Keith
----------
http://www.economist.com/displaystory.cfm?story_id=3884623
or
http://www.commoditytrader.com/archives/000233.php
Oil in troubled waters
Apr 28th 2005
From The Economist print edition
Prices are sky-high, with profits to match. But looking further
ahead, the industry faces wrenching change, says Vijay Vaitheeswaran
"THE time when we could count on cheap oil and even cheaper natural
gas is clearly ending." That was the gloomy forecast delivered in
February by Dave O'Reilly, the chairman of Chevron Texaco, to
hundreds of oilmen gathered for a conference in Houston. The
following month, Venezuela's President Hugo Chavez gleefully echoed
the sentiment: "The world should forget about cheap oil."
The surge in oil prices, from $10 a barrel in 1998 to above $50 in
early 2005, has prompted talk of a new era of sustained higher
prices. But whenever a "new era" in oil is hailed, scepticism is in
order. After all, this is essentially a cyclical business in which
prices habitually yo-yo. Even so, an unusually loud chorus is now
joining Messrs O'Reilly and Chavez, pointing to intriguing evidence
of a new "price floor" of $30 or perhaps even $40. Confusingly,
though, there are also signs that high oil prices may be caused by a
speculative bubble that could burst quite suddenly. To see which camp
is right, two questions need answering: why did the oil price soar?
And what could keep it high?
Oil
The New York Mercantile Exchange posts information about the prices
of Brent crude oil and West Texas Intermediate crude oil. OPEC
announces its basket price and posts the opening address, a summary,
resolutions and quotas from its March meeting in Iran. The Institute
for International Economics publishes "Energy: A Gathering Storm?",
by Philip K. Verleger Jr. CERA releases an interview with its
director, K F Yan, about Chinese oil demand. See also Chevron Texaco,
PFC Energy, Saudi Aramco, the Federal Reserve and Goldman Sachs.
To make matters more complicated, there is in fact no such thing as a
single "oil price": rather, there are dozens of varieties of crude
trading at different prices. When newspapers write about oil prices,
they usually mean one of two reference crudes: Brent from the North
Sea, or West Texas Intermediate (WTI). But when ministers from the
Organisation of the Petroleum Exporting Countries (OPEC) discuss
prices, they usually refer to a basket of heavier cartel crudes,
which trade at a discount to WTI and Brent. All oil prices mentioned
in this survey are per barrel of WTI.
The recent volatility in prices is only one of several challenges
facing the oil industry. Although at first sight Big Oil seems to be
in rude health, posting record profits, this survey will argue that
the western oil majors will have their work cut out to cope with the
rise of resource nationalism, which threatens to choke off access to
new oil reserves. This is essential to replace their existing
reserves, which are rapidly declining. They will also have to respond
to efforts by governments to deal with oil's serious environmental
and geopolitical side-effects. Together, these challenges could yet
wipe out the oil majors.
The ghost of Jakarta
But back to the question of why prices shot up in the first place.
The short explanation is that oil markets have seen an unprecedented
combination of tight supply, surging demand and financial
speculation. One supply-side factor is OPEC's clever manipulation of
output quotas. Back in 1997, at a ministerial meeting in Jakarta, the
cartel decided to raise output just as the South-East Asian economies
were hit by crisis, sending prices plunging to $10. Desperate to
engineer a price rebound, Saudi Arabia targeted inventory levels:
whenever oil stocks in the rich countries of the OECD started rising,
OPEC would reduce oil quotas to stop prices softening. It worked like
a charm.
Another supply-related factor has been the shortage of petrol in the
American market. Over the past year or two, prices have spiked as
refineries have been unable to meet local demand surges.
Supply concerns have also played a part in the so-called fear
premium. The nerve-wracking uncertainty before the invasion of Iraq,
and the terrible terrorist attacks in Iraq and Saudi Arabia
afterwards, have pushed up prices to a higher level than the
fundamentals would seem to justify. Other supply worries arose from
the crackdown by the Russian president, Vladimir Putin, on the oil
company Yukos, and from civil strife in Venezuela and Nigeria. Some
pundits think the fear premium may have added $7 to $15 to the cost
of oil on futures markets in New York and London.
