here's the economist stuff
CHEAP OIL
The next shock?
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
Nigeria's future
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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.
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.
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.
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. |
