Oil markets show virtually no signs of improvement, and the situation is expected to get worse before it gets better.
The London branch of Commerzbank AG reckons that Brent crude oil futures will average $11/bbl this year, a drop of $3/bbl from its previous forecast.
While the bank expects Brent futures to recover to an average of $13/bbl in 2000, it also fears that Persian Gulf producers may attempt to keep oil prices at $10/bbl for a number of years to squeeze out higher-cost producers.
Market update"Demand remains very weak," said Commerzbank, "OPEC (Organization of Petroleum Exporting Countries) compliance is slipping, and further production cuts are unlikely before March; inventories are still at record highs; and the hoped-for cold winter in the Northern Hemisphere has, as yet, failed to materialize."
The bank said that hopes for an oil price recovery are now pinned on additional OPEC production cuts, and it reckons that further cuts of 1-1.5 million b/d are needed through 1999 to remove the global stock overhang of 400 million bbl of oil.
"Many of the smaller producers," said Commerzbank, "such as Kuwait, Algeria, and Libya, have called for further cuts. But the three largest producers, Saudi Arabia, Iran, and Venezuela, have been much less keen.
"Saudi Arabia, the single largest producer, has indicated it wants to see greater compliance with the existing agreements before it will reduce its own output below the 8 million b/d level."
Shift to Persian Gulf E&P?The bank speculated that the supply/demand situation could soon go so far out of balance that oil prices will stay low long enough to encourage investment in low-cost producing regions, particularly in the Persian Gulf states, in preference to relatively high-cost resources outside the region.
"The result," said Commerzbank, "could be a sustainable environment of very low oil prices. But why would the gulf states, which have most of the world's lowest-cost reserves, want to tolerate such a situation?"
The bank reckons that, if the gulf nations could afford to forego cash flow through lower prices in the short term-and also fund investment to boost production capacity-it could yield return on investment of 13%: "This is well above their cost of borrowing, so it is potentially a highly attractive economic scenario."
Another possibility, said Commerzbank, would be for Saudi Arabia to pursue a low-price strategy on its own: "If we assume that it picks up 60% of the extra production required from the gulf, then the investment return ratio for the Saudis is even more attractive, at 15% real."
The bank believes that the balance sheets of the gulf states would be able to withstand the cost of such a policy, despite the apparent pressure on domestic budgets (see related story, p. 32).
"The low-cost, long-reserve-life producers of the gulf have a clear economic incentive to endure a period of very low prices," said Commerzbank.
"This has been a fact of life in the oil industry since John D. Rockefeller, founder of Standard Oil, first gave his competitors a 'good sweating' back at the turn of the last century.
"Now, as we approach the new millennium, it is the big reserve holders of the gulf that have the power to bring about such low prices. It is a risk that equity investors should bear in mind."
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