|Date||August 5, 2004|
|Speaker||Michael LYNCH(President, Strategic Energy & Economic Research Inc. (SEER))|
|Moderator||TANABE Yasuo(Vice-President, RIETI)|
I will talk today about the world oil market in the next year or so. To be honest, if you think that I am trying to predict short-term oil prices, then I will tell you that I do not invest based on my predictions of the oil price. This is because the short-term oil market is very volatile and very uncertain for many reasons. Partly, the reality is that data is not very good. Also, the market is driven by a lot of things that are inherently unpredictable, such as the weather and gross domestic product (GDP), and that affect supply and demand. Finally, there are a lot of political elements. What I am trying to do is provide more an interpretation of what is going and not pretend that I really know where the price is going to be in the next week or month. I am actually best known for my long-term forecasting and being much more accurate than others over the past 25 years or so, but that is easier than predicting the short-term market.
At the moment, the oil price is extraordinary. The U.S. monthly price not adjusted for inflation is over $35 now, but for the last four years, the price has mostly been between $25 and $30 and for the 15 years approximately before that it was between $15 and $20. This unusually high price has been because in the last year, there was a recession and the severe acute respiratory syndrome (SARS) epidemic in Asia, partly lowering demand. There are also problems in the refining sectors. Refineries have to change to meet stricter environmental regulations, especially in Europe and the U.S., making it harder for them to respond to changes in the product price in the short term.
This year, the role of speculators has become very important. There are always traders in the market, but this year has seen a heavy presence of hedge funds, or so-called "dumb money." This refers to people who are not experts in any particular field, who move from market to market in the short term based on what they read in the newspapers or what they think are changes in historical patterns and so forth. They do not really understand the oil market, but they are so big that they can move the market in certain ways.
Just to give you an example of how different this year's phenomenon is, I compared the forecasts from the International Energy Agency in Paris for this year made last December and the revisions that have been made by May. There is additional demand for oil of the Organization of Petroleum Exporting Countries (OPEC), mostly from China and Asia, but there are also other effects: higher demand and slightly lower supply. However, the difference is that it looks like we are going to need almost 1.5 million barrels a day more oil from OPEC than we thought we would last year. You may remember that last fall and even into the winter, OPEC was talking about a weak market and trying to defend against it because people did not expect this high level of demand.
Another big problem is the security premium. Although the inventories are slightly above last year's levels, the price is about $10 per barrel higher, which represents mostly the security premium. Why is it so high? There are three and a half reasons. First, there are a lot more political threats to oil supplies than normal. There are always little disruptions, but of recent there has been instability in Venezuela, Iraq and Saudi Arabia. Second, it is also the case that there is very little, essentially zero, spare capacity in OPEC. Although it was the same for most of the 1990s, you did not have these other problems, particularly the political threats. In 1994, there was a slight price collapse even though there was almost no spare capacity. Third, the level of inventories held by private companies, as taken from data of the Organisation for Economic Co-operation and Development (OECD), are pretty low compared to the historical level.
This combination of things means that you are more likely to have a small or medium loss of supply, and almost no ability either to get more OPEC oil to offset that or for the companies to take it out of inventories in the short term. In the past, if you lost half a million barrels of Nigerian oil, it was not a big deal. Now, it is more important and it is likely to push prices up. In 2003, the total amount lost was over 500 million barrels, but most of that was offset by the Saudis and others raising production, but they cannot do that now. If Iraq went down completely for six months, for example, the market would be in very bad shape.
The "half" reason is that the current and the previous Bush administrations have taken a policy of not wanting to release oil from the strategic petroleum reserves unless there are physical shortages. During the Venezuelan oil strike, they had requests from refiners to replace the oil for a short period but the Bush administration refused so as not to interfere in the market and because the problem was not considered so severe. The decision is arguable, but it also tells traders and speculators that Bush is less likely to release oil, meaning it would be safer gambling on the price going up.
In terms of Iraq, I think the transfer of sovereignty will mean fewer attacks on the oil sector, because most of them in the past appear to be coming from the Baathists (former regime members) essentially waging a guerrilla war. With control over oil and electric industries under the interim Iraqi government, an attack would be seen more as being against the nation and people of Iraq, and I think Baathist will try attacking more political targets. In a political sense, my interpretation is that a lower level of attacks against oil infrastructure represents this approach, which was evident in the Algerian civil war. I think in the future, while the level of violence overall may not decline very quickly, the oil production levels will be much more stable. At the same time, there is a lot of ongoing investment resulting in more reliable and higher level of production.
