From The Economist –
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?
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.
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.
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.
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.