Adding to the froth has been the sudden influx of new kinds of
financial investors into the oil market. Some are merely chasing the
huge returns recently offered by oil. Big equity funds, fearful of
what $100 oil could do to their holdings, might invest in oil futures
at $40 or $50 as a cheap insurance policy. OPEC ministers love to
blame hedge funds for high oil prices, but they are only partly
correct. The "net long" positions (that is, their speculative bets on
higher prices) held by such funds peaked in March last year and
dropped through 2004, but oil prices kept rising regardless.
Phil Verleger, an energy economist associated with the Institute for
International Economics in Washington, DC, reckons that the cartel
itself may be to blame for the speculation: by declaring its
intention to prop up prices, first at $30 and now at $40, "OPEC has
given Wall Street a free put option" (because investors believe the
cartel will cut output to stop prices falling).
Supply constraints coincided with a huge boom in oil demand. Global
oil consumption last year increased by 3.4% instead of the usual
1-2%. Nearly a third of that growth came from China, where oil
consumption rocketed by perhaps 16%. One senior European oil
executive claims that, in contrast with the embargoes and
supply-driven price rises of the past, "This is the first demand-led
oil shock."
And it was not just China that used a lot more oil. India's oil
consumption too leapt last year, and America's was quite robust. In
fact, despite $50 oil, global oil demand in 2004 grew at the fastest
rate in over 25 years. The global economy also grew at a scorching
pace. That appeared to defy the conventional wisdom that high oil
prices drag down demand, and prompted the question whether oil prices
even matter any more (see article).
No safety net
So was it supply or demand that pushed prices above $50? Both matter,
of course, but neither provides a complete explanation. What is new,
and what has set the market alight, is the lack of spare production
capacity.
In a normal commodity market, no producer in his right mind would
keep lots of idle capacity. But that is precisely what several OPEC
countries have been doing with their oil wells for years. Saudi
Arabia, in particular, has maintained a generous buffer that it has
used to prevent the market from overheating during unexpected supply
interruptions. For example, during the Iran-Iraq war, the first and
second Gulf wars and Venezuela's political crisis of 2003, oil
exports from the countries concerned were disrupted, but the Saudis
immediately started pumping more oil from their idle fields and
single-handedly prevented a price surge and possibly an oil shock.
This vital buffer, argues Robin West of PFC Energy, a consultancy,
helps Saudi Arabia to act as the "central bank of oil".
Alas, the buffer has been in decline for some years, because OPEC has
not been investing sufficiently to keep pace with growing demand. As
a result, global spare capacity last year dropped to around 1m
barrels per day (bpd), close to a 20-year low. Almost all of this was
in Saudi Arabia. In short, the market for the world's most essential
commodity now has no safety net to speak of.
In such a tight market, argues Edward Morse of HETCO, an
energy-trading company, even relatively minor changes in supply and
demand can get magnified into unnerving price spikes. In the past,
there has often been an inverse relationship between spare capacity
and oil prices (see chart 1). The IMF has recently told OPEC that it
must increase global spare capacity to 3m-5m bpd in order to ensure
"the stability of the world economy."
More worryingly, Mr Morse believes the problem extends well beyond
just spare production capacity. He points to the tightness in markets
for oil rigs, tankers, petroleum engineers, refinery capacity and
various other bits of the oil value chain, and concludes that the
problem is systemic: "The illusion that oil is in perennial
oversupply has led to two decades of underinvestment in the oil
industry. The world has been living off the legacy spare capacity
built up many years ago."
Given today's high prices, surely the market will soon enough provide
the necessary new infrastructure? Probably not, for two reasons. The
first is that the world seems to be coping rather well with today's
shockingly high prices, so perhaps they have to persist for longer or
rise higher still before investors are stirred into action. The
second reason is the bitter memory of oil at $10 a barrel.
