Oil producers face key question: How long will prices stay low?

Bob Williams
Managing Editor-News

The global oil industry is moving toward a consensus (which, in this business, is usually ample reason to be skeptical) that it is in for a sustained period of low oil prices. Whether that period is a year or two or a decade or more has all the soothsayers-including Oil & Gas Journal-scrambling to divine meaning from the entrails of a decidedly contrary market. While there are still those who contend that the current oil price crisis will blow over in 12-18 months or so, the chorus is growing louder that something of a structural upheaval-a sea change-is under way in the oil industryellipseEveryone keeps looking for a magic bullet to slay the dragon of oil price uncertainty. All of the prescriptions listed here are probably correct to some degree, but none is the final answer. The one unshakeable truth is that an oil company that keeps its costs at the lowest feasible level will probably survive this crisis, no matter what the price today or tomorrow will prove to be.

The preeminent question for oil producers today is no longer: How low will oil prices go? It is now: How long will they stay low?

While there are still those who contend that the current oil price crisis will blow over in 12-18 months or so, the chorus is growing louder that something of a structural upheaval-a sea change-is under way in the oil industry.

Those pessimistic voices cite these trends as underpinning the view that a sea change is under way:

The collapse in Asian oil demand growth-which, prior to its collapse, was the engine driving a buoyant industry outlook that has evaporated in only 12 months. The prospect of double-digit growth in oil demand among the "tiger" economies of Asia persisting well into the new millennium is now seen as much of a chimera as $50-100/bbl oil turned out to be in 1985.
The seeming inability of the Organization of Petroleum Exporting Countries to manage markets, production, prices, or perhaps even its own survival.
The shift among more OPEC nations toward embracing foreign investment in their upstream sectors, a prospect that had been largely off-limits prior to the dazzling success, Venezuela has had with that strategy.
The evolution and spread of technology that has rendered many hitherto marginal fields economically viable and has slashed finding and development costs for many others-with its consequent leveling of the playing field for many independents.
The emergence of Wall Street as a 500-lb gorilla dominating corporate strategies in the oil industry, with the scramble by firms to please investors driving such startling developments as the largest industrial mergers in history (Exxon Mobil and BP Amoco) and the biggest writedowns in memory (Royal Dutch/Shell).
The campaign by governments and companies to make the Caspian Sea region the world's "backup" Persian Gulf, ostensibly to spread the risk of reliance on the vital oil supplies of one volatile region with reliance on the still-speculative vital oil supplies of another volatile region.
The drive by Iran and Iraq to rebuild their oil sectors after many years of warfare and hardship, undaunted by an ineffectual U.S. policy of "containing" both countries. Even trade sanctions and cruise missiles have done little to reverse the prospect for still more growth in oil supplies from these two OPEC giants.
The prospect that higher oil taxes emanating from the Kyoto climate change treaty will curb oil demand growth still further in the next millennium, giving more breathing room to renewable energy sources that otherwise would be on life support in a world of $10/bbl oil.

How we got here

Was it just a year ago or so that oil companies and oil field service/supply companies were touted by Wall Street analysts, buoyed by the prospect of $20/bbl-plus oil for years to come and ever-rising oil demand?

A review of this year's oil market inflection points, as well as those of the prior 2 years, is in order (see upper chart, this page). Perhaps no one is better suited to summarize this review than Sheikh Ahmed Zaki Yamani, co-founder of London think tank Centre for Global Energy Studies (CGES) and the former Saudi oil minister who presided over Saudi oil policy at the time of the 1986 oil price collapse.

In a presentation at a Dec. 10 conference in Dallas sponsored by CGES and Southern Methodist University's Institute for the Study of Earth and Man, Yamani said that the fall in oil prices was no surprise, but that the speed and depth of the plunge were.

"I have always thoughtellipsethat the return of Iraqi oil, if not handled properly by OPEC, would be extremely disruptive," Yamani said. "Sooner or later, increasing amounts of this oil would reenter the oil market, implying that OPEC had better have a contingency plan in place-or face the consequences.

