On Mar. 6, 1999, the London-based periodical The Economist had a cover story with the title Drowning in Oil. The price of West Texas Intermediate was then hovering at $12/bbl, and the title expressed a worldwide consensus for that particular moment.
What happened, then, to cause such an abrupt transition only a short time later? In early July 2000, less than 11/2 years later, the price of WTI had risen above $30/bbl and by Oct. 12, it had reached $36/bbl.
The significance of this shift and its enormous implications for the world's economy justifies profound reflection, particularly for the medium term. An appropriate starting point for that reflection might be a look at today's world energy demand (see table).
From the numbers in the table, it is easily seen that 89% of total consumption is for fossil fuels; 64% of the total is hydrocarbons (oil and gas); and crude oil, which represents 40% of total demand, is the most important supply source.
In addition, when looking into the future, the most conservative estimates speak of energy demand growing at a rate of 2%/year. This means that, by 2010, total energy demand will have increased to 230 million boe/d, and by 2020, the figure will be at 280 million boe/d.
Within that scenario, oil demand, despite losing some 2 percentage points in energy market share in the next 20 years, will increase in absolute terms to some 88 million b/d in 2010 and to 106 million b/d in 2020. Natural gas will increase its relative participation by 2 percentage points during the same period, meaning that consumption will grow to 58 million boe/d in 2010 and reach 73 million boe/d in 2020.
As the numbers show, hydrocarbons represent the dominant force in today's energy slate, and, for many years to come, the world will continue to rely on massive consumption of fossil fuels, mainly hydrocarbons.
The next aspect worth reviewing is the resource base. With conventional oil reserves standing at 1.02 trillion bbl, and natural gas reserves at 5,100 tcf, availability of oil and gas is secured well into the 22nd century, without counting some 5 trillion bbl of nonconventional hydrocarbons, such as extra-heavy oils, shale oil, and tar sands.
In summary, it is not anticipated that there will be any significant restriction that would reduce the relevance and transcendence of the oil and gas industry in the demand for oil in the foreseeable future, and no risk is expected concerning the availability of hydrocarbons.
Environmental trends
In analyzing the future of oil, it is of fundamental importance to consider and evaluate the environmental trends that restrict or otherwise impact the hydrocarbon industry.
Foremost among these are regulations governing liquid effluents such as acid water, drilling mud, and sludge that have been frequently discharged into pits around oil fields or into creeks and streams. In general, it is accurate to say that the industry has those problems very much under control through modern technologies and improved operational practices.
Where the atmosphere is concerned, there is no simple link between energy consumption and air pollution. To date, most industrialized countries that typically suffered from high levels of urban pollution several decades ago have managed to essentially clean the air in their cities, despite a very high-and still growing-energy use per capita.
Furthermore, there are many causes of air pollution, and the burning of fossil fuels is not always the main one. For example, in 1997, forest fires in Indonesia, stoked by drought induced by the El Ni
However, it is important to recognize that it is the burning of fossil fuels that attracts the most attention and scrutiny, which is understandable, as it is responsible for 80% of the emissions of the greenhouse gases carbon dioxide and methane.
The burning of oil products, such as gasoline, jet-kerosine, diesel oil, and other light oils used by households and small industry results in a diverse mix of pollutants. Emissions of sulfur oxides may cause acid rain, while those of nitrogen oxides and particulates, in general, are linked to respiratory problems in humans and animals.
However, technological evolution in the automotive industry has translated into higher energy efficiency, and the use of catalytic converters and devices for collecting and reprocessing tailpipe emissions have all progressively reduced those contaminants to reasonable levels.
With global contaminants, specifically the greenhouse gases, the situation is considerably more complex. Many actions are currently being undertaken by groups of nations to address this issue, including multilateral agreements such as the Kyoto Protocol.
Also, many oil and automotive companies have voluntarily launched unilateral initiatives to curtail emissions, especially CO2, motivated by the value that the market places on environmental quality today.
However, there is a universal admission that, despite the maximum possible efforts in energy efficiency and the use of renewable sources, it will not be possible to arrest the escalating trend of accumulation of greenhouse gases.
It is for that reason that a new line of research and technological development will focus on modifying the carbon cycle of forests and oceans to increase their capacity to act as sinks and to develop chemical processes that can transform greenhouse gases into usable products.
