High oil prices will sag under weight of OPEC potential

Oil markets are likely to cool off in 2001 from their superheated levels of second half 2000.

But what does that portend in the next few years and in the longer term? Higher oil prices? Lower oil prices?

If past is prologue, then the pattern of the preceding 3 years would suggest that the answer to both questions is yes-and that therefore oil price stability is all but impossible.

At this writing, oil prices had just done what common sense would dictate should not happen: during an extremely tight market and with the imminent prospect of a major supply disruption, they fell.

On Nov. 30, Iraqi leader Saddam Hussein had threatened to cut off oil exports over yet another of those seemingly perpetual procedural tiffs with the United Nations body that oversees the sale of Iraq's oil for food and medicine in that benighted nation.

The next day, crude oil for January delivery on the New York Mercantile Exchange (NYMEX) fell 81¢ to close at $33.82/bbl.

On Dec. 1, Saddam made good this threat. The next day, NYMEX January crude plunged by $1.80 to close at $32.02/bbl.

There is precedent for this seemingly counterintuitive turn of events. When US-led allied air strikes were launched against Iraq on Jan. 16, 1991, following its blitzkrieg takeover and occupation of Kuwait, oil prices registered their biggest 1-day drop in history (OGJ, Jan. 21, 1991, p. 19).

This shows that the transparency of oil markets today not only tends to foster short-term price volatility, it can also exacerbate or alleviate supply concerns pretty quickly.

It also shows the resiliency of oil markets in the face of supply difficulties. And it shows the reason why energy forecasts are always doomed to failure. That's because, given the dynamics of an unfettered market, the anticipation of a shortage always spawns the very market forces that eventually eliminates that shortage-and that holds true for surplus as well.

What is different about oil markets today is that, for the moment and perhaps for the next few years, the Organization of Petroleum Exporting Countries is trying to micromanage that process, with mixed results to date.

What must be remembered is that, despite the short-term anxieties over supply or price, the "implicit" surplus capacity of OPEC (namely certain key members' vast untapped reserves and ultimate potential) will always loom over the market.

What must be recalled is that a Saudi Arabia will always have the capability-whether immediate or longer-term-to cause oil prices to fall to a level close to its lifting cost, which is low enough to shut in much, if not most, non-OPEC oil production.

What also must be brought to mind is that Iraq, for all of its mischief that kept a prop under oil prices over the previous 2 decades, really does want to convert its enormous oil potential to increased productive capacity. And the prospect for that happening is growing, not shrinking.

But, for now, the concern that must concentrate wonderfully not only the minds of OPEC and consuming nations but also energy producers is this: Will OPEC's fine-tuning of supply today be accurate enough and sufficiently speedy in its responsiveness to avoid undermining neither its members nor its customers?

That will require a deft tightrope walk. And time will tell whether the organization's pursuit of the engineered "soft landing" for oil prices this year proves to be a chimera or a Holy Grail.

Consensus and forecast

If energy forecasts are always predestined to self-destruct, then a consensus of forecasts would seem, at first glance, to add up to a parade of lemmings.

But consensus in the oil industry also gives way to action. That's why markets were tight and prices high in 2000. It is also why high prices cannot last today any more than they could rise indefinitely after 1982.

What has accelerated the situation in which markets find themselves today is that oil and gas companies have been more cautious and skeptical about the sustainability of a price that high. After the battering they took in 1998, companies are welcoming the opportunity that juiced-up cash flow presents for them to clean up messy balance sheets. And irrespective of whether one believes that the recent wave of mergers and megamergers was price-driven, the upshot is this: A lot of assets and people and corporate culture must be digested before a lot more drilling can happen.

Then there is the infrastructure angle. OPEC has been especially fond of pointing to this market aspect as one of the culprits in recently high oil prices: a lack of capacity in tankering and supply bottlenecks in refining and pipelines-both linked to new environmental strictures.

There are also the perhaps apocryphal tales of the "The Phantom Barrels in Storage," "The Will-O'-The-Wisp Inventory Data," and "The Attack of the Rogue Market Speculators" that allegedly have contributed to the whipsawing of markets in 1997-2001.

One must also consider the "people and equipment capacity" problems, which are anything but apocryphal in the traditional producing areas of the US, Canada, and Europe. Even with high oil and gas prices and healthy commodity demand outlooks, the very real shortage of qualified personnel and the right equipment will rein any rapid ramp-up in drilling activity in those regions-with attendant ripple effects elsewhere.