OPEC countries are unlikely to rush to build lots of spare capacity
because they are worried that another price collapse may follow. PFC
Energy observes that when the oil price hit $55 late last year, spare
capacity was less than 15% of the 8.7m bpd peak reached in 1985, and
notes: "OPEC national interests do not lie in creating large capacity
surpluses that have existed for most of the history of oil."
The western oil majors are even more terrified of another price
collapse, and are keeping a tight rein on their capital expenditure.
Projects are typically "stress-tested" for profitability at $20 a
barrel or below. Some argue that Big Oil is being too cautious. But
nobody thinks that spare capacity will ever return to the gold-plated
levels of the mid-1980s.
Still, the crunch may ease if the Saudis rebuild their buffer. It may
be in their interest to do so. For most of the OPEC countries, it
makes sense to try to maximise prices in the short term because their
reserves of oil are relatively small. The Saudis, by contrast, are
sitting atop at least 260 billion barrels of proven oil reserves, far
more than Libya, Venezuela, Indonesia and Nigeria combined. Even at
current production levels of around 10m bpd, which make them the
world's top exporters, they have enough oil to pump for most of this
century. They will not want prices to stay too high for too long, or
else investors will put money into non-OPEC oil or alternative fuels.
The desert kingdom's rulers also remember the lessons of the 1970s
oil shocks, when the biggest losers were not consuming economies
(which eventually adapted to higher prices) but the petro-economies
of OPEC. Ali Naimi, the Saudi oil minister, rejects the idea that his
country wants prices to rise ever higher: "We are misunderstood: we
thrive on the economic growth of others, which is concomitant with
energy demand." That is why the Saudis have long acted as the voice
of moderation within OPEC, resisting calls from price hawks such as
Libya, Iran and, since the rise of Mr Chavez, Venezuela to squeeze
consumers.
Indeed, at the most recent formal OPEC meeting, held in Iran on March
16th, the Saudis in effect bullied reluctant cartel members into
trying to calm prices down. They won agreement for a rise in oil
production quotas to boost global oil inventories that looked like a
reversal of the cartel's established policy of keeping OECD
inventories tight and prices high.
Developments within Saudi Arabia seem to confirm that the buffer is
being rebuilt. Saudi Aramco, the state-run oil giant (and the world's
largest oil company), has recently launched its biggest expansion
programme in many years. Outside contractors report a surge in rig
counts and drilling activity as the country increases spare capacity
to its stated goal of 1.5m-2m bpd. But even if Saudi Arabia is
willing to re-establish an adequate buffer, this could take years.
Will prices stay high until then?
For much of the late 1980s and 1990s, the world enjoyed low and
stable oil prices between $20 and $30. Now oil prices have shifted to
double that level, apparently without causing much pain. OPEC
ministers and Wall Street analysts talk of a new "price paradigm". At
first sight, there seems to be something in that. In the past,
contracts for delivery of crude months or years ahead (what Alan
Greenspan, the chairman of the Federal Reserve, has poetically called
"distant futures") usually stayed low and stable even if the spot
price shot up because of some short-term disruption. But for the past
couple of years the distant futures have tended to shoot up too. The
markets clearly expect that higher prices are here to stay.
Political scientists point to the bloated welfare states in most OPEC
countries which will require higher oil prices to balance budgets and
avoid social unrest. Some industry analysts see a new "floor" price
of $30-40, if only to persuade oil firms to splash out on necessary
investments upstream. Matt Simmons, a prominent energy investment
banker, thinks that in view of rising input costs (for such things as
oil rigs, steel pipes, tankers and so on) the oil price "needs to go
way, way up".
