The Long and Short of Oil PricesvWe’ve recently experienced oil price fluctuations that remind us of the economic importance of fossil fuels. But, just how important is petroleum today and going forward? What are the shortterm, medium-term, and long-term trends driving oil prices? What’s likely to happen to oil prices and what are the implications?
For consumers, the most visible evidence of higher oil prices can be seen as prices skyrocket for the gas they buy at the pump, and as the higher costs of jet fuel are passed down from airlines in the form of more expensive airfares. Some have even begun to compare this to the oil crisis of the 70s, but the reality is quite different.
Before we look at the longer term, let’s consider the three trends driving the recent run-up in oil prices in 2004: increasing demand for oil; problems in the oil distribution system; and speculation, which is raising prices based on the potential threat to the oil supply.
Let’s talk about the rise in demand first. The fact is that the demand for oil is growing, and that development is good news. Why? Because oil is the lubricant for the engine of economic growth. As the economies in the U.S., Europe, and Japan rebound from their recent slumps, oilthirsty companies are working at full throttle. Meanwhile, the booming economies of China and India are creating new demand for oil compared to only a few years ago, when they needed relatively little oil to fuel economies that were still lagging behind the modern world.
This short-term growth in demand does not present a major problem at the moment, because the world’s oil producers have enough production capacity available to keep up.
However, at the same time the demand is soaring, the oil supply has been squeezed to a trickle because of distribution problems. Bottlenecks, especially in the U.S., are responsible for higher gas prices. These bottlenecks are only temporary, however, and once they are removed, oil prices should get back to normal levels and gas prices should tumble.
This still leaves the third trend driving the recent price spike: the risk of future interruptions in supply. This is likely to be the biggest threat to the stability of oil prices.
Many investors are still concerned that terrorists will disrupt the world oil supply. It’s not just the risk that Iraqi militants or Al Queda operatives will prevent Iraq’s oil from flowing. The bigger fear is that terrorists will strike Saudi Arabia’s oil industry.
As The Economist1 recently reported, “Saudi Arabia remains the indispensable nation of oil. The Saudis not only export more oil than anyone else, but they also have more reserves than anyone else ? by a long shot. Fully one-quarter of the world’s proven reserves lie in Saudi Arabia.”
The country also is the only supplier of reserve capacity; in an emergency, it can crank out several million more barrels of oil per day. But if terrorists dealt a major blow to Saudi Arabia’s oil industry, the global economy could suffer.
There’s already reason to worry about the stability of this U.S. ally. Consider that 15 of the 19 hijackers on September 11 were Saudi nationals. And that, on May 1, 2004, Saudi terrorists attacked an oil-export terminal, killing several foreign workers.
The scenarios for an even deadlier attack are outlined in the book Sleeping with the Devil,2 by intelligence expert Robert Baer. He warns that terrorists could crash a boat filled with explosives into the port of Ras Tanura, which exports 4.5 million barrels of oil per day. Or a hijacked airplane could destroy Abqaiq, which is the biggest oilprocessing complex in the world, choking off for months the 7 million barrels per day that it currently produces.
If such a disaster occurred, the world oil market would be stunned. On the positive side, most developed countries maintain strategic reserves of oil ? a lesson they learned when they were at the mercy of the OPEC countries during the oil embargo 30 years ago. On the negative side, it takes time to tap those reserves, and there isn’t enough to last for the months that a terrorist strike could cripple Saudi oil production.
Also, the total spare capacity of all the OPEC countries is nowhere near the level that would be needed to meet world demand in the event of an attack on the Saudi oil industry. Twenty years ago, OPEC had roughly 15 million barrels per day of spare capacity, which was equal to 25 percent of the world demand. Today, as demand grows and spare capacity plummets, OPEC could produce only 2 million extra barrels per day.
As a result of this very real threat to the price stability of oil, financial experts believe investor speculation has added a “terrorist premium” to the price of oil. Of the recent price of $42 per barrel, as much as $12 was due to this risk. All it would take is a successful attack by terrorists to send the price of oil into the stratosphere. However, we don’t expect that to happen, as we’ll explain when we present our forecasts a bit later.
