THE RIGHT AND WRONG PRICES OF OIL

"What is the right price for oil?"

Ali I. Al-Naimi, Saudi Arabia's minister of petroleum and mineral resources, asked that question during a closely watched speech in Houston this week.

"I doubt that any two people within the oil industry would give the exact same answer," he said. "Yet we all know the wrong price. When the price of oil dropped to around $10/bbl last year, all of us in the oil industry, and outside as well, knew it was the wrong price."

Nothing explains the oil market's behavior in 1999 better than that observation by the Saudi oil minister.

The main force in the oil market this year has been unprecedented production restraint by members and allies of the Organization of Petroleum Exporting Countries, of which Saudi Arabia is the most important member.

Never before has OPEC coordinated production levels so successfully for so long. Since Apr. 1, the group has kept output reasonably within self-imposed limits. And the world export price of crude has climbed and remained above $20/bbl, at times nudging $25/bbl.

How did this happen? Why did OPEC make production restraint work this time when it could not do so before?

Because, as Al-Naimi said, everyone in the industry "knew" that $10/bbl was too low. They knew it because they suffered from it.

"Oil producing and exporting countries faced hard times, while oil company stock shares and profits declined sharply," when oil sold at $10/bbl, the Saudi oil minister said. "Oil production in some areas was shut in or otherwise declined."

Ten-dollar oil also precipitated a decline of more than 20% in worldwide oil investment.

"The drop in investment will disrupt the development of new oil fields and the search for new deposits as well as retard the steady growth of production and production capacity," Ali-Naimi said. What he called an "investment crisis" would have worsened if low oil prices had continued for another year.

"One thing is for sure: Saudi Arabia...cannot accept a low oil price."

Just moments earlier, Ali-Naimi had asserted that Saudi Arabia's "all-inclusive" production cost falls below $1.50/bbl. When he says "low oil price," though, he means $10/bbl, which is probably close to the upper limit of production costs worldwide, not something below that level but above Saudi costs.

Saudi Arabia spends the cost differential sustaining and expanding its modern infrastructure. It depends on the revenues it can achieve only when the price of oil exceeds $10/bbl. Other key producers with national treasuries funded by oil production face the same situation.

So $10/bbl is now the global price floor. It's the level that inspires production restraint across the entire cost spectrum.

The oil market has demonstrated this crucial point since Apr. 1. And Ali-Naimi made it explicit in Houston this week.