Sheikh Ahmed, Zaki Yamani
Centre for Global Energy Studies
London
The oil market has certainly not disappointed those who might have feared that it had lost its ability to shock. The recent dramatic events in the gulf have resulted in the oil price more than doubling within 2 months, reaching-at over $40/bbl-levels not seen since November 1980.
This is a faster rise than that observed during the height of the Iranian crisis, when the price of oil took 7 months to double.
Once again, political events in the turbulent Middle East have managed to generate huge shock waves in the oil industry and to toss much else besides into dizzy confusion. Of course, the governments of many oil producing states and a number of oil companies may feel euphoric about the price-driven surge in their incomes.
However, price rises of this rapidity and magnitude are bound to make any jubilation turn sour, if past experience is anything to go by-and these days the turn-around will happen sooner rather than later.
Three times during the last 17 years the volatile politics of the region have had a powerful effect on the oil market. Towards the end of 1973, the oil measures taken by the Arab oil producing states in support of Egypt's war with Israel in October of that year resulted in the oil price rising to a level four times higher than before. Six years later, strikes in the Iranian oil fields during the revolution against the Shah caused a temporary loss of oil production which led to a doubling of the price of oil.
A year later still, the start of the Iran-Iraq war precipitated a 30% increase in the price of oil over 2 months. Sandwiched between the 1980 price rise and the current crisis, however, there was a reverse shock in 1986, during which the price plummeted from about $25 to a low of $8/bbl, eventually stabilizing at around $15. It was the market's way of bringing the price of oil down to earth, so to speak, after the crisis-induced surges of the previous decade and a half.
From 1986 onwards the oil industry has enjoyed a steady revival largely due to the fact that the price has stayed at sensible levels, oscillating around $16/bbl. Oil demand in the non-Communist world (NCW) has been growing on average by 1 million b/d each year, and surplus capacity among members of the Organization of Petroleum Exporting Countries has more than halved as a result. Towards the end of 1989, the oil price even managed a strong rally, touching almost $21/bbl in January this year-the highest point for 5 years. Significantly, in view of what happened subsequently, this peak was achieved by the market itself, without-that is-the help of any political developments in the Middle East.
The steady erosion of the price thereafter to a low of under $15/bbl in June again owed little to outside influences. It was a direct consequence of OPEC's overproduction as a group during a period of seasonally weak demand for its oil, and not-as some have claimed-the result of excess Kuwaiti oil production. This point is of considerable importance.
THE OPEC QUOTA
Oil demand during the second quarter is usually quite low for seasonal reasons. Our Centre for Global Energy Studies (CGES) estimates that the call on OPEC needed to keep prices constant was not greater than 21.5 million b/d during the second quarter of this year-it could even have been lower still. At that time, OPEC's formal quota total was set at 22.1 million b/d, with the United Arab Emirates' allocation at 1 million b/d, although the emirates had refused to accept this figure. This quota total was therefore already too high.
Now had the U.A.E. abided by a quota of 1.5 million b/d, which was offered to them by OPEC in November 1989 and which they subsequently accepted at the July 1990 conference in Geneva, the OPEC quota total would have amounted to 22.6 million b/d-that is, 1.1 million b/d more than the estimated aggregate production level needed to keep prices stable. In the event, OPEC's actual production during the second quarter averaged 23.6 million b/d-fully 2.1 million b/d more than was needed.
Based on its quota of 1.5 million b/d, Kuwait's excess production in the second quarter was 380,000 b/d, amounting to 18% of OPEC's estimated overproduction 2.1 million b/d, while Iraq's excess production calculated on a similar basis amounted to 10%, as did Iran's. It is therefore difficult to lay the blame entirely on Kuwait for the slide in the oil price that was observed.
With a little cooperation among the member states of OPEC-in the form of a return to the quota levels that were already in place-and the seasonal buildup of oil demand in the third and fourth quarters, there was a good chance that the oil market would have been back in balance by the end of 1990.
This was not to be. Politics once again intervened, first in the form of Iraq's gunboat diplomacy before OPEC's July conference and then with the actual invasion of Kuwait, which apart from sending the oil market into convulsions and threatening the health of the world economy has ushered in an extremely dangerous phase of the region's troubled history.
Oil and politics have been inextricably linked over the decades, especially in the Middle East. This has meant that political and strategic considerations have often intruded into the world of oil.