"However, when Iraqi oil exports began to flow once again in December 1996ellipseOPEC had no plan. The winter was extremely cold, prices were around $23.50/bbl, and Iraq's exports initially were a mere 320,000 b/d, so OPEC-complacent as ever-did nothing." OPEC's lack of vision was underscored by its decision in November 1997 to increase quotas that had remained unchanged for 4 years, despite the fact that Iraq's exports had reached 1.3 million b/d and OPEC production was already on the rise.

"The price crash of 1998 is basically about far too many barrels chasing too few customers, and one of the avoidable reasons for this oversupply was rising Iraqi output," Yamani said. "OPEC knew about the growing tide of Iraqi oil but chose to ignore it."

At the same time, the expected 1 million b/d or so increment of oil demand growth in the Far East failed to materialize, the victim of a collapsing Asian economy. Instead, oil demand in the Far East is projected to fall by almost 100,000 b/d-a stunning reversal.

"Economic collapse started in the Far East in the late summer of 1997 and had gathered pace by November of that year," Yamani said. "Yet OPEC also chose to ignore the implications of this economic debacle."

Yamani noted that OPEC compounded its November 1997 quota hike mistake by delaying its production cuts-in response to the looming supply glut-until April 1998 and by subsequently not cutting enough, by not complying fully with pledged cuts all the time, and by failing to do anything of substance at the November 1998 meeting.

This has led to a massive overhang in oil inventories that CGES estimates has grown in the past 12 months by 6 days' worth of forward cover, or to 88 days (see lower chart, this page, and table, p. 20). The OPEC basket in that time has fallen to $13/bbl from $19/bbl, noted Yamani: "An extra 6 days' worth of oil inventories seems to imply $6 less on the oil price. It is that simple."

Missing barrels?

A new theory has emerged that this overhang is, in fact, something of a phantom; that the surplus inventories are really the result of miscalculation on the part of the International Energy Agency in estimating oil supply and demand. The discrepancy between IEA's estimates for oil supply, demand, and inventory levels has come to be known as the "missing barrels" phenomenon and has even led to calls in the U.S. Congress for an investigation by the General Accounting Office of the reliability of IEA data and its consequent effects on oil prices (see Journally Speaking, p. 15).

If, in fact, the "missing barrels" theory were proven to be true, then that means underlying oil supply is less than thought or oil demand is greater than believed, and all the market really needs is a little bit of OPEC discipline and a long cold snap this winter.

But CGES is convinced the massive inventory overhang is real enough.

Leo Drollas, CGES deputy executive director, noted, "If these missing barrels are truly missing, then the oil market is tighter than we think; but, if they're not missing, and we just haven't counted them, then demand is weaker (than believed)."

Drollas estimated that the global stock increase, implied by IEA data between September 1997 and September 1998, was 438 million bbl. The reported stock increase within the Organization for Economic Cooperation and Development countries during this time was only 177 million bbl. Of that resulting 261 million bbl discrepancy, 100 million bbl could be accounted for stocks in floating storage, leaving about 161 million bbl officially unaccounted for. CGES's analysis yields an estimate of independent storage for hire in the world at about 620 million bbl, "a vast amount of storage available," Drollas said.

"Now, some of that storage is hired by companies, by the majors, and is recorded by the IEA and becomes part of the OECD recorded stocks," Drollas said. "But some of those stocks do not belong to the majors, and therefore they slip through the OECD net. The independent storage outside the OECD is of the order of 143 million bbl, including 40 million bbl in South Africa, where a lot of the Iranian barrels are stored.

"So we think that the missing barrels are all too real and constitute an overhang that the market will take a long time to get rid of."

OPEC and $5/bbl oil

But if the oil glut is real, and demand is slack while oil prices are in the cellar, then why is OPEC producing even more oil rather than cutting output?

According to Middle East Economic Survey, OPEC compliance with pledged cuts fell sharply in November from the prior month, to 73% from 93% (OGJ, Dec. 21, 1998, Newsletter).

Yamani wondered why OPEC should try to boost oil prices back up to $18/bbl.

"After all, there is one key lesson that OPEC has learned," he said. "The price spikes of the 1970s encouraged the spectacular growth in non-OPEC oil production that took its share from 44% of the world output in 1973 to a peak of 71% in 1985. Non-OPEC's share has declined since 1985-86 and the first oil price crash, stabilizing at around 59.5% at present, and is certain to go even lower with oil prices so weak.