Finally, on the question of the benefit Japan can get from Iraq and about oil contracts, my answer is that rather than oil contracts, you want engineering contracts. At some point, the Iraqis will start offering contracts for developing some of their giant undeveloped fields, although whether this is of benefit to the contractors is unclear since they will probably charge high tax rates. This will result in a situation similar to the case of the Saudi opening, when the American companies were happy until they saw the contracts and that the profits were not very good. American companies like volume but they have to have high profits before they make an investment. Some Japanese, Asian and French companies will go in and invest and not make money, in the hope that they will get more profits later on. But most of the American companies that I have talked to are not that interested in Iraq, in part because of the political situation as well as the potential financial pressure being very strong.
Indeed, I think that the interim government will probably not offer any contracts, because they know that if they give a fuel development contract to ExxonMobil, Lukoil or TotalFinaElf, the opposition will attack them accusing them of corruption. It does not matter what the reality of the contracts are; this is politics. This I why I do not expect large increases in Iraqi production for another year or two, but it should gradually rise. The Iraqi government now says that they hope to reach 3 million barrels a day by the end of the year, which would be towards the high end of what I forecast in September. I think they are going to get reasonably close to that and add more next year.
The Saudi oil sector is a whole other problem. People have worried for 25 years about the stability of the Saudi regime, not the oil sector per se, and the possibility of overthrow by a new Khomeini or Bin Laden. There is always a very low-level background danger of that, but it is not enough to affect the price of oil. Two events recently have changed perceptions. One was the recent killings in Khobar and the other is the failed attack on the Basra oil terminal in June, which was the first time you had a big attack against a major oil facility by al-Qaeda. This makes people worry that although security in Saudi Arabia is pretty good, no security is perfect. With possible increased attacks by al-Qaeda on oil facilities and the considerable number of sympathizers in Saudi Arabia, all that has added to the security premium quite a bit.
My interpretation is a little different. The attack on Basra was presumably done mostly by foreign al-Qaeda operatives from outside of Iraq. In Saudi Arabia, the attacks were all done by Saudis, but almost all the attacks have been not against Saudi interests, but against foreigners and occasionally officials. Again, it is like the Algerian case where they are trying to win a political battle, so the threat probability is very low. On the other hand, there are a few facilities in Saudi Arabia, for example, the Ras Tanura export terminal, that are really big that some desperate and foreign radical al-Qaeda member may decide to attack. If they did, it would have a serious impact on the price, so there is a small chance of a bad problem, but I would not wage my portfolio on that.
As to what can be expected from next year, the main thing is we will not get the same demand growth as this year's, which was the highest ever at 2.5 million barrels a day. The big question is how much lower it is going to be and part of the question there is the Chinese economy. Although we have some data on the Chinese economy, it is not very good. In China, because of the lack of information on consumer debt level both in the aggregate and the individual level, there are bound to be problems with bad debts, especially if the economy gets worse. The Chinese government is trying to engineer a soft landing, but reports coming out of China in the last month or so are starting to look a bit negative, causing some concern. If China suffers a hard landing, the rest of Asia will see lower economic growth, lower oil demand growth and weak demand.
On the supply side, we are probably going to see an increase next year about the same as this year. More production will come from deep water fields, especially off West Africa, Angola and some from Brazil and the U.S. Another big change is that Russian oil exports are not expected to grow as much, based on the Yukos affair. I had actually argued last year that exports would decline this year because of the Yukos affair but capital flight did not actually come to pass as much. So far it is still perceived as a personal struggle between two men. It is possible that Yukos will keep producing but may drill less next year and their production may even fall allowing other companies to use up the spare pipeline capacity.
Although this may be a little too pessimistic, the main conclusion is that it looks like demand and non-OPEC supply will be about the same amount. There is uncertainty on both sides. If anything, demand is probably going to be a bit lower and non-OPEC supply might be a little bit higher. This means that next year's demand for OPEC oil will be about the same as this year's. Internally, Iraq will be growing and a lot of the other OPEC members - Libya, Algeria and Nigeria - are raising production, especially if the price is up. What this means is that the core OPEC members - Saudi Arabia and Kuwait - are going to have to find themselves cutting back almost certainly next year, maybe as much as 1 million barrels a day.
Through most of the last 20 years, that would have caused struggle within OPEC over quotas, but this coming year, I do not think that will be a problem at all. If the Saudis think the market is weakening, they will very quickly cut back production. They historically have not shown a great interest in increasing their production forever. They have never had to, so it has never been tested. There has been the impression that they have a goal of 8.5 million barrels a day. Sometimes they have acted as if what they really care about is their share of OPEC sales. It is not clear, in the short run at least, that they will take action. I doubt that they will start a price war next year if the price is falling towards $30. I think we are a long way from the Saudis having to go below 8 million barrels a day without calling on the others to do more.