In the next few decades, environmental trends will continue growing with their own dynamic inertia, but they will not imply significant changes in the pattern of hydrocarbons consumption and, therefore, will not create insurmountable hurdles for the hydrocarbon industry.
Controlling costs
Technological evolution has translated into significant cost reductions in the past 20 years. For example, in the early 1980s, the economic threshold for production in the North Sea was about $16/bbl, while today's figure is $6-10/bbl.
Finding costs in the late 1970s ranged from $20/bbl in the US to $14/bbl in other regions of the world; today's costs stand at $4-5/bbl.
These reductions have significantly changed the economics of oil production. Today, the marginal barrel in the world oil supply curve costs about $10 in a completely open market (for the current demand of 76 million b/d).
In theory, the marginal barrel could be temporarily cheaper, if low-cost producers that own gigantic reserves flood the markets, displacing other producers from competition. This type of "dumping" seldom occurs, however, because companies generally don't want to liquidate their reserves at a very low price or experience the terrible disarray that such a strategy would bring about.
Nevertheless, the economic supply curve rarely, if ever, applies, because throughout the modern history of the oil industry, a supply management system that alters the price has always been in place.
During the first half of the 20th century, the big oil companies that had signed the Achnacarry Agreement in 1928 managed supply, geographically distributing the market among them and establishing a pricing policy. After 1960, with the foundation of the Organization of Petroleum Exporting Countries, the supply management control began to change hands.
Recent oil markets
With these considerations as a backdrop, it is interesting to address the evolution of the oil market during the past few years.
World oil demand grew by 7 million b/d during 1993-97, with yearly growth in 1996-97 above 2 million b/d. In that environment, every producer who could do so was expanding its market share.
However, the Asian economic crisis that became public in mid-1997 via the Thailand case and later rippled across the region provoked a major shortfall in the expected demand for 1998.
A growth of 0.5 million b/d, which, in other circumstances could have been labeled as robust, became a major disappointment compared with the anticipated increase of more than 2 million b/d. The well-known result of this imbalance was the drastic fall of oil prices in December 1997.
In early 1998, officials of Saudi Arabia, Mexico, and Venezuela met in Riyadh in an attempt to jump-start concerted efforts among producers to correct the existing imbalance and improve the price of oil.
At that time no consensual target price existed, but perhaps Saudi Arabia's need for a price of $22/bbl in order to balance its foreign accounts was the underlying prevailing force. Diffusing the imbalance proved more difficult than expected, and, despite several successive production cuts, the stock build-up remained significantly high throughout most of the year (some 2 million b/d on average).
In early 1999, the combined effects of the production cuts and the recovery of demand (which would average more than 1 million b/d for the year) began showing, and prices started to increase steadily, eventually exceeding $30/bbl.
Neither the rapidity of the price ascent nor the level attained could be properly anticipated, and the latter was clearly an overshot. This overshot can be attributed to the difficulty in accurately assessing demand elasticity in a nonmarket-supply-managed environment. But the producers became prisoners of the high price, and while welcoming the resulting high revenues, they had difficulties outlining a course of action for moderation, mostly due to their fears of suffering a precipitous fall of prices such as the one in 1997.
Then OPEC's answer came in the form of the price band. The band has had the positive effect of being a signal of stability. But it has already shown that it hardly works when the triggering moment comes, because the actual volumes only remotely resemble those agreed to in the formal meetings, and only a few member countries have enough surplus capacity for increasing production.
It has been difficult just to make it work effectively when prices have pierced the ceiling of the band, so the difficulty of having to allocate cuts among OPEC producers when the floor of the band eventually is pierced is even worse.
New factors Against this background, demand again picked up, and oil stocks during 1999 were drawn at an average rate of at least 0.6 million b/d, tightening up an already strained market.
Worldwide concern led OPEC to actions that, through several production increases, attempted to alleviate the price situation. With prices in October reaching $36/bbl and OPEC claiming to "have done its part," the US government released 30 million bbl of oil from its Strategic Petroleum Reserve. This move provoked an almost immediate drop of some $6/bbl, and everything then pointed in the direction of $30/bbl WTI for the rest of the year. As part of the same strategy, the US government also created the Northeast Heating Oil Reserve, but its relatively small size (2 million bbl) suggests that it would only have a modest impact on the market when-and if-it is released.