"Is there any reason why OPEC should seek to stop this tendency gathering speed? After all, if OPEC is to gain market share, as it hopes to do, it must do so from the higher-cost producers elsewhere."

Fadhil Chalabi, CGES Executive Director, outlined a scenario of incremental oil supply growth that bodes ill for any tightening of markets.

Plans for new crude oil productive capacity in non-OPEC nations calls for another 4 million b/d by 2005.

During 1998-2005, OPEC will add productive capacity of 5.5-8.6 million b/d, depending on what happens with Iraq, Chalabi said. He forecast these additions to OPEC productive capacity in that period, in million b/d, as: Iran 1.6, Kuwait 0.9, U.A.E. 0.9, Nigeria 0.6, Venezuela 1.6, Iraq 4.1 or 1.0, Saudi Arabia 0.8, Qatar 0.3, Libya 0.5, and Algeria 0.4 (with zero growth in Indonesia).

OPEC has reached its limit on regulating supplies, Chalabi said: "Because of OPEC's past policies, it is no longer able to control prices. Producers are now competing with each other for market share."

Yamani put it more ominously: "I would not be surprised to see OPEC collapse, which would result in a free-for-all."

Fluor Corp. Pres. Phillip Carroll concurred, telling the CGES/ISEM conference, "The hope of OPEC reasserting itself and managing the oil price again is very dim, indeed. Mexico, (heavy oil in) Venezuela, Canadian oil sands, the Caspian region-those supplies are there, and they are not going away."

Perhaps it is time to think of the once-unthinkable: $5/bbl. Referring to that price level, Edward N. Krapels, director of Energy Security Analysis Inc., WashingTon, D.C., said, "It certainly is conceivable. My own guess is we'll see $8 in the next few months, barring a debacle in Iraq. I don't believe the Saudis have a strategy for dealing with this, but now that we're here, they're not panicking.

"I also don't believe OPEC can 'get its act together' anymore, but alliances within and without OPEC will form from time to time. Their impact depends on the market condition at the time.

Sometimes, when the underlying market is closer to balance than traders think, even an announcement can have a bullish effect. Other times, even a real cut won't help. Put another way, a given supply/demand balance at any given time does not create a unique price. Today's fundamentals might support a $15 price as easily as an $8 one. Oil balance remains enigmatic."

Demand to the rescue?

Will resurgent oil demand resulting from economic recovery come to the rescue of anemic oil prices? The portents are not good. The oil demand ripples emanating from the Asian economic "flu" are likely to be felt for at least several years.

Chalabi sees 1998 as not just a short-term change in oil markets, but a structural change that will be long term for the industry, perhaps 5-7 years. Demand will remain weak, he contends, estimating that more than 40% of the incremental demand growth seen in recent years has come from Asia.

"With the collapse in Asia, the incremental (global) demand growth of 1.4 million b/d each year won't return. During the previous 7 years, Asia has shown fabulous (oil demand) growth rates, sometimes as high as 11%. That won't be repeated."

Complicating any benefits from economic recovery in the developing world is a fundamental shift under way in the nature of many of those economies.

"Developing countries have already embarked on the heavy energy-intensive investments," Chalabi said. "Now they will begin the shift to a service economy. So even if economic recovery happens, growth won't be as great as it had been. Post-recovery growth in oil demand is likely to be only 2%/year."

Meanwhile, those evolving econ- omies will see greater energy efficiencies as they mature-especially with the "easy" Kyoto treaty fixes-and oil intensity (oil use per unit of GDP) will continue to decline.

Kyoto's mandate, notes Chalabi, requires introduction of a tax wedge of $4/bbl to discourage growth in oil demand. "At least part of this will be implemented. The effect of low prices on consumption will be dampened by higher taxes on oil."

Futures role

For the near term at least, oil futures markets-seen by some oil producers as a chief culprit, along with OPEC, for their woes-do not offer much in the way of price relief.

"Short-term, it's more a waiting game for a change in the trading patterns of funds and other speculators," Krapels said. "We believe the market fundamentals could justify $14 as easily as $10, but funds have made a packet of money shorting this market, and they'll not be systematic buyers until they've lost a packet of money selling crude short.

"Calling the timing of that financial market turnaround will be really tough. This kind of analysis has become our bread and butter, and we still find it exceptionally difficult to do."