All these factors have contributed to the state of high oil prices in 2000-01. And the consensus is that these factors are largely temporary. There are contrarian views that a more-fundamental change has occurred in energy markets, that oil productive capacity and storage data are woefully overestimated-and that a true energy crisis is at hand.

But oil companies have, for the most part, positioned themselves for a market that sees oil prices remaining in a range well below what would be conjured up for a crisis scenario.

It always boils down to the best guess of what supply and demand will be-and how well those two elements dovetail in the year to come.

Put simply, if OPEC can resist the calls to increase production-beyond making up any shortfall from Iraq-and succeeds at its March 2001 meeting in ratcheting output back down to meet the reduced level of demand in the second quarter, then oil prices are likely drift back down to about $25/bbl as demand eases.

If the group cannot roll back at least 2 million b/d of its 2000 output hike by March, then the downhill rollercoaster will probably gather momentum again, and the market could see $18/bbl by late summer.

Supply-demand scenarios

The International Energy Agency in 1999 predicted world oil demand will jump to 94.8 million b/d in 2010 and 111.5 million b/d in 2020, with the respective call on Middle East OPEC nations jumping to 40.9 million b/d and 45.2 million b/d.

The US Energy Information Administra- tion in 1999 pegged world oil demand at 93.5 million b/d in 2010 and 112 million b/d in 2020. But it saw the call on Middle East OPEC oil rising to only 28.3 million b/d in 2010 and 41.6 million b/d in 2020.

In their most recent forecasts, released in November 2000, IEA and EIA upped their forecasts for 2020 global oil demand to 115 million b/d and 117 million b/d.

The world faces a surge in dependence on Persian Gulf oil; it's just a question of when.

There is ample evidence that those nations have the potential to meet that demand.

According to the Centre for Global Energy Studies, Saudi Arabia could expand its estimated proven reserves of 261 billion bbl (25% of the world total) by 50-60% simply by incorporating new discoveries such as Shuaiba oil field and implementing more aggressive enhanced oil recovery methods. That would allow the kingdom to boost productive capacity to as much as 18 million b/d "under favorable investment and market conditions."

Another CGES study concluded that Iraq's undiscovered reserves exceed its proven reserves estimate of 112 billion bbl. Accordingly, the London think tank contends, a rehabilitated and sanctions-free Iraq could expand its production capacity to as much as 12 million b/d.

That does not even take into consideration the combined 275 billion bbl of proven reserves and added potential of Kuwait, Iran, and the UAE.

The sanctions against Iran and Iraq continue to be whittled away, and the world's biggest companies are lining up to move in. A parade of supermajors and lesser majors has beaten a path to the doorsteps of Saudi Arabia and Kuwait in the past few years in hopes of helping these nations-tremulous though the first feelers might be-to tap such vast potential. A case could be made for the view that the consolidation of majors was precipitated by this opportunity.

CGES Executive Director Fadhil Chalabi contends that Saudi Arabia's unwillingness to undertake reforms needed to slash its domestic budget keeps it from snatching a much bigger share of the market.

In a talk at IP Week in London in June 2000, Chalabi said, in referring to the Saudi economy, "An optimization of oil wealth should aim at maximizing oil income through the production and sale of as much oil as necessary from those abundant low-cost reserves at a price that would encourage world oil consumption and discourage investments in high-cost producing areas."

All in the timing

There is a stunning 12.6 million b/d spread in the earlier IEA and EIA forecasts of the call on Middle East OPEC oil in 2010, and the spread narrows in the subsequent decade.

When Saudi Arabia finally gets its budget under control, it may well make that market share grab Chalabi suggests-especially in light of the reviving prospects for alternate energy under a scenario that includes high oil prices and climate change concerns. When Saddam Hussein is overthrown or eventually wears down the sanctions regime to a nub, then the least explored of the Persian Gulf giants will also be opened up.

These seem to be inevitabilities, so perhaps it's all in the timing of these two scenarios that depends whether the call on OPEC oil almost doubles in 10 years or in 20.

So it might be wise to look at high oil prices as a temporary blip on the radar screen, occasioned by an anomalous fall in OPEC spare capacity.