Bizarre Economics: Why High Oil Prices Have Reduced Supply

High oil prices are reducing oil supply.

I know this sounds crazy... after all, one of the most basic laws of human behavior dictates that if a product soars in price, folks will come out of the woodwork to produce and increase supply. In today's case, the price of oil is up 256% in the past five years.

The soaring price of oil is causing something funny to happen to the world's oil supply. Oil-producing countries like Ecuador, Venezuela, Russia, and Nigeria sit on unbelievable stores of wealth... and they're not keen on sharing it with anyone... especially a Western oil company. Ask an oilman who's done business in Russia or Venezuela recently, and he'll simply shake his head.

I've got no problem with a country legally protecting its interests... but here's the problem: Most government oil companies aren't as efficient at producing oil as the public companies that must operate at a profit or die.

Companies like ConocoPhillips and ExxonMobil are forced into less promising areas... which drives up production costs... which drives up oil prices. I recently read a report that claimed oil producers must now spend twice the money for one-third less production than they did six years ago. These diminishing returns are hard on shareholders.

And so is Hugo Chavez... The big man of Latin America just stole billions of barrels of oil from a whole set of oil companies, including Statoil, ConocoPhillips, and ExxonMobil. Ecuador is doing much the same thing to Occidental, and Bolivia with Repsol and Total. In fact, the disease is spreading. Nigeria is considering a similar route.

Major oil companies take all the financial risk of exploring for oil... conducting geologic analysis, putting crews in the field, building camps and roads, and doing all the work that leads to the drill bit being put to ground. If they're wrong, they're left with nothing. If they're right, they'll find a giant field that produces for years to come.

Nationalization changes that calculation entirely. Companies still take all the risk, but governments bank all the rewards. Less return to oil companies means less investment in exploration. In the end, nationalization will lead to much higher oil prices.

Hugo Chavez hired his cousin to run PDVSA, the state oil company. In spite of record oil prices, the company ran up $12 billion in debt in 2007. In addition, it could wind up responsible for another $10 billion in compensation to Exxon.

That kind of nepotism will eventually destroy the petroleum industry in many of these countries, much as it's done in Mexico. Pemex, the national oil company, is now more than $42 billion in debt, and its single best asset, the Cantarell field, is a debacle. Its production is declining precipitously (down 28% in 2006 alone).

In the meantime, demand for oil is rising... relentlessly.

China, for example, plans to build at least eight 200,000-barrel-per-day refineries in the next five years, which will compete with the U.S. refiners for supply. And, paradoxically, higher oil prices have led to higher demand in the Middle East, as oil wealth trickles down.

So where does that leave us?

Canada. Much of the world – and its oil companies – have turned to Canada for a solution. Canada holds some of the largest untapped oil reserves. It's in the most politically stable region of the world. It's protected by the world's greatest military power.

Even better, Canada still lets oil companies enjoy the rewards for taking risks. And the risks are low – the oil is easy to find. It's not like drilling through a mile of ocean and two miles of sediments. You only need to drill down about 500 feet...

Canada is already the U.S.'s favorite oil supplier. We buy nearly 18% of our crude oil imports from Canada. In fact, by the end of 2007, Canada supplied more oil to the U.S. than all the Persian Gulf states combined.

Investors in Canada's enormous oil industry can sit back and watch the antics of Venezuela and their ilk without worry. All that fuss is just making Canada's resources more and more valuable.

Good investing,

Matt Badiali