The concessionary system itself gave the oil companies too much power over production and pricing, which in the fullness of time led to a series of confrontations with the host governments. The system's dissolution, on the other hand-following as it did the 1973 politically inspired reduction in oil supplies form the Arab states and soaring oil prices-left the producer governments with the impression that the exercises of sovereignty was all-important and that market forces did not matter that much. The price shocks since 1973-including the present one-provide ample evidence of the dramatic effect political events can have on market sentiment-indeed, so much so as to cause the "market fundamentals" to be disregarded.
TYPICAL SCENARIO
The typical scenario goes somewhat like this: There is a political decision (the 1973 cut in oil production by the Arab states) or a political event (the Iranian revolution in 1978-79, or the recent Iraqi invasion of Kuwait) that results in a temporary loss of oil supplies. The industry, however, has enough surplus oil stocks to make up the shortfall for many months to come.
At the same time, there tend to be compensatory production boosts by oil producers not directly involved in the crisis. This was indeed the case both in 1973-74, when Iran and Nigeria increased production, and during the Iranian revolution, when Saudi Arabia, Kuwait, and Iraq raised the level of their oil output.
In reality, the supply of oil is thus not seriously threatened-at least not for more than a period measured in months rather than years. In any case, any shortfall can easily be accommodated-in theory-by drawing on stocks, which were adequate in the first crisis and more than ample during the second; indeed, the NCW's oil stocks during the Iranian crisis were enough to fully cover the loss of Iranian oil for 8 months before stocks dropped to dangerously low levels, and this without a drop of extra oil being produced by those able to do so. The price of oil need not therefore rise by much, but it does and by a lot. Why is this so?
Typically, the market is not sure about the duration of the curtailment in supplies and can never be certain about the actual amount of compensatory production boosts by those countries able to do so. Holders of stocks therefore tend to be unwilling to allow them to be run down in the face of such uncertainty at the very time when some of the players wish to hold higher stocks for precautionary reasons.
As a result, the market price of oil rises steeply, generating expectations of further increases, which in turn foster speculative purchases that add impetus to the upward spiral. There comes a point, though, when the market turns-perhaps because the political crisis abates-and then the forces that pushed the price up work in reverse, sending the price spiralling down as unwanted stocks are released onto the market.
So far we have talked about the professionals in the market, but when the end users panic about oil supplies and attempt to boost their stocks (the market's so-called tertiary stocks), then the price rises become even steeper. This in fact happened with a vengeance during the 1973-74 crisis. It is estimated that motorists "topping up" their tanks at that time caused a surge in the demand for gasoline equivalent to a third of the stocks at large distribution terminals or 40% of gasoline stocks at refineries-and all within a week or two!
The economic aspects of the current crisis are no different from preceding ones, except for tertiary stock-building, which seems to be less pronounced. The loss of Iraqi and Kuwaiti crude exports amounts to abut 8% of NCW consumption, which is proportionately the same as the peak loss during the 1973-74 crisis.
However, when one takes into consideration the compensatory increases by those able to expand production (principally Saudi Arabia and Venezuela), the net loss of oil is no greater than 2% of consumption, which is even lower than the percentage net loss of oil during the Iranian crisis. It must therefore be emphasized that the current crisis does not involve a physical shortage of crude.
ROLE OF STOCKS
Then there are the stocks. At 99 days of forward consumption, these were exceptionally high when the latest crisis unfolded, much higher than the level of stocks during the Iranian crisis. Running down these stocks to 70 days' worth of forward consumption-which is still 15 days more than the absolute minimum the industry reckons it needs for operational reasons-will take over a year at current, let alone reduced, rates of consumption. This is the case without taking into consideration the extra oil production that is actually forthcoming.
The fundamentals therefore do not justify oil prices much above $20/bbl-let alone $40, the level touched recently. It seems that the usual fear about future supplies has taken hold of the market, given the threat of war and the prospect of damage to Saudi oil installations.
Additional factors that have played a role in exacerbating the current situation include the delay between the announced compensatory boost in production and the actual arrival of cargoes in the consuming areas (expected to be landed from early October onwards), production difficulties in the North Sea that have restricted the availability of prompt Brent blend crude, and the appreciable amounts of heavier crudes included in the extra oil offered to the market, which tend to boost the prices of lighter products disproportionately.
The consequences of oil prices staying at such high levels are, of course, grave. Furthermore, upward pressures on the price will tend to persist, apart from the obvious fear of war, because there is very little leeway on the supply side at the moment.
According to CGES estimates, the world's economic growth rate will drop by a full percentage point if oil prices stay at the $40 level for any length of time, while the world's inflation rate has already probably jumped by half a percentage point. There will be winners and losers as always, but the third world as a whole will suffer more than the developed countries at a time when many members of the former group are heavily indebted anyway.
