Increasingly the economists and politicians discussing the current economic downturn are referencing the early 1980s recession, or in some cases the 1973-74 recession. Both of these recessions were hard and lasted about 16 months, whereas the current recession is only 13 months old, but is already a challenging one. There has also been talk by economists and stock market seers about how the current recession could morph into the next Great Depression. Unfortunately, a Great Depression comparison provides little help for investors trying to understand how energy markets might be affected. The International Energy Agency (IEA) in its recent oil demand forecasts has been commenting that the back-to-back declines of 2008 and 2009 would mark the first time for that to occur since 1982-1983, some 25 years ago.

In our November examination of the possible future course of the U.S. drilling rig count, we used the 1980s downturn to plot how the current rig count downturn might unfold if this one were similar. At the time, we speculated that if this cycle's rig count fall followed the 1980s downturn pattern, we were at risk of losing about 1,000 rigs from peak to trough. Now, we are seeing and hearing estimates that this rig downturn will be so severe, largely because of how low natural gas prices have fallen and the absence of a catalyst for them to rise soon, that the rig count could fall to a low of 800 active rigs. We have had discussions with various drilling company management teams who suggest, based on the rate of weekly rig count declines that we could reach that target sooner rather than later. It's amazing how, when things come unglued, the outlook rapidly shifts to the catastrophe scenario. Maybe it's because people want to emulate President Obama.

If the U.S. rig count reaches the 800 working rig number sometime this year, the drilling industry will have lost about 1,200 active rigs from its peak activity level last fall. With that many rigs going idle, it will be extremely difficult for drilling contractors to sustain profitability and if a contractor has significant debt levels, companies may have issues with remaining in business. On the other hand, the level of optimism within the drilling contractor fraternity that this downturn will be quick to rebound is keeping managements focused on where the geographic strength will be on the upside.

The key question, however, is will the global economy remain depressed for several years making the energy demand forecasts of almost all analysts wrong, and suggesting that 2010 will be another down year for energy consumption rather than a year of demand recovery? As we have pointed out before, the 1980s downturn actually lasted for four years. The peak in oil demand came in 1979 and growth resumed in 1984. It was not until 1989, however, that global oil use exceeded the total consumed in 1979. Could a multiyear oil consumption downturn happen today?

There were several factors at work in the early 1980s downturn that contributed to it lasting as long as it did. First was the scope of the economic problems that led to the recession. Second was the energy-consumption adjustments undertaken by the United States, Europe and Japanese economies in response to the dramatic climb in oil prices that began in 1973. Third was the oil supply response driven by the fear of oil shortages and the correspondingly high oil prices experienced throughout the ‘70s. Let's examine these issues and whether any of them exist today.

The 1970s was a decade marked by seismic social and economic shifts that radically altered the global status quo. The social stresses and economic turmoil that came from the Vietnam War and the various attempts to resolve it resulted in an accelerated inflation rate by the end of 1960s. Early in the 1970s, the automatic inflationprotection clauses incorporated into union labor contracts in the late 1960s in response to that period's increase in inflation began topressure the economy, even though the actual inflation rate, as measured by the consumer price index (CPI), was moderating. In fact, in 1970, the inflation rate flirted with 6% before falling back, but it remained above 4%, a rate thought to be intolerable. On August 15, 1971, President Nixon instituted wage and price controls on the United States economy along with ending the exchangeability of dollars for gold bullion. These were unique acts in peace-time, but they were supposed to only last for 90 days, but instead ended up lasting for 1,000. With the August pronouncement, the future course of the United States economy, and that of the world, was altered permanently. The change set in motion actions and reactions that have shaped our world.

In the energy world, seismic shifts were also occurring at this time. The low and regulated natural gas prices of the 1960s contributed to the U.S. beginning to run out of gas supply. To offset that eventuality, gas consumers began substituting oil for gas. The growth in global oil consumption began to strain supplies, especially as the United States, the world's largest oil producer, hit peak production and began to decline. As these shifts were occurring, the Seven Sisters international oil companies commenced efforts to reduce the Middle East posted price for crude oil on which the royalties owed to the host producing countries, primarily those countries that were members of the Organization of Oil Exporting Countries (OPEC), were based. This effort angered those countries and, as the global oil supply/demand balance tightened, emboldened them to push for higher prices, increased taxes and eventually the partial nationalization of the production concessions. The shift in oil supply/demand fundamentals was altering the power in the global energy market in favor of OPEC.

