Next few months to decide whether 4-6 year up cycle on tap for oil

It almost beggars the imagination that this industry was in a severe slump scarcely a year ago, and yet here we are, contemplating the prospects of $35/bbl oil and $5/Mcf gas.

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It almost beggars the imagination that this industry was in a severe slump scarcely a year ago, and yet here we are, contemplating the prospects of $35/bbl oil and $5/Mcf gas.

What's more, while few people that such high prices can stand for long-at least past this winter's expected tightness-a consensus seems to be emerging that at least a respectable level of pricing for these two commodities is expected to persist for at least another year or two, or more. In recent weeks, a number of industry officials have begun to talk of the arrival of another 4-6 year up cycle.

Of course, given industry's track record on such predictions and its lemminglike predilection for chasing until reality hits and the edge of the cliff looms, one's reflex is to run screaming from any such consensus. One can, in a sense, take some comfort in the fact that there is nothing resembling consensus about the market in the near term.

Near-term scenario

In any event, just looking at the near term, the market seems to be looking at a replay of the "soft-landing" scenario for oil prices that OPEC had to grapple with early this year. There is little doubt that OPEC will vote to approve an increase in quotas at the ministerial meeting that starts this weekend in Vienna. With NYMEX futures piercing the $35/bbl watershed this week, OPEC will have to acknowledge the outcries of the consuming nations in some fashion. Saudi Arabia already has pledged to Pres. Clinton that an increase is coming.

But how much? There's the rub. Press reports quoting unidentified Saudi officials put the amount at 2.4%, or 700,000 b/d. Other press reports suggest an increase of anywhere from 500,000 b/d to 800,000 b/d is in the offing. Some analysts quoted in the press say it will take nothing less than a 1 million b/d increase by OPEC to quell jittery markets. Unfortunately, what none of these press reports mentions-or has the minimal market sophistication required to understand-is whether these prospective increases are actual increases in output or merely the quota affirmations, plus a bit extra, that OPEC already is overproducing. If OPEC is already producing over its collective quota by 500,000 b/d without any dampening effect on oil prices, then a quota affirmation-under the price-band mechanism-of only 500,000 b/d will only serve to heighten market tensions, perhaps pushing oil futures to $40 as the heating season approaches. The prospect of an incremental 500,000 b/d on top of the current quota exceedence might work out to 1 million b/d, but even that prospect (which one assumes that is the way the market interpreted the Saudis' pledge to Clinton) failed to keep NYMEX crude from rocketing to $35.39/bbl last night, up 49

So it would appear that the market is looking for an incremental 1 million b/d, which would be hard for even the Saudis to pull off quickly (even if the technical challenge could be readily overcome in good time, there are the political hurdles of getting this past-officially or unofficially-the Iranians and Venezuelans, who favor the price-band-trigger volume. But while the market may be looking for those volumes, it isn't expecting them soon; consequently, there seems to be a premium of about $5-7/bbl simply on supply timing. The market is discounting the likelihood that any new production will arrive in time to ease the crude and distillate inventory problems in the US and Europe.

This is the crux of the dilemma for OPEC. If it doesn't announce some sort of increase at the Sept. 10 meeting, crude futures are likely to zip up to $40/bbl even before the end of the month. But what worries the price hawks-a view endorsed by some analysts-is that an incremental boost of 1 million b/d on top of current overproduction could arrive about the time seasonal demand peaks. If that extra crude supply is used mainly to rebuild inventories of crude and, ultimately, distillates only for a short term, and then production falls back as demand eases, then it will have the beneficial effect of easing prices back to an acceptable level without crashing them-i.e., the hoped-for soft landing.

The worrisome part is that OPEC-not even the swing-supplier stalwart Saudi Arabia-has ever been able to fine-tune market supply to this extent. So ingrained is this belief that some analysts are already hinting darkly of another price collapse around the corner should a big volume of increment oil hit the market and stick around long enough to hit the seasonally slack second quarter. The Iranians and Venezuelans don't want to risk that and will oppose any sizeable quota increase, even at the risk (as if Tehran and Caracas even care these days, so the "risk" may be moot) of arousing US ire.

Are the Saudis so worried about offending the US and the effects of high oil prices on demand and the global economy that they are willing to risk taking away a key presidential campaign issue from the opponent of a man who has proclaimed himself Public Enemy No. 1 for fossil fuels? The best guess here is that the Saudis' chief concern is the intertwined state of oil demand and the economy, not necessarily the state of chumminess with the US. So whatever the actual quota increase happens to be, look for the Saudis to find a comfortable middle ground by officially accepting a quota everyone can live with but also unilaterally producing more than that-probably along with Kuwait and the UAE. The subsequent reports of overproduction ought to be enough to bring oil back below $30/bbl again. Come the second quarter, oil could be back to a respectable $25/bbl (where at least Clinton says he wants it, for whatever that's worth).

The rest is up to Mother Nature, because the rest of the current crude oil price premium owes to the distillate shortage. An early, brutally cold winter could spike heating oil and crude oil back up into the stratosphere again-and there won't be much OPEC can do about that but wait it out.

How well the Saudis micromanage this market in the next few months will be a litmus test of well this new price dynamic will work in the years to come. And then we can see whether that emerging consensus about a 4-6 year up cycle is viable.

Natural gas

Mother Nature is the key for natural gas prices too, but the question here is one of degree, not direction. In other words, the coming winter will determine whether gas prices test the upper limits of our imagination at times (in our case, that would be about $10) or whether $4-5 is a comfortable floor, with occasional spikes to $7/Mcf.

Because this is a wellhead deliverability issue that has been long in coming, and because all forecasts call for annual increases in gas demand that will far outstrip those for oil, the consensus for an up cycle lasting 5 years or so looks a lot firmer for natural gas. It may be a long time before we see sub-$2/Mcf (or even sub-$3?) gas again.

So watch the Saudis in October and November (discounting any potential market disruptions linked directly or indirectly to Saddam or the Palestinians). If the Saudis can get their act together on market fine-tuning, then both oil and gas producers can put on their happy faces. And wear them for at least a few more years to come.

OGJ Hotline Market Pulse
Latest Prices as of September 8, 2000

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Nymex unleaded

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Nymex heating oil

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IPE gas oil

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Nymex natural gas

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