In the longer term, the Saudis have to worry about the possibility of the Iraqis expanding so quickly taking several million barrels a day of sales away. Ever since the first Gulf War when Iraq was shut out of the market and the Saudis took most of the Iraqi sales, the other OPEC members have said that Saudi Arabia should cut back when the time comes to make room for Iraq. The Saudis have never agreed and it is not clear that they will. If anything, they have sometimes argued that they are not going to cut back unilaterally, so it is possible at some point in the next two years there may be another quota war, and ultimately a price war started due to calls by the Saudis for negotiation.
Over the next three to five years, you are probably going to see an ongoing situation of oil demand growth not being that much higher than non-OPEC supply growth. There is a lot of oil out there to be produced, with a lot of expansion into tar sands, heavy oil, deep-water production and so forth. Only if you have a real boom in demand can that lead to substantial increase in demand for OPEC oil. At the same time, you have Iraq wanting to add up to 3 million barrels a day of capacity over the next five or six years, which is possible, technically, although I am not sure they will do it. Many of the other countries within OPEC, except Venezuela and Indonesia, would like to see higher production and most of them are moving in that direction. With flat demand and growing supply, that is a problem. It might mean a return to quota wars and price collapses every two or three years. There may be some kind of longer term agreement between the Saudis and some of the smaller members.
It is also quite possible that the price will go down to $20 or even lower and stay there. I think what we will see is moderate prices in the low to mid-20s in the long term because that will allow more room for oil-demand growth. People now are saying that price is not important in terms of demand and I remember hearing that in the 1970s. I had prominent economists telling me that, as a political scientist, I did not understand that higher prices do not affect demand and that oil is different, but it turned out that was not the case. It just takes a longer time with something like oil to see a demand response. In July, oil demand in the U.S. was dropping compared to earlier in the year, so I think some in OPEC may be getting nervous, in particular those in Saudi Arabia, Kuwait and in the United Arab Emirates with long experience who remember what happened in the last period of high prices and how weak the market became and how much pressure they were under.
In the short term, you run the risk of suddenly finding out that demand has been dropping but that you did not see it for a couple of months because the data was not good and inventories have already built up. The danger is that the market can turn around very quickly. Experts are quoted as saying that we are now in a new high-price regime, but I think that while prices will be higher than in the 1990s, they will not stay above $30 because market economics are not going to justify it in the long run.
Finally, in the Western press, we are seeing a lot written about "peak oil" and those of you who follow this issue may have seen that I am the person who says that peak oil is, politely put, nonsense. I have studied this issue very carefully and I have found that most people making these arguments are repeating the works of others. When you look at what the original geologists have written, there is actually very little research and it is inconsistent with theories changing from year to year. For example, Colin Campbell constantly changed his prediction of when oil would peak, to which I have voiced my criticism. There are also people saying Saudi oil is very limited, but if you look at the work carefully, again, you will find that there is no actual research.
Questions and Answers
Q: When we discuss energy policy issues in Asia, we often talk about the "Asia Premium." Some people say that there is a way for us to handle the premium; others that it is just a reflection of market conditions. What are your thoughts?
A: My impression is that it is mostly market conditions, although I have not studied it. I think the main problem is that the marginal market supply is much further away for the East Asian market than for the Atlantic basin, but I am not convinced. There are questions of microeconomics involved, of how market structure, number of buyers and regulation affect the market. Somehow I think the market is allowing the price to be higher and a good strategy might be able to bring it down.
Q: From past experience, I gathered that you think that the period for the price elasticity for both the supply and demand side was not so short in the oil shocks. I think the current price level is a very high level. How do you judge the price elasticity being longer than you expected?
A: I have done a report reviewing some of this and part of the answer is that it is just hard to know. During the first two oil price shocks, you had price controls in a lot of countries, which was part of the reason it was slow. I think you will start to see it more quickly this time than before. The fact that you do not get a big demand response is that the price change is not that great. In Europe, the strong euro means that they are not seeing much response. Also, this summer, gasoline demand is pretty low and some of it is just savings behavior. If the price stays at $44, within a couple years you will see a very strong response. Nobody has a number for the elasticity, but I think that it is usually higher than people expect. Penn State economist, Richard Gordon, said that if one thing energy economists have learned is that markets always clear, usually faster and at lower prices than expected. So the Saudis are very worried about demand dropping and prices coming down and I think that they are right to be so. It is an amazing combination of things that has kept it up as long as it has.