In spite of the current burst of euphoria felt by the main beneficiaries of the price rises, the damage inflicted in due course on the oil industry itself will be considerable also. Simulations undertaken by the CGES staff suggest that oil consumption in the NCW will decline by 3.8 million b/d between now and 1995 if oil prices remain at $40/bbl or thereabouts. Admittedly, the price of oil is highly unlikely to stay at such height so far ahead into the future.
Nevertheless, the simulations show clearly the devastating effect such a price rise will have on oil demand. This in turn will put pressure on downstream profit margins, while the petrochemicals industry will also experience difficulties at a time when the financing charges associated with the capacity increases undertaken over the last few years are expected to drain cash flows.
More damagingly for the longer term, the high price of oil will trigger political and economic changes that will lead inexorably to a reduced dependence on oil, especially at the heavier end of the barrel. These changes in turn will eventually precipitate-as indeed happened in 1986-a disastrous collapse in the price.
The members of OPEC are hardly likely to emerge unscathed either. A study included in the centre's latest Global Oil Report came to the conclusion that if we assume $25/bbl oil after the crisis subsides-which happens to be the medium-term target price for a number of OPEC countries-it will result in over 12 million b/d of surplus capacity for OPEC by 1995.
The study states, "...Such a level of excess capacity would thus signify a return to the levels last seen prior to the price collapse of 1985 and would constitute a serious threat to price stability." If $25 oil leads to such dire potential consequences for oil prices, and thus OPEC's revenues, imagine what $40 oil would. In fact, it is unlikely that $40 oil would persist because the emerging excess capacity, even without Kuwaiti and Iraqi oil, would see to it that the price duly declined.
On the other hand, if the crisis is resolved peacefully and the embargoed production comes swiftly back on stream, then the price of oil is likely to drop very steeply, especially when the high stock positions are unwound. The price of oil in such circumstances could drop well below $15/bbl, unless OPEC acts promptly to cut production.
I personally doubt, however, that the organization's production would be reduced all that much. The Kuwaitis will need to pump a lot of oil to fund the reconstruction of their country, while Iraq's financial needs are also likely to be substantial. Saudi Arabia, for its part, is unlikely to go below its quota, because it, too, will experience financial difficulties.
WATCH AND WAIT
Given the powerful military forces confronting each other across what President Bush described as "a thin line in the desert," there is little the oil industry can do to diffuse the political crisis but to watch and wait.
On the economic front, however, the industry is not quite so powerless. There are a number of actions it can take to minimize the damaging repercussions of an oil market in crisis, for it is imperative to reduce the adverse effects of the current situation on the world's growth and inflation rates-and this can only be done by bringing the oil price down, as close as possible, to its longer-term equilibrium. This should not be difficult, anyway, in view of the favorable market fundamentals that I have outlined.
The immediate priority must therefore be to prevent any further price rises-better still, to actively encourage a return of prices to sensible levels. The OPEC producers have certainly played their part by boosting production to the limits of capacity. Now it is the turn of the companies and the consuming countries' governments to show that they too are pulling their weight.
The companies should desist from adding to their stocks at present in view of the reasonably healthy overall supply/demand position. In fact, the companies could safely allow commercial stocks to actually decline steadily from the 70 or so days' worth of forward consumption held at the start of the crisis to 65 days or even 60 days, provided legally binding stockholding requirements are relaxed where appropriate. This would still leave overall stocks-including public stocks-not far from the minimum level (90 days) required by the International Energy Agency to implement its international energy program.
The active encouragement of lower prices now will benefit the companies themselves later on because by helping to prevent prices from rising to damagingly high levels the companies will be contributing to the avoidance of a disastrous price collapse in the future, from which they will suffer as much as-if not more than-the producers.
In any case, as I have said already, the industry faces no great physical shortage to speak of when one takes into consideration the next two or three quarters, and not just the fourth quarter of this year. Looked at in a different way, the embargo of Iraqi and Kuwaiti oil exports has withdrawn from the system oil that was, strictly speaking, not needed once all the other OPEC producers agreed to pump as much as they could.
Even so, there is no extra capacity at present, a situation which leaves the market a hostage to fortune should an accident occur in, say, the North Sea. The market remains jittery in the circumstances, which is of course understandable; nevertheless, it is important not to lose sight of the longer-term dangers if prices are allowed to stay at these high levels.