While most people associate the Arab oil producers' embargo of those western countries that supported Israel in the 1973 Six Day War, as the start of the rise in oil prices, the reality is that underlying oil market supply/demand trends had become sufficiently tight that producers could begin to extract economic rent for providing their oil to the market earlier in the decade. From $1.80 a barrel in 1970, posted oil prices rose to $2.55 by early 1971 and were then pushed up to $3.45. In response to rising inflation and depreciation of the U.S. dollar, OPEC members lifted oil prices and tax rates higher, and increasingly gained more control over the oil producing concessions they had granted to the international oil companies decades earlier. By the start of the fourth Arab-Israeli war on October 6, 1973, posted oil prices had climbed to $5.12 a barrel. A couple of weeks after the war, Arab oil producing countries imposed their embargo and in December, OPEC boosted oil prices to $11.65 a barrel, effective January 1, 1974.

In response to these energy industry dynamics, the Nixon Administration moved to put controls on oil prices leading to the August 17, 1973, announcement of a new, two-tier pricing regime -- "old" oil, that oil produced at or below 1972's average production level and sold at a March 1973 prices plus $0.35 a barrel and "new" oil, or the oil produced in excess of 1972's average production level that was sold at uncontrolled prices. This intersection of politics and regulation distorted the oil market pricing mechanism and triggered the 1970s oil boom, which ultimately led to the industry's 15-year recession.

Most people remember the 1970s as a period of escalating oil prices, accelerating inflation, and severe government regulation. The reality is that oil prices jumped fourfold in 1973, remained essentially flat until 1978 when the Iranian revolution overthrew that country's government and resulted in the removal of its oil from the world market sending oil prices from the mid-teens to the midthirties. The subsequent Iran-Iraq war sent global oil prices to the upper thirties per barrel. This explosion in oil prices, coupled with the psychological impact of the Malthusian view of the globe's future -- too many people, not enough food nor sufficient raw materials to support them -- contributed to a bleak outlook for living standards.

Out of the explosion of oil prices early in the 1970s emerged a huge energy conservation effort throughout the western world -- the globe's primary consumer of oil and gas. More efficient automobiles and household appliances; increased energy efficiency building standards; and greater use of nuclear and non-hydrocarbon fuel sources for power generation marked the world of the 1980s. That can best be seen in the United States by the impact of the amount of liquid petroleum fuel used to generate electricity compared to that sourced from natural gas. Coal also increased its contribution to the power generation mix.

This is a reason why the world's demand for oil fell in the early 1980s and was slow to recover as the decade wore on. These energy conservation and fuel-switching trends were in addition to the decline in oil demand due to the economic recession set in motion by the harsh monetary policies implemented at the start of the 1980s in an attempt to break the back of the rampant inflation in the United States that had spread globally. The U.S. Federal Reserve took actions to push short-term interest rates above 20%, crippling manufacturing and commerce and undercutting consumer demand. The effect, however, was to cut the inflation rate in half to 6.2% in 1982 from 13.2% in 1980 and cut it in half again to 3.2% in 1983. But the resulting revival in economic activity did not reverse the energy efficiency gains put in motion during the second half of the 1970s.

For the four years 1980-1983, global oil consumption fell by a cumulative 6.5 million barrels a day. This consumption fall amounted to 7.5% of global oil consumption from 1979's peak. Had this been the only oil market dynamic at work, the members of OPEC may have been able to compensate and prevent the cataclysmic fall in oil prices experienced in the mid 1980s as oil fell from $38 a barrel to $28 and then collapsed to near $10 before the bottom was reached. The other significant dynamic at work during this period was the growth in non-OPEC production stimulated by the twin factors of oil supply shortages and high prices.

The 1973 oil embargo set off alarm bells within the oil industry and governments that the world's consumers could potentially be held captive to politically motivated oil supply shortages. Coupled with high oil prices, the petroleum industry embarked on a global exploration surge that resulted in the development of the hydrocarbon resources on Alaska's North Slope and offshore England and Norway in the North Sea. These new producing areas were also assisted in expanding non-OPEC oil supplies by growing oil production in Mexico and Brazil – although its increased production merely offset imports freeing up additional oil supplies for western governments to purchase.

While these new supply basins had begun production during the 1970s, they matured as large and sustainable supply sources in the 1980s. The fall in global oil demand and the rise in OECD oil supplies combined to pressure OPEC's share of world oil production. The loss of oil sales because of growing non-OPEC supplies created economic problems for the OPEC member countries. Those OPEC countries facing the greatest economic pressures from falling oil prices cheated on the reduced OPEC production quotas designed to help stem the oil price decline. As oil supplies in the global market grew, oil prices collapsed. This price collapse was a contributing factor in the battle to reestablish low inflation worldwide and it helped to stimulate a global economic recovery that eventually became one of the longest sustained economic growth periods in history.

