Oil price collapse around corner? Not likely

March 10, 2003
The mind reels: $40/bbl oil looms on the horizon, natural gas futures top $11/Mcf, heating oil futures set a record above $1.15/gal, and odds grow that gasoline prices will hit a record in the spring. Yet oil and gas companies still sit on their budgets, and investors continue to snub the universe of petroleum-related stocks. What gives?

The mind reels: $40/bbl oil looms on the horizon, natural gas futures top $11/Mcf, heating oil futures set a record above $1.15/gal, and odds grow that gasoline prices will hit a record in the spring. Yet oil and gas companies still sit on their budgets, and investors continue to snub the universe of petroleum-related stocks. What gives?

As always, trackers of commodity price movements bet on the come. In this case, many market-watchers seem to think that energy prices that high cannot last.

That's a given, as the oil world found out to its chagrin in the 1980s. The real questions to focus on are: How long before the fall occurs, and how far will the fall be? That's what makes the current reticence of producers and investors such a puzzler for this corner.

The prevailing consensus seems to be that such high prices cannot last very long. Some see a steep oil price collapse as early as the second half. Some forecasts for 2004 see oil and gas prices sharply lower than they are today.

But a strong case can be made that oil and gas prices, while inevitably destined to decline from today's stratospheric levels, will remain robust this year and next. This week, the focus is on the oil side.

How long?

So much of the apparent consensus about collapsing oil prices centers on the ability of Iraq and Venezuela to resume production at precrisis levels and then expand output quickly thereafter.

But all the best evidence is to the contrary. Iraq's productive capacity, in fact, is falling at the rate of 100,000 b/d/year. Sanctions have taken a toll, and the lack of materiel has cost the Iraqi oil industry dearly. The question here really should be: How long can a postwar Iraq sustain even its current production levels? This question does not consider the possibility of sabotage or collateral damage from hostilities to oil fields. Another factor being overlooked is the shoddy state of Iraq's transportation and export infrastructure—thus reining exports even with a production capacity boost.

In short, Iraq may very well have the second-largest oil reserves in the world—leaving international oil companies champing at the bit once entry is possible—but for now, it is incapable of sustaining production of more than 2.4 million b/d. And only a true Pollyanna would see that situation improving before several years have passed, even in the best-case postwar scenario.

As for Venezuela, it seems that the optimism emerging a few weeks ago about that country's revived oil sector may be short-lived. True, production has rebounded and is reliably said to be about 1.3-1.4 million b/d.

But something else has rebounded in Venezuela: President Hugo Chávez's truculence. Just as the general strike began winding down, South America's newest "little Castro" has declared war anew on state oil company Petroleos de Venezuela SA and is stepping up his efforts to gut the firm, splitting it in half, firing thousands, arresting fired executives and labor leaders, and shutting down key divisions. Such moves increase the likelihood of further violence and of further mismanagement of oil field operations. Early estimates were that PDVSA has lost, perhaps permanently, 400,000 b/d of productive capacity. The latest estimates double that figure. So the presumption that Venezuela's return will come to the market's rescue in the spring—ostensibly at a point when (recent or ongoing) war in the Middle East will underscore the need for that return—is misplaced. Even a best-case scenario suggests maximum postcrisis output of 2.2 million b/d for some time to come.

A brutal winter afflicts the entire Northern Hemisphere, spiking demand. Stocks hover near record lows. Civil strife looms in Nigeria. The US refuses to release strategic stocks just to quell high prices. And the Organization of Petroleum Exporting Countries, which has proven itself adept at quickly ratcheting back supplies when oil prices soften, fixates on an OPEC basket oil price equivalent to about $28/bbl for West Texas Intermediate.

Yet oil companies are loath to spend money to boost production, and investors are loath to provide them with more capital. Thus the market tightness persists but becomes attenuated as demand is destroyed. And the longer the attenuation, the softer the fall, as supply gradually responds to lingering high prices. Perhaps forecasters should look ahead to 2005, not 2004. And think about 2001 as an oil price model, not 1986 or 1999.

(Online Feb. 28, 2003; author's e-mail: [email protected])