In other words, we believe the companies will benefit from drawing down their stocks now in spite of the short-term uncertainties, because they will contribute greatly to the market's stability in the longer run.
On a practical level, however, it is difficult to urge the companies to draw down their stocks when the consuming countries' governments are seen to be reluctant to release stocks under their control, as the late-September IEA board meeting showed. The IEA member governments perceive the crisis as having more to do with price than supply.
I believe that this distinction is not very helpful. When prices double over a couple of months we are faced with a crisis all the same, whatever the cause. Whether the market's behavior is justified or not, the crisis must be contained, and one of the ways of doing so is by the judicious use of stocks. Incidentally, the world is lucky this time to have strategic stocks to call on; during the Iranian crisis such stocks were negligible.
VICIOUS CIRCLE
All the same, we seem to be in the grip of a vicious circle. The companies do not want to move until the governments show the way, and the governments do not want to start selling stocks in case they give the impression that there is a real shortage.
There is another fear, too-that sales of government oil stocks will simply be hoarded by the companies. The answer, as always, is that it is a question of both timing and degree. Like a long distance runner, who must conserve his strength and yet also press on, ample stocks should be released at the right time in order to calm the market and avoid a damaging drop in confidence.
In this context, President Bush's executive order to sell 5 million bbl from the U.S.'s Strategic Petroleum Reserve, although a token amount, was a step in the right direction, for it gave a clear signal to the market that the 590 million or so bbl in the SPR are not sacrosanct and will be used when necessary. Enough stocks should be kept in reserve, though, in case matters get out of hand in the gulf.
There are other policy steps that could also help to lessen the adverse effects of the crisis. The companies should do their utmost to ensure the continued availability of production supplies to consumers. Additionally, the companies should take care while the crisis lasts not to shut down refineries and other installations for maintenance except where strictly necessary.
The governments, for their part, could suspend for the duration of the crisis any oil production restraints that may be in operation for conservation or environmental reasons. Governments everywhere should also refrain from imposing extra taxes on petroleum products for the simple reason that the oil price rises themselves are inflationary enough without the additional burden of higher taxation.
Formal restrictions on oil consumption are not needed, either, not only because they will give entirely the wrong signal to consumers, but also because the oil price rises themselves constitute the most efficient way of allocating supplies to those who most need them.
These measures and responses ought to be able to dilute the worst effects of the crisis, especially if the military confrontation in the gulf degenerates into full-scale war. Yet it must be said-and reiterated time and time again-that one must not forget the longer-term future of the oil industry.
The foundations of permanent price stability need to be established so as to avoid future crises. What the industry desperately needs is a framework that will secure stable oil revenues for the producer at prices that the consumers feel able to carry on paying.
Unless the economic tensions emanating from the clash of wills of certain oil producing countries are reduced, and unless a new spirit of cooperation between the OPEC producers, the companies, and the consuming countries' governments is fostered, the oil market is destined to be preyed upon by political forces beyond its control and thus to stagger from one crisis to another.
INTERNATIONAL CONFERENCE
Perhaps the time has come for an international conference to be convened at which major oil producing and consuming countries could get together to discuss the real causes of the recurring crises that have plagued the oil industry and to consider ways of isolating the energy industry from the influence of politics.
In order to make such a conference reasonably effective, it would be necessary to restrict participation to significant oil producing nations, like Saudi Arabia, Venezuela, Mexico, and others with large reserves, and important consuming nations-say the G7 countries plus the U.S.S.R., along with leading countries from the developing world like Brazil and India.
It is our belief, however, that the efficacy of such a conference would be greatly reduced without the involvement of the leading oil companies, who should be present at least as observers. President Perez of Venezuela's recent call for a similar conference under the auspices of the United Nations is a step in the right direction and is warmly welcomed. I would only add-in line with my previous statement-that the Venezuelan initiative would do well to include the companies in one way or another. What needs reiterating is that any such conference should be limited to the major players in the market in order to focus the discussions and thus help the conference reach a binding consensus.
In the meantime, the industry will continue to be exposed to serious long-run problems as a result of growing concern about the environment, especially global warming. Furthermore, the possibility of a technological breakthrough that will render oil an anachronism can never be excluded. Someday-maybe in the not-too-distant future-this magnificent petroleum endowment may no longer be as critically important to our lives as it has been until now.
Faced with such potentially grave difficulties, the least we can do to stop undermining from within the credibility of our industry is to smooth as far as possible the oil price volatility that has been such a marked characteristic of the last two decades.
Copyright 1990 Oil & Gas Journal. All Rights Reserved.
