national oil company was set by politicians in Mexico City eager to grab as much of the company's revenue as possible for the country's budget. Pemex right now provides about 40% of total government income. Without the cash to invest in water-separation technology, Pemex simply shut any well in the Cantarell field as soon as water content reached 5%. Production at Cantarell fell by 12% in 2006 and is forecast to fall an additional 15% in 2007.

In response, the Mexican government has increased Pemex's capital budget. In 2007, Pemex will invest $2.3 billion in Cantarell. A new water-separation plant will let Pemex handle well output with as much as 9% water. The company began drilling its first horizontal wells in 2006 in an effort to get more oil out of the Cantarell formation. That should slow the decline of production. Pemex projects that production will decline by only 200,000 barrels a day in 2007, about half the decline projected without these steps. But production is still on track to fall to 600,000 barrels a day by 2013 from 1.5 million barrels a day in 2007.

Trading cheap oil for expensive oil

I'm telling you the story of Cantarell in such detail because it is exactly the scenario sketched out by peak oil theory. Much of the controversy surrounding that theory is concentrated on when global oil production will peak. Peak oil believers say global oil production already has peaked or will do so soon. Opponents say that oil production will grow until 2040 or 2050 as new technology opens up new sources of production or gets more out of existing fields.

But the debate over an exact date is largely beside the point. Peak oil, a theory put forward by American oil geologist King Hubbert, describes what will happen as the world moves toward a peak in oil production from conventional sources. Big fields will decline -- at first gently and then rapidly. New finds will become smaller. Finding new oil will become more difficult and more expensive. Producing oil from declining older fields and from these "geologically challenged" new fields will be more difficult and more expensive. The marginal cost of each additional barrel of supply will climb even as it becomes more and more difficult to add enough new barrels to keep production growing.

Look around. Cantarell, the world's second-largest field, is in decline. Kuwait's Burgan field, another top-five field, is showing signs of maturity. The world's biggest field, Ghawar in Saudi Arabia, is either already in decline or is likely to start declining within a decade. Since 1990, only one new field, Kahagan in Kazakhstan, has been discovered that might pump more than 500,000 barrels a day at its peak.

Technology has indeed expanded supply. The percentage of wells drilled that go into production climbed in the 1990s to 45% from 25%. Enhanced production technology has increased the amount of oil that is recovered from an oil field to as high as 60% in some cases, from 20% just a decade or two ago.

But all of this means that we're replacing the cheap oil of the 1990s with expensive oil. The new reserves, the new supplies that result from this technology, the unconventional sources of oil such as Canada's oil sands -- all of these come with higher production costs than the supplies they are replacing. As recently as 1997, the net wellhead cost of Saudi oil was 95 cents a barrel. I've seen estimates that say producers in Canada's oil sands will need oil prices of $60 a barrel to make a 10% profit.

Who profits

You can debate whether the world is running out of oil all you want. It is certain, however, that the world has run out of cheap oil.

Almost any oil stock will profit from that scenario, especially if the company owns oil still in the ground. In an era of rising prices for oil, such companies are sitting on an appreciating asset.

Continued: One company to watch

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