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Since When is a High Oil Price a Bad Thing?  
Date: October-09-2000

Since When Is A High Oil Price A Bad Thing?

9/29/2000  Reprinted/posted with permisssion from Oil and Gas Online (http://oilandgasonline.com)

by Frederick Parnell

For the first time in ten years, the price of oil has been making headlines, hitting highs not seen since the Gulf War of more than US$36/bbl. It rose and fell in late 1997 and 1998, leading the oil industry to hope for a stable, high oil price, but now that its here, the world wants to know how high it may go and if it will stabilize.

A high oil price has its pros and cons depending upon whom you talk to. On the pro side, the high price has given producers the necessary economic backing to explore for more oil to replenish rapidly depleting reserves, something that was almost uneconomic when oil hit $11. Conversely, on the con side, the high oil price has hit the pocketbooks of consumers driving up gasoline prices and resulting in an increase of inflation.

The most dramatic drop in prices occurred during the Arab Oil Embargo, when they fell from $3.00/bbl in 1972 to $12.00/bbl by late 1974. Prices more than doubled in 1978-81 from $14/bbl to $35/bbl due to the Iranian Revolution and the Iran-Iraq War of 1980.

But what goes up must come down, and, in the early 80s, recession set in and prices began dropping, prompting OPEC to impose its first production quota in an attempt to stabilize the prices. It didn’t work, since most member countries cheated, so Saudi Arabia tried cutting production to stop the free-fall in prices, but to no avail, and in 1986, tied its production to the spot market and increased it from 2 to 5 million b/d. By mid-year prices had fallen below $10/bbl.

Prices peaked at $40/bbl in 1990 during the Gulf War, but then fell again. By 1994, they were at the lowest level since 1973.

World Crude Oil Production. Courtesy: US EIA.

The most recent problem with oil prices began in late 1997. With economies in the US booming and Asian demand showing signs of strong growth, prices again rebounded. At that time, OPEC decided to meet the projected increased demand from the Asian market by increasing its production quotas by 10% to 27.5 million b/d, but then the Asian economy collapsed and the demand dried up, resulting in a world oil glut and prices at $10-11/bbl.

In June of 1998, OPEC agreed to close the taps by some 2.6 million b/d and several non-OPEC producers agreed to cut another 500,000 b/d. Then, in March of 1999, OPEC cut its production again by another 2 million b/d.

After this, with western economies reaching record heights, Asia began a strong recovery, and, of course, the price began to recover as well. But when low prices prevailed, numerous operators were forced to reduce E&P levels to maintain their viability, and the mergers of many operators and service companies produced a massive decline in activity, resulting in reserves being drained faster than they could be replenished and fewer and fewer new reserves being found.

Today, with low inventories and a strong world economy—hence strong demand—and a lack of refining capacity, oil prices have more than tripled since the end of 1998, putting operators back to work exploring for new reserves and producing reserves from fields deemed uneconomic at the time of the last bust.

High prices: good or bad?
One would think that a high price would be a godsend for the industry, and in many ways it has been—operators have revised their budgets based on higher oil prices and activity is surging ahead. But at the same time, it has many people worried as consumers are suffering and economies are beginning to be affected.

Bob Rose, President and CEO of Global Marine, one of the leading offshore oil and gas drilling companies, has seen his company benefit from these high oil prices as rigs have returned to work and utilization rates are growing. But, he is quick to point out the danger of the high prices.

“High oil prices are just as much an enemy for our business as low oil prices are,” he says, “because high oil prices begin to affect economies and demand, and conservation measures start kicking in. In the long run, you start having reduced demand and that’s not good for our business.”

Rose added, “In my view they are too high and would feel much more comfortable if oil would get down below the $30 level back into the $25 to $28 level that OPEC sort of targeted and a range that I believe is good for the producer and good for the consumer.”

Sir Mark Moody-Stuart, Chairman of Shell was also quoted in the French newspaper, Le Monde, as saying oil prices need to drop under $20/bbl in order to appease producer countries, operators, and consumers. He added having disgruntled clients is never good for oil companies.

James Wolfensohn, President of the World Bank, said a high oil price could cut world growth. He said a $10/bbl shift in prices can result in 0.5% lower growth at the world level, and for developing countries, it could be as high as 0.75% lower.