But some of this may be wishful thinking. In reality, oil companies
have little control over prices. OPEC ministers are better placed,
but even they cannot reliably control the oil market, as the
industry's history of booms and busts clearly shows. Saudi Arabia's
Mr Naimi seems to be arguing for moderation when he says that working
out a fair price for oil is "a moving target: it needs to be
comfortable for both consumers and producers, and at a level where
investors will put money in to grow this industry." But it is quite
possible that prices could drop lower even than Mr Naimi would wish.
One factor is potential weakness in demand. There is much talk about
Chinese demand changing all the rules, but that is just plain wrong.
China's share of world oil consumption is still under 8%, far smaller
than America's at 25%. Goldman Sachs, an investment bank, estimates
that even assuming robust growth, China will remain a smaller oil
consumer than America for decades to come.
And the growth in China's oil demand of nearly 16% last year is
unsustainable. For one thing, there are simply not enough cars in all
of China to guzzle that much oil. Much of the 2004 rise was related
to the country's overheating economy and is unlikely to be repeated.
For example, shortages of cheap coal led to the use of pricey fuel
oil or dirty diesel for electricity generation; as bottlenecks in the
coal system ease, that oil use will disappear. Over the past two
years, as the country has developed its oil infrastructure, it has
needed to fill pipelines, storage tanks and the like, but these were
one-off purchases. The International Energy Agency (IEA) says that in
January and February 2005, Chinese oil demand rose by only 5.4% on
the same period in 2004, less than a quarter of the rate a year
earlier. And if China's banking sector or its overall economy takes a
knock, oil consumption is bound to be hit too.
Katz
Follow that oil price
On the supply side, too, things may ease up. Julian West of CERA, an
energy consultancy, has compiled a list of all of the oil projects,
led by both government companies and by private firms, that are due
to come on stream over the next few years, "all found, all
commercial, and all economic at half today's price." He calculates
that this "river of supply" could lead to a dramatic net increase in
global oil production, with 2007 perhaps seeing the largest rise in
production capacity in history. By 2010, this might add 13m bpd to
the 2004 total of 83m bpd. Not everyone agrees with his assessment,
and Mr West himself cautions that geopolitics could choke off this
pending supply, but otherwise "the supply problem in two to four
years will be too much oil."
The financial markets offer another possible route to a sharp fall in
oil prices. Pension funds have usually shunned commodities in the
past, but in the past year or two they have poured tens of billions
of dollars into securitised investments in oil, hoping for returns
above those they can get on the anaemic stockmarkets. Mr Verleger
worries that they have now developed a herd mentality reminiscent of
the internet boom. As returns inevitably decline over time, the herd
may turn tail and prompt a price collapse. In short, despite China's
undeniable thirst and the shortage of global spare capacity, the
oil-price boom may yet prove a bubble.
Volatile substance
Aramco's boss, Abdallah Jumah, sums it up: "Where the oil price goes,
nobody knows." He wishes it were otherwise. "The key is stability so
we can plan. Oil investments take a long time to come to fruition."
His boss, Mr Naimi, argues that "oil is simply too vital a commodity
to be left to the vagaries of the marketplace." But even Saudi Arabia
cannot guarantee oil-market stability, especially with its buffer so
depleted. Indeed, the only sensible thing anyone can say about oil
prices today is that they are unlikely to remain stable. A terrorist
attack on Saudi oil infrastructure could send them past $100; a
financial-market crash could push them below $10.
That uncertainty creates enormous problems for the western oil
majors. Big Oil has never been much loved, but since OPEC's rise in
the 1970s the majors have actually been the consumer's best friend,
because their success at developing non-OPEC oil has restrained the
cartel's market power. So it is worrying that their economic health
is not as robust as it appears.
_______________________________________________
Biofuel mailing list
[EMAIL PROTECTED]
http://wwia.org/mailman/listinfo/biofuel
Biofuel at Journey to Forever:
http://journeytoforever.org/biofuel.html
Biofuel archives at Infoarchive.net (searchable):
http://infoarchive.net/sgroup/biofuel/