But it’s not as if we only have to worry about ensuring that Saudi oil keeps flowing at current levels. The International Energy Agency warned in November 2003 that huge investments would be needed to offset declining output from aging Middle Eastern oil fields. The agency, based in Paris, forecasts that Saudi production will need to reach 20 million barrels a day by 2020, compared to 8 million today. The current geopolitical tension is making it difficult to secure this investment. For example, last year’s effort by Crown Prince Abdullah to secure a commitment from the world’s oil companies to invest $25 billion in exploration and development essentially collapsed.
Some of the potential solutions to the non-terror-related causes for the recent hike in oil prices are starting to emerge.
Both OPEC and non-OPEC producers are increasing their output to meet the growing demand for oil. At the same time, the supply chain bottlenecks are beginning to relax. While these may not be totally resolved until regulatory constraints are lifted or additional refinery capacity is added, we expect some of the worst problems to disappear in the coming months.
Essentially, this will bring prices down in the short-term. But in the long-term, the situation is much more complex.
Finally, the handover of sovereignty to the Iraqi interim government and increased capabilities of indigenous army and police forces will go a long way to stabilizing Iraq and bringing its production back in line.
But that may not be enough. Because the output of oil fields is shrinking, producers need another 4 million barrels of oil each day to keep pace with today’s consumption, which totals about 80 million barrels per day. But as we’ve discussed, demand is growing. At an average increase in demand of 1.5 percent, by a decade from now the world demand will be 40 million barrels higher than today ? a 50 percent increase.
This reality explains why the complex interaction of political, technological, and economic trends that we’ll examine here are so crucial to understanding what’s going to happen to petroleum prices over the coming decade and how that will affect our lives.
Let’s start with the political trends. OPEC is still very much in control of world oil prices. But oil production in non-OPEC countries is expanding, so OPEC’s only tactic for increasing prices is to cut back on production ? an approach that some members of the cartel resist.
Re-stabilizing the Middle East to ensure global oil supplies is crucial, and the two biggest areas of concern are Iraq and Saudi Arabia. For global energy companies, Iraq remains among the most promising, yet dangerous places to operate.
The country has the world’s second-largest oil reserves, behind Saudi Arabia. However, its oil fields have been ravaged by war and by poor management. The infrastructure was damaged by looting after the end of the war. The situation is getting better, and production is returning to normal levels.
However, the Iraqi oil pipeline continues to be tempting targets for terrorists. Iraq’s only alternative is to export its oil through the port of Basra. While U.S. companies would like to get involved in Iraq’s oil industry, the Bush administration is favoring the establishment of an oil company that would be run by the new Iraqi government.
And Iraq isn’t the only oilproducing nation that is plagued by political concerns.
In Venezuela, which is an OPEC member, oil production still hasn’t recovered from a strike that ended more than a year ago, when half the employees of the state oil enterprise were fired.
In Nigeria, another OPEC country, ethnic clashes caused oil production to shut down for nearly two weeks last year, and damaged a critical pipeline.
In Russia, oil tycoon Mikhail Khodorkovsky, the largest shareholder in OAO Yukos, was arrested for allegedly defrauding the state. Many observers see his arrest as politically motivated, because he supported candidates who opposed Russian president Vladimir Putin. This has prevented the creation of a publicly traded energy company through the merger of Yukos and OAO Sibneft. While production hasn’t been hampered, the arrest has slowed plans by the biggest global oil concerns to invest in the new company.
In the face of this uncertainty about the world supply of oil, the U.S. has been trying to increase its production of oil and natural gas, or to at least keep its production from declining.
To increase oil production from mature wells, companies are forcing steam into the ground until the composition of the sand thins out and the oil can be extracted.
Many of the innovative techniques that American companies are using are designed to extract the maximum amount of natural gas out of mature basins. For example, one approach is to exert enormous pressure on wells by forcing millions of gallons of water and sand into the wells until the rocks around them break. When that happens, the natural gas that had been trapped in the rocks can be captured.
But at some point, even with the most novel techniques, there’s a limit to how much oil can be drawn from a well. As a result, companies like ChevronTexaco Corporation are reporting that their production is falling, mostly because their mature U.S. oil fields are running dry.
