The curse of $95 oil

Nov. 12, 2007
For reasons that will prove to have been fleeting, the price of crude oil exceeds $95/bbl at this writing and is flirting with the $100/bbl landmark.

For reasons that will prove to have been fleeting, the price of crude oil exceeds $95/bbl at this writing and is flirting with the $100/bbl landmark. While market fundamentals account for some of the buoyancy, they don’t explain the seeming imminence of a triple-digit crude price. Neither will they explain a possibly sudden price correction about which there can be only one question: When?

For the oil and gas industry, the self-levitating crude price is regrettable, as refiners already know. Producers will regret it when they discover how quickly extraordinary revenue can vanish but how slowly, by comparison, swollen cost structures react. If commercial costs, such as those of oil field services and supplies, were all that had risen lately, the problem would be manageable. Political costs are another, troubling matter.

Unusual pressures

The potential for a price slump rests on two unusual price pressures. One is historic weakness of the US dollar. Some analysts say the puny dollar accounts for $12-15/bbl of the crude price; some say more. The price influence, whatever its measure, is amplified to some controversial degree by the increased activity of nonphysical traders, some of whom apparently see oil as a haven for money fleeing turmoil in credit markets.

Market experts disagree over the net effects of all this. What’s important for oil and gas companies is the work of unusual upward forces on the price of crude-forces that will subside at some point, perhaps suddenly, in response to changes in markets related only indirectly to petroleum. This is a prediction not of a price crash but rather of a possibly quick correction when-not if-the dollar recovers and credit markets stabilize. With demand still growing, albeit at a diminishing rate, and some inventories unseasonably low, oil won’t shed all its dollar-denominated value anytime soon-just, probably, some of it. The important question for oil and gas companies is by how much costs-commercial and political-will rise in the meantime.

Predictably, the commercial costs of oil and gas operations are rising as activity stimulated by rising commodity prices intensifies competition for services, supplies, and equipment. Just as predictably, governments are increasing their claims on wealth generated by oil and gas production under their jurisdictions. Government money grabs have been as brazen as the asset expropriations of Russia and Venezuela and as benign, by comparison, as royalty increases by Alberta and the US Minerals Management Service. They haven’t run their course. Legislation in a US Congress embittered by high oil prices and related profits would pummel oil companies with taxes to fund government programs.

Governments raising royalties, taxes, or production shares always point to elevated oil prices and insist oil companies can carry a greater load. But load-carrying capacity depends not on prices but on profits, which inevitably are eroding now as competition raises operating costs. Cash-hungry governments notice only the profit gains that immediately follow a spike in the crude price, never the shrinking margins that follow as costs catch up.

Oil and gas companies are by no means suffering hardship. Because costs are rising for both competitive and political reasons, however, they must confront an imminent crude-price downturn with newly lifted thresholds of financial distress. Just as cost bases shrunken by many years of frugality leveraged profit jumps when oil prices finally recovered, swelling costs of the present will produce losses for some projects and some companies at oil prices that not long ago seemed high.

Uneven adjustments

The commercial dimension of the industry’s new cost base will adjust to the coming price correction as it always does, perhaps faster than anyone expects. Adjustment of the political dimension will require much more time. Governments don’t lower taxes and otherwise improve terms of participation for operators in anticipation of diminished activity; they wait until torpor makes the need for fiscal relief painfully evident.

Crude prices above $95/bbl are destined not to last. Political costs that rise with oil prices, however, will sully the industry’s fiscal landscape for many years.