The International Monetary Fund further echoed this in its semi-annual World Economic Outlook Report, which warned that ‘significantly’ higher-than-expected oil prices are a major threat to the continued strength of the global growth.

Seeking stability
While most OPEC members want to keep oil above $30/bbl, the group has agreed three times this year to boost production to curb the price. Most recently at a meeting in Vienna the group, excluding Iraq, agreed to raise output by 800,000 b/d and there are plans to revisit the issue at the next meeting on November 12. Saudi Arabia also said it has been producing an additional 600,000 b/d privately since July to cool prices.

While price is a critical issue, the real issue is stability, which has eluded the industry since its inception and has caused the ongoing price turmoil. OPEC has long sought price stability. Its latest plan is aimed at keeping oil within a target range of $22 to $28/bbl. Under the plan, if the price of a basket of seven OPEC crudes stays below $22/bbl for 20 trading days, the group will cut production by 500,000 b/d. Conversely, if the price stays above $28/bbl for 20 trading days, production will be increased by 500,000 b/d.

OPEC Secretary General Rilwanu Lukman said this mechanism will be put into effect if the latest production increase does not affect the market, but warned that the market must absorb the 800,000 b/d first when it comes onstream on October 1 before more production is added.

OPEC President and Venezuelan Minister Ali Rodriguez says the group could make another 2 million bbl available for the winter, if needed. Saudi Arabia Crown Prince Abdullah bin Abdel Aziz agrees and has said his country could increase output immediately if necessary. Many believe some OPEC members have reached their production capacity, however.

Leading Crude Oil Producers. Courtesy: US EIA.

Kuwaiti Oil Minister Sheikh Saud Nasser al-Sabah has been reported as saying the country is unable to meet its new quote of an additional 64,000 b/d. “Our production capacity has reached its limit,” he was quoted as saying in a London newspaper. “We cannot produce a single barrel more.”

The Minister further added Kuwait was not the only one. He said production capacity of OPEC members is at maximum levels with only Saudi Arabia and the United Arab Emirates having spare capacity.

According to the Centre for Global Energy Studies in London, strong demand from Asia, specifically China and India, has limited the amount of Middle East crude getting to the US. This, the group says, has kept stocks low and pushed up prices for short-haul crudes in the region.

Rose adds, “We have to figure out how to bring additional supply onstream. One way of doing that is to allow US oil companies access to some of the offshore areas that are in moratorium or are off limits to us. There are a number of things that can be done domestically in order to encourage more production and help bring oil prices down.”

Who is to blame?
As with any crisis, much of the focus has been pinned at placing blame rather than working to solve the problem, and most have targeted OPEC as the primary controller of oil prices. Many governments and analysts have said OPEC has not done enough to curb prices and say the most recent increase is a sign of profiteering and will have little impact on the market.

European Union Energy Commissioner Loyola de Palacio said that anything less than a substantial increase could jeopardize European economic growth. French Finance Minister Laurent Fabius also attacked OPEC by saying the group cannot expect consumer countries to subsidize higher oil prices out of their budgets. He added prices will stay high until the group changes its policy.

OPEC has refuted these accusations by blaming taxation in consumer nations for high prices. President Rodriguez said in a press conference, “People have begun to realize that despite the increase in petroleum output, the price they have to pay for gasoline is very high, and that even when the price of petroleum goes down, the price of gasoline continues to fluctuate.”

And in some areas such as Europe this rings rightly true. Europe imposes a heavy tax on gasoline to counter for other subsidized benefits to its people. Former British Prime Minister John Major recently cited taxes on fuel prices in the UK as 70% of the price.

Finance ministers from the Group of Seven industrial nations are to discuss the danger of high oil prices and are targeting not only OPEC for blame but the entire oil sector.

German Chancellor Gerhard Schroder has called for an investigation in the oil industry sector for price ramping. US Presidential candidate Vice President Al Gore also points out the oil industry for profiteering, saying the big oil companies’ profits have gone up two to three times while Americans are paying sky-rocketing prices at the gas pump.

Gore further asked President Clinton to release oil from the Strategic Petroleum Reserve, a reserve that has been drawn upon only once, during the Gulf War, and is meant for national security purposes, and President Clinton complied with a staged release of 30 million bbl.

