Oil in troubled waters

The Economist has oil as its cover story this week, a subject oft-covered on this blog. Vijay Vaitheeswaran is writing this story in the Economist. Here’s a nice graph:

CSU598

Vijay notes, and I will highlight the bits I like:

More worryingly, Mr Morse believes the problem extends well beyond just spare production capacity. He points to the tightness in markets for oil rigs, tankers, petroleum engineers, refinery capacity and various other bits of the oil value chain, and concludes that the problem is systemic: “The illusion that oil is in perennial oversupply has led to two decades of underinvestment in the oil industry. The world has been living off the legacy spare capacity built up many years ago.â€?

Given today’s high prices, surely the market will soon enough provide the necessary new infrastructure? Probably not, for two reasons. The first is that the world seems to be coping rather well with today’s shockingly high prices, so perhaps they have to persist for longer or rise higher still before investors are stirred into action. The second reason is the bitter memory of oil at $10 a barrel.

OPEC countries are unlikely to rush to build lots of spare capacity because they are worried that another price collapse may follow. PFC Energy observes that when the oil price hit $55 late last year, spare capacity was less than 15% of the 8.7m bpd peak reached in 1985, and notes: “OPEC national interests do not lie in creating large capacity surpluses that have existed for most of the history of oil.â€?

But as always in the style of Economist articles – on the other hand…

Still, the crunch may ease if the Saudis rebuild their buffer. It may be in their interest to do so. For most of the OPEC countries, it makes sense to try to maximise prices in the short term because their reserves of oil are relatively small. The Saudis, by contrast, are sitting atop at least 260 billion barrels of proven oil reserves, far more than Libya, Venezuela, Indonesia and Nigeria combined. Even at current production levels of around 10m bpd, which make them the world’s top exporters, they have enough oil to pump for most of this century. They will not want prices to stay too high for too long, or else investors will put money into non-OPEC oil or alternative fuels.

The desert kingdom’s rulers also remember the lessons of the 1970s oil shocks, when the biggest losers were not consuming economies (which eventually adapted to higher prices) but the petro-economies of OPEC. Ali Naimi, the Saudi oil minister, rejects the idea that his country wants prices to rise ever higher: “We are misunderstood: we thrive on the economic growth of others, which is concomitant with energy demand.â€? That is why the Saudis have long acted as the voice of moderation within OPEC, resisting calls from price hawks such as Libya, Iran and, since the rise of Mr Chavez, Venezuela to squeeze consumers.

Indeed, at the most recent formal OPEC meeting, held in Iran on March 16th, the Saudis in effect bullied reluctant cartel members into trying to calm prices down. They won agreement for a rise in oil production quotas to boost global oil inventories that looked like a reversal of the cartel’s established policy of keeping OECD inventories tight and prices high.

Developments within Saudi Arabia seem to confirm that the buffer is being rebuilt. Saudi Aramco, the state-run oil giant (and the world’s largest oil company), has recently launched its biggest expansion programme in many years. Outside contractors report a surge in rig counts and drilling activity as the country increases spare capacity to its stated goal of 1.5m-2m bpd. But even if Saudi Arabia is willing to re-establish an adequate buffer, this could take years. Will prices stay high until then?

Well will they? In short, yes. But there is a ‘but’ attached. Here’s why.

OPEC ministers and Wall Street analysts talk of a new “price paradigmâ€?. At first sight, there seems to be something in that. In the past, contracts for delivery of crude months or years ahead (what Alan Greenspan, the chairman of the Federal Reserve, has poetically called “distant futuresâ€?) usually stayed low and stable even if the spot price shot up because of some short-term disruption. But for the past couple of years the distant futures have tended to shoot up too. The markets clearly expect that higher prices are here to stay.

Political scientists point to the bloated welfare states in most OPEC countries which will require higher oil prices to balance budgets and avoid social unrest. Some industry analysts see a new “floorâ€? price of $30-40, if only to persuade oil firms to splash out on necessary investments upstream. Matt Simmons, a prominent energy investment banker, thinks that in view of rising input costs (for such things as oil rigs, steel pipes, tankers and so on) the oil price “needs to go way, way upâ€?.

But…(and what was Bush saying about China’s demand for oil recently?)

One factor is potential weakness in demand. There is much talk about Chinese demand changing all the rules, but that is just plain wrong. China’s share of world oil consumption is still under 8%, far smaller than America’s at 25%. Goldman Sachs, an investment bank, estimates that even assuming robust growth, China will remain a smaller oil consumer than America for decades to come.

And the growth in China’s oil demand of nearly 16% last year is unsustainable. For one thing, there are simply not enough cars in all of China to guzzle that much oil. Much of the 2004 rise was related to the country’s overheating economy and is unlikely to be repeated. For example, shortages of cheap coal led to the use of pricey fuel oil or dirty diesel for electricity generation; as bottlenecks in the coal system ease, that oil use will disappear. Over the past two years, as the country has developed its oil infrastructure, it has needed to fill pipelines, storage tanks and the like, but these were one-off purchases. The International Energy Agency (IEA) says that in January and February 2005, Chinese oil demand rose by only 5.4% on the same period in 2004, less than a quarter of the rate a year earlier. And if China’s banking sector or its overall economy takes a knock, oil consumption is bound to be hit too.

And to conclude:

Aramco’s boss [Saudi’s and indeed the world’s largest oil company] Abdallah Jumah, sums it up: “Where the oil price goes, nobody knows.â€? He wishes it were otherwise. “The key is stability so we can plan. Oil investments take a long time to come to fruition.â€? His boss, Mr Naimi, argues that “oil is simply too vital a commodity to be left to the vagaries of the marketplace.â€? But even Saudi Arabia cannot guarantee oil-market stability, especially with its buffer so depleted. Indeed, the only sensible thing anyone can say about oil prices today is that they are unlikely to remain stable.