... tempered by some bad news:
Front page of most recent "The Economist":
CHEAP OIL The next shock?
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The price of oil has fallen by half in the past two years, to just over $10
a barrel. It may fall further—and the effects will not be as good as you
might hope
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OIL is cheaper today, in real terms, than it was in 1973. After two
OPEC-induced decades of expensive oil, oil producers and the oil industry
as a whole have more or less given up hope that prices might rebound soon.
The chairman of Royal Dutch/Shell, Mark Moody-Stuart, three months ago
unveiled a five-year plan that assumed a price of $14 a barrel. He has
since publicly mused about oil at $11. Sir John Browne, chief executive of
BP-Amoco, is now working on a similar assumption.
Consumers everywhere will rejoice at the prospect of cheap, plentiful oil
for the foreseeable future. Policymakers who remember the pain of
responding to oil shocks in 1973 and in 1979-80 will also be pleased. But
the oilmen's musings will not be popular with their fellows. For if oil
prices remain around $10, every oil firm will have to slash its exploration
budget. Few investments outside the Middle East will any longer make sense.
Cheap oil will also mean that most oil-producing countries, many of them
run by benighted governments that are already flirting with financial
collapse, are likely to see their economies deteriorate further. And it
might also encourage more emissions of carbon dioxide at just the moment
when the world is trying to do something about global warming.
Yet here is a thought: $10 might actually be too optimistic. We may be
heading for $5. To see why, consider chart 1. Thanks to new technology and
productivity gains, you might expect the price of oil, like that of most
other commodities, to fall slowly over the years. Judging by the oil market
in the pre-OPEC era, a “normal” market price might now be in the $5-10
range. Factor in the current slow growth of the world economy and the
normal price drops to the bottom of that range.
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That the recent fall in prices has been so precipitous merely confirms
that, for the past 25 years, oil has been anything but a normal commodity.
Although the Middle East contains two-thirds of the world's proven oil
reserves, it produces less than a third of the world's oil. If production
were determined by cost and quality alone, most oil would come from these
countries. Oil in the Gulf is cheap to extract—barely $2 a barrel, a
quarter of the cost in the North Sea. Unlike the heavy crudes of Mexico or
Venezuela, it is of high quality and high value. Much of the world needs
fancy technology and expensive rigs to extract oil; in Arabia, as the old
hands say, “you just stick a straw in the ground and it gushes out.”
The Gulf countries are to blame for their small share of the market. By
nationalising their oil industries and doing their best through the OPEC
cartel to keep prices high in the 1970s and 1980s, they encouraged oil
development elsewhere. With oil so profitable, prospectors searched
inhospitable parts of the world. The perverse result is that high-cost
regions (such as the North Sea) have been exploited before low-cost ones
(such as Iran).
The oil industry is like a ship with its centre of gravity above the water
line, says Jeremy Elden of Germany's Commerzbank. It can sail smoothly for
years, but capsize suddenly in rough seas—and do so quite rapidly. An
unprecedented combination of excess supply and weak demand has created just
such rough seas in the past year. The finances of the Gulf states are
suffering, as budget cutbacks and recent talk of defence cancellations have
shown. <Picture: picture>
Yet if the Gulf producers thought that oil prices would remain low for some
years, it would pay them to abandon all attempts to boost oil revenues by
propping up prices, and instead to increase production. The result would be
a world in which supply and demand were determined not by geopolitics and
cartels, but by geology and markets—meaning that, in today's conditions,
the price would head down towards $5. That sounds appealing. But it carries
also a less happy corollary of a world that depends upon a highly unstable
region for half its oil, with the proportion rising all the time.
Well down A new report by Arthur Andersen, an accounting firm, and CERA, an
energy consultancy, argues that the present price collapse is fundamentally
different from the previous one, in 1986. Then, high prices had choked off
demand; but as soon as oil became cheap again, the thirst for it returned.
This time demand has barely picked up, even though the price has fallen by
half.
One short-term reason is yet another unseasonably warm winter in the
northern hemisphere. A more lasting one is the economic troubles of Asia,
the region that had been expected to drive oil-company profits for years to
come. Even such sceptics as David O'Reilly, one of Chevron's bosses, who
continues to pooh-pooh what he calls a temporary “price siege”, still worry
that, because of Asia's crisis, demand might not rebound. Demand may fall
further if and when America's record-breaking growth comes to an end.
There is another threat on the demand side: worries over global warming.
Although the science remains inconclusive, rich countries agreed at the
Kyoto summit in 1997 that it is worrying enough to warrant pre-emptive
action. So they have agreed to binding targets to reduce their emissions of
greenhouse gases. Whether or how countries will hit these targets is
unclear. But demand for oil (though not for cleaner gas) in the rich world
is likely to be one casualty.
The supply situation is even gloomier for producers. Unlike 1986, oil
supplies have been slow to respond to the past year's fall. Even at $10 a
barrel, it can be worth continuing with projects that already have huge
sunk costs. Rapid technological advances have pushed the cost of finding,
developing and producing crude oil outside the Middle East down from over
$25 a barrel (in today's prices) in the 1980s to around $10 now.