Fortunately, companies are responding with discoveries of new oil fields in North America. For example, in January 2004, seismic surveys yielded promising results in the deepwater oil frontier off northeastern Newfoundland.3 The Orphan Basin is expected to produce six billion to eight billion barrels of oil. That’s half to three-quarters the amount discovered in the 1960s at Prudhoe Bay in Alaska. Other recent discoveries outside the Middle East, in places like the South China Sea, should help satisfy the growing Asian demand.
But, in North America, the hardest part has not been an inability to find oil. Even without the most recent discoveries, oil companies know where huge reserves are located beneath the Gulf of Mexico and elsewhere, but they have not been permitted to drill there for environmental reasons.
However, the mood has changed somewhat since the threat of terrorism became so pronounced in recent years. In January 2004, the Bush administration finalized a plan to open land in the National Petroleum Reserve in Alaska to oil and natural gas drilling, despite opposition from some environmental groups.4 The leasing plan makes much of the northwest portion of the reserve available for oil production. Also, the federal government has opened eight million acres of federal lands in Wyoming and Montana for natural gas drilling.
Another solution to dwindling supplies of energy resources is to turn natural gas into a liquid that can be shipped more easily.5 Today, there are large reserves of natural gas in West Africa, Qatar, and Australia, but there are no pipelines to bring it to market.
By lowering the temperature of natural gas to minus 260 degrees Fahrenheit, companies can convert it into a liquid that can be poured into tankers and shipped across oceans. Without the need for pipelines, the cost falls dramatically.
Energy companies are investing about $30 billion to build the infrastructure for making and transporting liquefied natural gas to markets around the world, including the U.S.
Based on all these developments, we offer the following four forecasts:
First, we expect oil prices to stabilize in the short term. It’s highly unlikely that terrorists could mount an attack capable of shutting down Saudi production, due to the billions of dollars that the Saudis spend per year on security, and because of the strength of the coalition forces in neighboring Iraq and elsewhere in the region. We expect that the Saudi government will continue to work closely, but secretly, with the CIA and U.S. Special Forces to track down and obliterate Al Queda operatives within its borders. Nevertheless, some of the risk premium associated with shrinking excess supply and unrest in the Middle East will become a permanent feature in the oil markets. Barring some unexpectedly successful terrorist attack, the net result should be prices falling to the Saudi target of $28 per barrel by late this fall, before creeping back to around $30 in 2005.
Second, looking further ahead, increased demand for energy is inevitable as India, China, and Latin America modernize and the developed economies of North America, Japan, and the EU return to robust growth. Many of the world’s largest producing fields are becoming depleted. Conservation can decrease consumption per dollar of GDP, but only increased supply can ensure the reasonable prices required for sustained growth.
Third, the search for increasingly elusive oil and natural gas in the U.S. will force companies to drill deeper, both on land and under the sea ? creating new business opportunities along with new oil fields. For example, at the Gulf of Mexico, ChevronTexaco is drilling in more than 10,000 feet of water, which is the deepest well in history at nearly two miles. Drilling such wells requires new equipment, such as drilling rigs that are bigger and faster than traditional rigs. And information technology will play a key role in helping companies determine where to drill. To process seismic data in the Gulf of Mexico, companies are building networks of computers that are among the fastest in the world.
Fourth, looking beyond this decade, expect our economy to become even less dependent on petroleum as alternative sources of energy become safer and more cost-effective. We’ll explore the drivers and implications of perhaps the most promising and controversial alternative in the next segment.
References List :
1. The Economist, May 27, 2004, "What If?" ⓒ Copyright 2004 by The Economist Newspaper, Limited. All rights reserved.2. Sleeping with the Devil: How Washington Sold Our Soul for Saudi Crude by Robert Baer is published by Crown Publishing. ⓒ Copyright 2003 by Robert Baer. All rights reserved.3. The Canadian Press, January 7, 2004, "Seismic Survey Indicates Massive New Oil Reserve Off Newfoundland." ⓒ Copyright 2004 by The Canadian Press. All rights reserved.4. Calgary Herald, January 23, 2004, "Alaska Oil Reserve Opened for Drilling," by Tom Doggett. ⓒ Copyright 2004 by Calgary Herald Group, Inc. All rights reserved.5. Wall Street Journal, February 9, 2004, "Trends: Oil ? OPEC, LNG and Deep Drilling," by Russell Gold. ⓒ Copyright 2004 by Dow Jones and Company. All rights reserved.