ESAI's own forecast calls for oil prices to average $14.60/bbl in 1999, $16.75 in 2000, $17.50 in 2001, $19.50 in 2002, $20.50 in 2003, and $19 in 2004.

That forecast incorporates trading ranges within each of those years that could be plus or minus $3; thus, next year could see $12-18/bbl.

Iraqi wild card

Iraq continues to be the wild card in scenarios for still-lower oil prices as well as for higher oil prices.

Last week's aerial bombardment of Iraqi military installations by U.S. and U.K. forces pretty much was met by markets with a shrug (see story, p. 24).

But ESAI's Krapels contends that, once Saddam Hussein is removed from the picture, "then Iraq becomes a monster in the oil marketellipseIraq is the best reason to believe, as ESAI does, in long-term prices remaining close to $16-18."

Chalabi, a former Iraqi oil minister, notes Iraq's huge untapped oil potential: "Because of wars and political problems, Iraq is heavily underexplored and heavily underdeveloped. Iraq could achieve productive capacity of as much as 8 million b/d and achieve 6 million b/d earlier than they are currently targeting."

The rogue nation could pull oil prices in the other direction just as easily, if military hostilities escalate or a coup ensues. Chalabi posits two Iraq scenarios, with a peaceful transition unlikely in either. The first envisions a powerful military man from Saddam's clan somehow deposing Saddam if he could control the 50,000-strong Republican guard: "Then Iraq could achieve a transition without a lot of bloodshed."

But a second scenario calls for feuding Iraqi factions, post-Saddam, that would come into conflict, "and that would be difficult to contain."

Roscoe Suddarth, president of the Middle East Institute, warns that the current U.S. stance on Iraq-setting a goal of deposing Saddam by arming and supporting opposition groups within Iraq "puts the U.S. in the dangerous position of being drawn into an Iraqi 'Bay of Pigs' situation, possibly even another Viet Nam, but with much more at stake. I could easily see a Republican Congress and President (current Texas Gov. George W.) Bush finishing what his father started, as the U.S. moves to massive air strikes and then to ground forces in order to oust Saddam," he said.

More likely is the frustrating continuance of the status quo. The U.S. has failed, Chalabi contends, to adopt a policy to change the regime of Iraq or to live with it under acceptable conditions. But Saddam is an even bigger obstacle to sanctions being lifted because he insists on sanctions being lifted on this own terms, without having to give up the 10% of his chemical and biological weapons that are his guarantees for survival and bid for hegemony over the Arab world.

Another "ticking time bomb" that could spike oil prices in the near term is the seemingly intractable Arab-Israel negotiations that have led to a Palestinian demand for Israel to hand over land for a Palestinian homeland by May 4, 1999.

Suddarth predicted: "Expect the U.S. to 'finesse' May 4-to declare victory and walk away from the problem. The U.S. has no policy for resolving this, and its resolve will weaken further as the presidential election approaches."

E&P strategies

Oil producers will have to build a strategy around a lower-than-expected oil price for the foreseeable future.

The oil industry's response to the latest oil price crisis has strong echoes of the last price collapse-perhaps not as severe as it was for post-1986, but then the industry does not have as far to fall as it did from the bloated excess of the early 1980s.

This response consists of dramatically scaling back exploration and, to a lesser degree, development, and weathering yet another spasm of staff cuts in an industry that had only briefly begun to enjoy the feel of a buildup in personnel after years of shrinkage.

That was shown in the latest Arthur Andersen survey of oil companies' spending and employment plans (see charts, p. 22). Fluor's Carroll calls for a reality check by the oil industry: "We all collectively have to face the reality that prices are going to be even lower than they are today. Is the industry done for? Not hardly. Look at 1986: Industry redoubled its efforts to reduce its cost base. I think the industry can recover again. The recent wave of mergers is a clear recognition that the industry can adjust. We will face excess capacity in production, refining, and transportation. That will have to be recognized, and it will be a painful process."

With so much excess capacity, then, will the merger boom be a solution for oil company survival? That is likely to be borne out only if the low-oil-price scenario holds true.

During a panel discussion at the CGES/ISEM conference, Marlan Downey, chief scientist at Sarkeys Energy Center, said that, if the participants in the megamergers guessed wrong about low oil prices, "they will have a hard time digesting over the next 5 years."