Privatisation and deregulation in such places as Argentina, Malaysia and
Venezuela have transformed moribund state-owned oil firms. According to
Douglas Terreson of Morgan Stanley Dean Witter, an investment bank, this
has “unleashed a dozen new Texacos during the 1990s”, all of them keen to
pump oil. <Picture: picture>
Meanwhile OPEC, which masterminded the supply cuts that pushed prices up in
the 1970s and 1980s, is in complete disarray. The cartel will try yet again
to agree upon production cuts at its next meeting, on March 23rd, but,
partly thanks to its members' cheating on quotas, the impact of any such
cuts will be small. OPEC members fear that Iraq, whose UN-constrained
output rose by 1m barrels a day in 1998, may some day be able to raise
production further. Last week Algeria's energy minister declared, with only
slight exaggeration, that prices might conceivably tumble “to $2 or $3 a
barrel.”
Nor is there much chance of prices rebounding. If they started to,
Venezuela, which breaks even at $7 a barrel, would expand production; at
$10, the Gulf of Mexico would join in; at $11, the North Sea, and so on
(see map). This will limit any price increase in the unlikely event that
OPEC rises from the dead. Even in the North Sea, the bare-bottom operating
costs have fallen to $4 a barrel. For the lifetime of such fields firms
will continue to crank out oil, even though they are not recouping the sunk
costs of exploration and financing. And basket-cases such as Russia and
Nigeria are so hopelessly dependent on oil that they may go on producing
for some time whatever the price.
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And $5? All this explains why oil prices will remain low. But there needs
to be a shift in the policy of the world's biggest producer, Saudi Arabia,
for them to be halved again. The kingdom has for years restrained output to
support prices. However, if its rulers think prices are going to remain low
anyway, their calculation may change.
“If it weren't for politics,” insists Euan Baird, head of Schlumberger, the
world's biggest oil-services firm, “every barrel of oil would be pumped out
of the Gulf—especially Saudi Arabia.” Politics is not dead yet, as troubles
in so many oil countries, from Venezuela to Russia to Nigeria have made
plain—indeed, it may be the very prize of oil that has created these
countries' problems. But a new kind of politics may now be at work to make
Mr Baird's assertion come true.
The latest oil-price shock has come at a sensitive time for the Saudi
ruling family. Power is passing from the ailing monarch, King Fahd, to his
brother, Abdullah. The autocratic family has had problems with dissent in
radical Islamist quarters. Low oil prices crippled the Saudi economy in
1998: output shrank by nearly 2%, both the current-account and the budget
deficits soared to nearly 10% of GDP and debt approached 100% of GDP. This
year will be worse.
The choice is simple. Either the Saudis must cut back their welfare state,
by slashing benefits and raising taxes, or they must find a way of
increasing oil revenues. But the ruling family's delicate domestic
situation makes the first option difficult. So instead the Saudis may now
do what once would have been unthinkable: throw open the taps. That,
according to McKinsey, a management consultancy, would certainly herald an
era of $5 oil.
It would also destroy OPEC. But the cartel is already moribund, and unless
Saudi Arabia can bring it back from the dead, which is highly unlikely,
going for full production is the strategy that makes most sense for all the
Gulf states. Mr Elden has crunched the numbers for the five main producers
(Saudi Arabia, Kuwait, Iran, Iraq and the United Arab Emirates) at a $10
price. His analysis shows that after a short period of lost revenues, the
Gulf states would enjoy years of strong cash inflow, as they take market
share from high-cost regions. He reckons that the real rate of return for
the Gulf states on such an “investment” is 13%, well above the cost of
borrowing to plug budget gaps. If Saudi Arabia, on its own, pursues volume,
he reckons its rate of return would be an impressive 15%.
The catch is finding the money needed to buy equipment and develop fields
now, so as to expand production fast. The strategy Mr Elden suggests of
going for full production might cost perhaps $110 billion, a good $50
billion more than the Gulf states have to hand. But these countries will
not have to beg for charity: their reserves have a present value of $1.2
trillion. Foreign oil bosses are already queueing up, chequebooks in hand.
Sensitivities about OPEC are one reason why some people doubt that the
Saudis will, say, double output to gobble up a 25% share within a few
years. Plenty of oilmen think that Saudi Arabia is too cautious for that.
The Saudis might instead respond to low prices by increasing output only
slowly and quietly. Such a strategy would serve Saudi Arabia's political
ends by keeping its chums in OPEC afloat, and its economic ends by forcing
many private-sector oil firms to slash output from high-cost, non-OPEC
fields.
There are signs that the nationalism of Gulf producers is crumbling. Kuwait
is debating opening its oil fields to foreign investment. Even Saudi rulers
have dropped some hints. Prince Abdullah, on his first visit to America
last autumn, met American oil firms to discuss possible upstream investment
in his country, a subject that would once have been taboo. Every few weeks,
another top oilman visits the Saudis. Last month, Bill Richardson,
America's energy secretary, arrived to woo the royals. Although the Saudis
were coy on that occasion, Mr Richardson says he is confident that a
framework for upstream foreign investment, beginning with gas, but likely
to go on to oil, will be in place within six months.