When we look at the global energy market today what do we see? Demand is falling, and each month the demand forecasts are ratcheted down as global economic growth projections are revised lower. Since February 2008, the IMF has reduced its 2009 outlook for world economic growth from 3.0% to 2.2% and now to 0.5%. Traditionally, a 2% growth rate has been considered the point below which the world enters a recession. For 2010, the IMF expects worldwide economic growth of 3.0%, but it calls for the advanced economies of the world, which includes the OECD countries, to recover but their growth will still be less than half the growth rate experienced in 2007. The developing Asian economies are expected to have a dramatic snapback in growth in 2010, but it also will be meaningfully less than in 2007.

The question for the energy market is whether the 2009 economic growth forecast holds at its barely positive rate and 2010's projection is revised meaningfully lower. At the moment, the more negative economic forecasters seem to be driving the outlook for the world's growth, or lack thereof. If there is a recovery in global economic activity that is above 2.0%, then we should probably be looking for higher oil demand. Just how high is debatable.

The other side of the oil demand coin is oil supply, and here the case for higher oil prices is stronger. While the world had about six countries experiencing oil production declines in 1980, today that number is more like 25 with a growing number of countries struggling to avoid falling into that category. In five years, we could have another 15-30 countries that have gone beyond their peak production capacity. That outlook begs a question: Where are the next North Slopes and North Seas? At the present time, these basins are in decline so the petroleum industry is working hard to slow the rates of decline while acknowledging that these basins are not going to be sources of new oil supplies.

By examining the production history and projected future production of one of the key non-OPEC basins, one can see the challenge facing the oil industry, and in turn, the world's economy. Norway commenced offshore oil production in 1970. Production grew fairly steadily until it reached peak production about the turn of this century. From that point, Norway's oil production has been in a steady decline that, with the help of some new discoveries and enhanced production, may be arrested for a brief time before then resuming its projected rapid rate of decline. Whether the oil industry is able to bring forth these additional resources or not will depend upon both technology and economics, each of which has their own unique challenges at the present time.

Maybe offshore Brazil will be the new North Slope and North Sea, but it will be a long time in coming and the oil will be expensive to produce. The country has found several potentially huge new oil discoveries in deep water and under salt formations, but no one is completely sure how easily these reservoirs will be developed and at what cost. In the mean time, the issue is whether global demand will continue to fall as it did in the 1980s. Most authoritative forecasts call for an upturn in oil consumption beginning in 2010, but those forecasts are predicated on economic projections calling for the current economic recession to end by then, also.

We believe that unless a worldwide global initiative to address the global warming concerns is undertaken and it leads to everyone radically changing energy consumption habits, energy demand growth will resume with a recovery in economic activity. Cap-andtrade or a carbon tax have the potential for raising the cost of carbon associated with hydrocarbon resources and altering the desirability of particular fuels, but probably not lowering total energy demand.

Until these systems are in place and functioning well, the needs and desires for improved lifestyles driven by population growth will push increased energy consumption. All the best forecasts predict that the maximum effort from alternative fuels will not displace a significant volume of hydrocarbon fuel. While natural gas might displace a certain volume of oil used for gasoline the transition will not happen in a meaningful way anytime soon. The issue for the oil industry will be capital availability to fund the development of the world's known resources. The future for oil and gas prices is tied to supply and demand fundamentals and an indicator of where oil prices may be headed in the near term is tied to OPEC's surplus productive capacity. At the moment with rapidly falling demand, OPEC is facing a growing production surplus.

Compared to the surplus productive capacity OPEC battled in the mid 1980s, this surplus is not serious and will probably turn out to be a transitory trend. The forecast surplus should be about five million barrels per day of capacity in 2010 compared to over 10 million barrels per day in 1985 when world oil consumption was substantially lower than today. Moreover, that surplus was the result of growing oil supplies from new producing basins.

The 1980s were marked by growing non-OPEC oil supplies and radically altered demand patterns that hampered the ability of OPEC to deal with the rapid and large production surplus. Those two key conditions do not exist today, and from all the available evidence are not likely to emerge anytime soon. In the near-term, demand is the critical issue, but barring another Great Depression killing economic activity for a number of years, the global oil market will be selfcorrecting, and quite possibly faster than many people think.



Reprinted with permission from PPH & B