A checklist for recovery

In times of turmoil, checklists can be handy. They at least create a sense of order. The International Energy Agency in Paris this month offered what amounts to a checklist for recovery from the slump in oil prices. "The rebalancing of world oil supply and demand has three aspects," IEA said in its July Monthly Oil Market Report: "a reversal of daily overproduction, absorption of excess oil already in the supply chain, and, finally, a reduction of the exceedingly high level of onshore stocks."

July 20, 1998

4 min read

In times of turmoil, checklists can be handy. They at least create a sense of order.

The International Energy Agency in Paris this month offered what amounts to a checklist for recovery from the slump in oil prices. "The rebalancing of world oil supply and demand has three aspects," IEA said in its July Monthly Oil Market Report: "a reversal of daily overproduction, absorption of excess oil already in the supply chain, and, finally, a reduction of the exceedingly high level of onshore stocks."

Understated variable

This is an elegant gauge by which to anticipate and track market recuperation. But it necessarily understates a market variable about which the industry should be very concerned, focusing instead on the immediate problem: too much oil sloshing around the world.

In the second quarter this year, says IEA, total worldwide supply exceeded demand by 2.8 million b/d. That's oil that must be stored. After a strong inventory build last year, however, permanent storage space is full in Europe and the U.S., although several months remain in the stockbuild season.

To a sometimes surprising degree, of course, the storage system can stretch. Deliveries can be slowed and tankers moored for storage service. As prices for immediately deliverable crude sink below those for later delivery enough to offset storage costs, buyers find storage not always counted in capacity figures in order to hold oil for later consumption or sale. Vehicle fuel tanks, for example, stay fuller than normal in times such as these as motorists, expecting prices to rise later, fill up frequently while prices are low.

The market pattern that encourages purchase for storage involves prices lower now than later and thus discourages production. Hence the two agreements among key producers so far this year to cut output, underscored by IEA's assertion about the need to reverse overproduction. The cuts are proper and essential responses to economic pain. Until production quits splashing against the outsides of brimming storage tanks, the price for immediately deliverable crude will fall. The question is who cuts production. The answer is producers who hurt the most.

Traders mindful of history doubt that members of the Organization of Petroleum Exporting Countries will limit production enough to reverse the price slide. An alternative view is that government-owned production heavyweights have lost so much cost advantage in the last decade that they now hurt more from low prices than many of their private competitors do-and that they therefore have unprecedented incentive to exercise restraint (OGJ, July 6, 1998, p. 25).

Of course, even if incentives have strengthened, restraint won't be easy to sustain. It won't affect supply immediately. And partly offsetting the effort is the 2 million b/d that Iraq produces with no regard for price (OGJ, June 22, 1998, p. 21). Furthermore, any strengthening of price will summon supply from inventories, encourage output, and thus test producers' resolve. In the next few months, production will deserve all the attention it surely will receive.

Yet a larger question looms and will ultimately outlast price hardship as a concern of the oil industry: Whither demand?

The key variable

Consumption effects of the Asian economic crisis remain as uncertain as the weather, which itself didn't favor demand for energy last winter in the Northern Hemisphere. Demand will determine how quickly the market checks off the second and third items on IEA's checklist. And it will define both the size and growth prospects of the industry that survives the price crisis.

So while production restraint deserves priority attention in the second half of the year, demand remains the key variable. Concerning demand, another checklist might be useful. This one involves only city names and serves mainly as a reminder about the disorderly dynamics now shaping petroleum's future: Jakarta, Moscow, and Kyoto.