Editorial: The whipsaw effect

Nov. 3, 2008
Extreme swings in the price of oil are bad for everyone. Price-related political mistakes compound the damage.

Extreme swings in the price of oil are bad for everyone. Price-related political mistakes compound the damage.

Before the middle of last July, the searing question was how high the price of crude might go. The answer, based on futures trading on the New York Mercantile Exchange: $147/bbl. Now the question is how low the crude price might go. The answer: Who knows? The recent low for the weekly average New York Mercantile Exchange price came the week of Dec. 11, 1998, at $11.09/bbl. Does that seem impossibly low? It did then, too.

In a business whose basic commodity can change in value by a factor of 13 in a decade’s time, investment planning is difficult enough. It becomes many times more so when governments react to price movements under the classically mistaken assumption that trends of the moment last forever.

Dissolving comforts

Official excess is playing out dramatically–but by no means uniquely–in Russia. Afloat in oil revenue when crude prices were $100/bbl and rising, Moscow turned against democratization and privatization. A newly prosperous and always nationalistic population cheered the authoritarian relapse.

With crude prices now barely above $60/bbl and falling, Russian comforts are dissolving. The country’s stock market is collapsing. Inflation is transporting the pain of macroeconomic distress to consumers. Political problems for iron-fisted Prime Minister Vladimir Putin are not out of the question. Internationally, Putin has lost standing by, among other things, using military troops and gas exports to bully neighbors. Lately he has wooed blowhard President Hugo Chavez of Venezuela, which has misappropriated its oil bounty even more severely and soon will learn the hard way what depletion and depreciation mean.

Mistakes made when oil prices rise don’t correct themselves when prices fall. The international industry will not soon forget Moscow’s abuse of Royal Dutch Shell in the Sakhalin-2 oil and gas project in the Russian Far East. Complaining about delays and cost hikes that were not unique to Sakhalin-2, the government used trumped-up environmental complaints to wrestle controlling interest away from Shell and its partners and into the hands of state-owned Gazprom. Since then, Moscow has shaken down international companies in other Russian ventures.

Russia isn’t alone in having groped for riches when oil prices were high. It’s simply, like Venezuela, among the most brazenly extortionate. Other countries renegotiated agreements or otherwise changed terms of participation by private investors to raise the state claim on proceeds of oil and gas production. Not all of them are centralized powers like Russia and Venezuela.

Benign Alberta, for example, changed its royalty regime in response to complaints that the state wasn’t receiving a fair share from oil sands development and conventional production. The increased government take now amplifies the effects of plunging commodity prices. The Canadian gas industry is shriveling, therefore, and operators are reconsidering oil sands investments. The US, too, raised the royalty on production from new federal offshore leases and more recently, in a nasty manifestation of pique over high gasoline prices, denied oil and gas companies access to tax relief due other American industries.

To some extent, companies expect governments to grab resource wealth when oil and gas prices rise. And to some extent, depending on how agreements are written, rising prices do ease the damage to project economics.

Extreme grabs

The latest grabs by governments, however, were as extreme as the price surge that precipitated them. Venezuela’s crackdown represented nothing less than renationalization of the oil and gas business. Moscow’s reassertion of control fundamentally changed the Russian investment climate–and not for the better. While not nearly as harsh as those moves, Alberta’s royalty change damages fragile oil sands economics in a down market and thus slows an important engine of provincial growth. And the US is fast showing itself to be officially hostile to oil and gas.

By discouraging investment in future supply beyond the effects of slumping prices, developments like these will aggravate the next market cycle. While prices will always fluctuate, the governmental whipsaw effect helps no one. Moderating it should become a new priority of government-industry relations.