The only other factor gravitating over this landscape that has not been built into the equation is the risk represented by a possible interruption of Iraqi exports resulting from any political skirmish with its neighbors, the United Nations, or the US. This possibility, considered improbable in principle, nevertheless did occur briefly in December, but with only negligible results.
In the past few months, violence has erupted in the West Bank and Gaza in a new episode of the secular territorial dispute between Palestinians and Israelis.
In addition to the normal concerns about the stability of the region, there is a new element worth observing. A new regional alliance among the Arab states is evolving to fill the vacuum left by fading western diplomatic efforts.
This alliance would result from a union between the Damascus accord-forged by Syria, Egypt, and Saudi Arabia to face Israel-and a recent rapprochement between Saudi Arabia and Iran aimed at neutralizing Iraq.
The new alliance could evolve into a vehicle for Iraq's accelerated rehabilitation after a decade of diplomatic isolation. This whole situation has been complicated even further by the recent terrorist attack against a US Navy ship in the port of Aden in Yemen, provoking panic in the market, with prices jumping again to the level of $36/bbl WTI.
And recently, Saddam Hussein, in a clear attempt to receive revenues not controlled by the United Nations, announced that the oil companies that lift Iraqi oil would have to pay a "commission" of 50¢ for each barrel of oil produced. He later backed down on that demand.
In a wider perspective, he was trying to perforate the boundaries of the international sanctions, stimulated by a few diplomatic successes, such as the arrival of commercial flights to Baghdad, Iraqi attendance at the Arab summit in Egypt, and the growing support of the European community. This, together with the customary difficulties of renewing the "oil-for-food" program, added sensitivity to the market.
However, Saudi Arabia clearly replaced any missing Iraqi volumes, and the government of the US said that it is ready to release additional volumes from the strategic reserve if it becomes necessary.
So, if no significant interruption occurs, stocks can be expected to continue increasing, with an estimated average build-up for this year of 600,000 b/d-compared with a drawdown of 1,300,000 b/d in 1999-and prices falling to about $25/bbl early this year.
Corporate environment
Until just a few years ago, the market would value oil companies on the basis of large volumes and deep pockets. However, in recent times, a major shift has taken place, with the market looking closely at performance, a balanced portfolio, and return on capital employed.
Emphasis is shifting from revenues to profits, from market share to volume share, from assets to people, from operations to customers, and, in general, from the inside to the outside. These changes reflect the search for a new business design, as in recent years, the performance of the oil sector and the energy sector in general has been lackluster compared with other industries.
Oil companies face the challenge of competing with those other industries for needed growth and consolidation capital. This trend, coupled with expansion and privatization trends by oil-producing countries, bolsters the prediction of a future oil world more integrated and efficient, as well as much more competitive.
Optimistic prognoses
The world will continue to depend on massive consumption of fossil fuels; oil, in particular, will continue to be the dominant force. The environmental trends will persist with their own dynamic inertia, but they are not likely to alter the energy slate significantly during the next 2-3 decades.
Within this backdrop, new investments and technological evolution will continue to promote new oil and gas developments in line with the increasing demand.
The current sensation of scarcity is not consistent with the fundamentals of the market in the longer term. The important OPEC producers realize the need to moderate prices and are also engaged in expansion and opening.
It is important to keep in mind that the Middle East will remain an unstable region in which various secular political and religious problems can translate into problems that affect the oil market. But, from a wider, long-term perspective, those problems can be considered transitory and do not change the essence of the above conclusions.
The author
Luis E. Giusti, a director of Shell Transport & Trading, is also a private consultant and a senior adviser to the Washington-based Center for Strategic and International Studies. He has authored numerous publications and is a frequent lecturer on energy, oil, and Latin America. Giusti graduated as a petroleum engineer from the University of Zulia (Maracaibo, Venezuela) in 1966 and received his MS in petroleum engineering from the University of Tulsa in 1971. He was employed by Shell Oil Co. of Venezuela during 1966-75.
In 1976, Giusti joined the staff of Maraven SA, an operating affiliate of the then newly established state oil company, Petroleos de Venezuela SA (PDVSA). He served there in exploration, production, refining, corporate planning, and marketing and was head of PDVSA's corporate planning unit in the late 1980s and early 1990s. He became chairman and CEO of PDVSA in1994, serving in that capacity until 1999 and guiding the company through major international investments and consolidation of PDVSA's downstream position through arrangements with Mobil Corp., Phillips Petroleum Co., Chevron Corp., and Amerada Hess Corp.