Companies should worry about flexibility more and less about the price of oil, Downey said, adding, "To get a good handle on a company's future, it should not be looking at supply/demand or counting barrels, but spotting investor confidence."

John Treat, a vice-president with Booz Allen & Hamilton and participant in that panel discussion, offered this paleontological analogy on the mega- mergers: "Remember that, in the extinction of the dinosaurs, the largest dinosaurs died first. The smaller dinosaurs proved to be more nimble and thrived and evolved into nimble little birds."

He added, "Creating the illusion of change (via merger) influences investors, but those marriages are not always happy."

Krapels thinks that, in terms of big and difficult projects (e.g., gas-to-liquids in Qatar), "the supermajors are in a league of their own. I see mergers like Exxon's and Mobil's as showing management excellence in abundance, but where's the idea generation?ellipseI'd rather work in a place where at least some of the capital budget is allocated to new ideas. I remain an admirer of Enron over Exxon."

Krapels advises smaller companies, "Keep costs under control.

Never invest as if oil prices will average $18. If you're independent, do some hedging to protect yourself against disasters like this one. But be smart-never sell production forward without an escape hatch."

Conclusion

The likelihood that oil prices will stay very low for a protracted period is diminished by the spike in demand and the loss of productive capacity it would produce.

Of course, this may mean that there won't be room for most of the stripper oil that is currently being produced in the U.S. With OPEC cutting back production to boost prices to a point where stripper oil isn't losing money, those nations are effectively shutting in low-cost barrels to allow the production of high-cost barrels-exactly opposite of the way economic theory, not to mention common sense, dictates a commodity should be produced.

Certainly, for the sake of the producers and state economies hurt by the decline in oil prices, some sort of relief in the form of tax/royalty abeyance can be justified, for the shut-in of these marginal wells also means, in many cases, the loss of a valuable oil resource that could provide important revenues down the line, especially in a higher-price environment (see story, p. 25). But producers are already getting some relief in the form of a dramatic drop in the cost of oil field supplies and services, which had shot up after the last round of capacity rationalization had tightened the market enough to make service/ supply companies the darlings of Wall Street and the bane of E&P budget planners.

There is not likely to be much in the way of other relief for stripper producers, especially from a federal government that has more often used the industry as a whipping boy than it has as a supporter. One relief proposal calls for buying stripper crude for the U.S. Strategic Petroleum Reserve (see Watching Government, p. 24).

Broad public support for stripper producer relief is not likely to be forthcoming, either. Farm Aid concerts were able to raise relief funds for farmers in dire economic straits because they successfully evoked an image of hardscrabble, salt-of-the-earth tillers of the soil that is tinged with nostalgia and set against a Dust Bowl backdrop. But any hypothetical "Oil Aid" benefit is more likely to evoke an image of television's greedy, villainous oilman J.R. Ewing and elicit from a typical consumer anything short of sympathy ranging from a shrug to bemusement, even if that consumer is in a diehard oil state like Oklahoma-where last week he could spend 70¢/gal for unleaded self-serve.

The low price of oil today might ensure its survival as a primary energy source tomorrow. Lowering the price of oil raises the bar for alternate energy sources, especially given the prospect of massive fuel switching that looms with the Kyoto climate change treaty.

And low energy prices are critical for the economies of developing nations trying to recover from the Asian "flu," much less reach the next stage of economic development.

Everyone keeps looking for a magic bullet to slay the dragon of oil price uncertainty. All of the prescriptions listed here are probably correct to some degree, but none is the final answer. The one unshakable truth is that an oil company that keeps its costs at the lowest feasible level will probably survive this crisis, no matter what the price today or tomorrow will prove to be.

Introducing an annual turn-of-the-year feature that offers special perspectives by OGJ editors on the worldwide petroleum industry, this article is Part 2 of a three-part series examining the current state of the industry and expectations for the coming year. This week, OGJ Managing Editor-News Bob Will- iams, who writes OGJ Online's weekly Market Hotline column, looks at the continuing collapse in oil prices from an upstream perspective. Next week, in the last part of the series, OGJ Editor John Kennedy will offer his perspective on the year past and for the year to come.