A more obscure point of blame has been placed on energy statistical groups such as the Energy Information Administration of Washington and the International Energy Agency of Paris. Petroleum & Chemical Consultants Groppe, Long & Littell of Houston released a report stating these group’s are contributing to volatility in world oil prices with inaccurate statistical data that could adversely affect market conditions if OPEC relies on these figures to adjust production quotas.

The truth and the future
Where oil prices will go in coming months is anyone’s guess. To date, no analyst, OPEC member, government official, or industry expert has been able to accurately predict the change in oil prices, and this is not about to change now.

The most accurate prediction ever heard was made in 1998 at the IADC Annual Meeting in New Orleans by Reed Tool. A spokesman for the company said, “More or less, the price of oil will go up or down—or maybe it won't.”

But the truth is prices are still in real terms one-third below levels in 1990 and half the level of 1981. In addition, the publication The Economist points out that, with increased energy conservation, the major economies are only using about half as much oil for every dollar of GDP (in constant prices) as they did in the early 1970s.

Consumer Prices for Petroleum Products and Crude Oil Import Costs. Courtesy: International Energy Agency.

Operators have gone backed to work and have pledged major capital expenditure programs for the coming years based on the profits of the recent upturn. This will eventually lead to new reserves and a filling of depleted inventories. It should not be forgotten, however, what oil companies have gone through over the past few years. It is almost impossible to run a business based on a commodity that fluctuates in price as much as oil does, and many of these companies are still not fully confident high prices are here to stay.

Global’s Rose quickly notes, “Because of the terribly low prices we had in 1999, people have been burnt so badly that they have not built excess inventory. You don’t want to build inventory at $30/bbl when the next day or the next month or in six months, it may be selling for $6—and you don’t want that in your inventory.”

Natural gas
So with oil soaring, where is gas going? All signs point up as well, but the real problem in coming months will be extremely low inventories of natural gas, which have caused many to predict a coming crisis.

Energy & Environmental Analysis, Inc.’s Pipeline Data Report points to historical patterns for natural gas storage during the coming two months, but notes the gas market in North America is still poised to enter the winter heating season with the lowest working gas level in a decade. The report cites end-of-August deficit storage in the east region, outside of Texas, as 90 Bcf below the five-year average and predicts that if things persist at this rate, the beginning of winter gas level will be 90 Bcf below the five-year average and 110 Bcf below last year.

Daniel Yergin, chairman of Cambridge Energy Research Associates says it is a shock, not a crisis. Speaking at the Governors' Natural Gas Summit in Columbus, Ohio, he said, “Current and projected high costs of natural gas are the result of ‘rigorous and efficient’ market dynamics that have doubled the price of natural gas to over $5 since the start of the year. As a result, most utilities anticipate an increase of between 20% and 40% in residential heating bills this winter while industrial customers will be hit even harder with some seeing increases of between 50% and 100%.”

Yergin added this doesn’t mean there will be a long-term supply crisis. He said the resource base in North America is vast and supply developments have slowed due to oil and gas price declines in 1998 and 1999, but production will increase in time as he called “the iron law of lead times” take effect.

He also cited CERA’s new study, The Future of North American Natural Gas Supply, saying demand for natural gas is at a record 22 tcf, and that it will require an industry investment of more than $500 billion over the next decade to increase capability to feed this demand.

He further added that general intervention in the market would hurt the supply response and the government should begin to ease the price shock among consumers through a combination of educational and conservation measures in addition to a low income energy assistance plan.

The future of oil
The fact of the matter is OPEC has done all that it possibly can. The lesson learned in this “crisis” is OPEC no longer has control of the market. While it did significantly aid in the collapse of oil by opening taps at the wrong time, it did not have full control over its rebuild. Supply shortages and a strong economy were the major reason for the rebound in prices, and now that oil is at record levels, it has been proven to be out of OPEC’s hands.

With increased production being absorbed into the market, not only from OPEC but from producers now back to work, inventories will fill again in time. Winter months will play a strong part at keeping prices high for the remainder of the year. The price will naturally settle at some point, but the question is for how long. There is one fact we can be sure of, we will continue to see this problem again and again and again.


Author: Frederick Parnell





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