The good news . . . One might expect a collapse in oil prices to fuel an
orgy of gleeful consumption. Indeed, when the oil price halved in the
mid-1980s, world consumption did soar—by 2.7% a year for three years. But
not this time, argues Joe Stanislaw of CERA, for two reasons. One is,
again, the advance of technology, which has made alternatives to oil, such
as natural gas, cheaper. In the mid-1980s oil consumption surged in part
because when oil fell below $20 a barrel, it was often substituted for gas.
Now, advances in gas turbines have made gas more attractive, even if oil
prices go below $10.
Another factor is a legacy of previous oil shocks—taxes that are aimed at
conservation. In all rich countries but one, taxes make up so much of the
price of petrol at the pump that consumers hardly notice any drop in crude
prices. In Europe, for example, about 80% of the purchase price (typically,
$1 a litre) is tax. The exception of course, is America, where taxes make
up only a third of the price—but at about 40 cents a litre, the price is
very low anyway. Philip Verleger, a petroleum economist, reckons that even
a prolonged period of low oil prices (below $10 a barrel) will provide a
negligible boost to consumption in OECD countries, perhaps no bigger than
1%.
In poor countries, where taxes are lower and more new power stations and
vehicles are being built, the effect of cheaper oil will be greater. Low
prices will mean that more poor consumers can enjoy the benefits taken for
granted by their rich-world brethren, although that will also mean they
produce more greenhouse gases. In places like China, most power now comes
from plants using inexpensive, but filthy, coal. Mr Verleger points out
that a $5 world might encourage a shift to oil-fired plants or, better
still, to cleaner ones using natural gas.
. . . and the bad Yet a falling oil price will not be good for everyone.
In particular, the oil companies and the producer countries will suffer.
Low prices have left both screaming in pain—and there may be worse to come
....
The six biggest American oil firms posted grim fourth-quarter results for
1998: their after-tax profits fell by 90%, or $4.8 billion, compared with
the same quarter a year earlier. The recent mergers of BP with Amoco and
Exxon with Mobil mark a new round of consolidation in the industry. A big
motive is to take costs out of the business: Exxon-Mobil for example,
expects to save $2.8 billion from its merger. With its own reorganisation
and internal streamlining, Shell is hoping to save $2.5 billion a year.
The big firms are also expecting Gulf countries to open up to investment
and are creating formidable lobbying machines in readiness. This week two
European oil firms, ENI and Elf, signed contracts to help develop Iranian
oil fields. The new BP-Amoco will take its place near the front of the
queue to see Gulf oil ministers, but it will also be able to call on new
American friends to put in a good word. Sir John Browne lobbied Mr
Richardson before his visit to Saudi Arabia.
If oil companies find that they can adapt, albeit painfully, OPEC countries
will find it much harder. The revenues of the cartel's members plunged in
1998 to about $100 billion, only one-fifth of their 1980 revenues in real
terms, according to Marvin Zonis of the University of Chicago. All the oil
producers are suffering, but some are in better shape than others. Mexico,
for example, has diversified its export base, though the federal government
still gets about a third of its revenues from Pemex, the state oil
monopoly. Britain has a diversified economy that can weather the price
drop. Norway has set aside surplus oil revenues to pay for pensions for its
ageing population as oil income wanes. Abu Dhabi and Kuwait, with few
people and lots of cash, have been able to stash profits away for rainy
days.
But other countries are heading for big trouble. Nearly half of Russia's
hard-currency earnings come from crude-oil exports; that figure rises to
about 80% for Venezuela and 95% for Nigeria and Algeria. In Russia (and
also in the Caspian) low oil prices may make much production unprofitable.
In Venezuela, where production costs are lower, the bursting of the oil
bubble has helped to propel a populist military man, jailed for two failed
coups in 1992, into the presidency. Prolonged low prices could trigger
social explosions in several other unstable producing countries.
As for the country that has most ostentatiously frittered away its oil
wealth, Nigeria, the delicate transition to democracy that took a further
step with last weekend's presidential election (see article) could yet be
undermined by economic troubles. Nigeria is a low-cost producer, so it will
still be in business even with low oil prices. But its
mismanagement—Nigerians have recently had to queue for two days to get
petrol—has been so bad that the transition could prove difficult
nonetheless.
In the short run, at least, the oil monarchies of the Gulf could also be in
difficulty. Low prices already threaten the delicate “ruling bargain”
between dictatorial rulers and coddled subjects. A further plunge in
revenues might put them at great risk. If they slash benefits or raise
taxes, they risk a backlash that could even shove them out.
In the medium term, however, the Gulf states will find that their revenues
recover and even increase with cheaper oil. So once they have made the
transition to higher production, a $5 world should not hold any terrors for
them. But it may hold more terrors for the rest of the world—for, just as
in 1973, it will find that it is increasingly dependent on a few unstable
and unreliable Gulf countries, notably Saudi Arabia, Iran and Iraq, for its
energy. Cheap oil may not then look quite so wonderful, after all.
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