Q: Could you give some more of your thoughts on elasticity of supply in the medium- to long term? It seems that technology could be driving the increase in oil production.
A: That is a lot of it. In the 70s, people thought it was a straightforward elasticity calculation, but it did not work because of the cost side. If you suddenly raise operations, costs go up, so you do not get the supply response even though you are spending more. The other thing is that in most producing areas, the government takes a high tax cut, so when the price goes up, only a fraction goes to the producing company. To compare that between countries, that is too much work and I do not know anybody who has been able to do that, so you cannot say exactly how much the companies get and how much they can spend. Finally, I think that it is a public policy issue. When revenues for an oil company go up tremendously in the upstream, they do not want to go and spend all the money because you wind up with a boom and bust cycle. BP made what I thought was a good comment, saying that they would spend up until $20, but anything above that, they will give back to the shareholders. They remembered the situation in 1998, so they all did not want to over-commit, meaning they have too much cash but also that you do not get a supply response from the higher prices that you would expect. So it is a mixed message. It is true that the technology brings down the cost, but it is also hard to quantify yet valuable in the long run.
Q: What is your opinion on the impacts of reforms or mergers and acquisitions (M&As) of major oil companies on the supply-demand balance or on prices? If there are none, what is the meaning of these drastic changes in the oil industry?
A: The main thing is that it is really much more from a microeconomic point of view about the company operations themselves. In 1970, the Seven Sisters controlled most of the world's traded oil. Now, even after BP bought ARCO and Amoco, they produce less oil than they did in 1970. Exxon and Mobil together produce less than they did in 1970, as do ChevronTexaco and Gulf. The nationalization means that the there are so many more companies on the global market as well as more buyers and sellers. One reason driving this merger trend is that some corporations simply do what other corporations do. Some mergers were to reduce costs when markets were weak in 1997 to 1998. There was also too much competition and by merging, your profits can go up a little. However, the barriers to entry are still relatively small and it is hard for someone to take over the market. I am not concerned at this level of mergers because there are too many oil companies and at the global level, it is about reducing overhead costs. Partly, I think it was also about listening to unknowledgeable financial analysts' advice.
Q: What are your impressions of Japanese oil companies, especially after the liberalization of markets? Did companies' behavior or structure change?
A: The Japanese way of business reflects Japanese culture and economic structure. A lot of problems with the Japanese oil industry reflected the oil industry law which restricted competition. It meant that Japanese companies competed on the basis of service. The Japanese oil industry overbuilt because they were encouraged to do so. Restrictions on free product trade meant there were distortions in the market. With their easy access to credit and low interest rates, Japanese companies have tended to have too much debt.
They should focus on maximizing capacity utilization, reduce capacity in a few cases, and work more to internationalize. For Japanese companies, upstream is a good business and has been more profitable in the last 20-50 years than the downstream. Especially due to their ties with American majors, Japanese companies did not go upstream very early and went poorly upstream afterwards. Since this is a mature market though, you wind up competing on cost in a commodity market. For example, De Beers could convince people that diamonds were special, so there was reason to pay extra; in the oil industry, you cannot do that. Gasoline is a commodity, so the only thing you can do is keep costs down. More trade and international investment can help, but the oil industry is tough. It may make sense to tie up with Saudi Arabia, but it is important not to think there is some special value to a Saudi contract. Japan has tried to maintain good relations with oil-producing countries, but when you are paying $3 billion for oil for ten years at the market price, you are essentially paying above market price while everyone else is paying market price, so I think it may not be such a good idea.
Q: In the 1970s or 1980s, the oil market was quite oligopolistic. Currently, there is much more competition. So maybe price elasticity could work more short term than before, not only on the demand side, but on the supply side, is that right?
A: I think so, yes. The supply side is more complex than the demand side, but it should work better. The biggest problem now is access to drilling areas. There is a little bit of a tendency in places to become more xenophobic and less willing to allow drilling. Nigeria, Algeria, and Colombia are very happy to have foreign companies come and drill for oil, but a lot of other places are not so happy. In Russia, there is still very little foreign investment. While supply has been growing very rapidly in the past few years, it is just that demand has been faster. I do not know that you can increase the growth in non-OPEC supply even more from now without prices staying up.
Q: Two weeks ago, a Chinese researcher on oil said that China will consume nearly 10 billion barrels in 2015. What is your prospect for the Chinese oil situation?
A: In the long term, it will grow rapidly and that scares people, but the U.S. demand for oil 20 years from now will still be much higher than China. The rate of growth in the 1960s with Japan, Europe and U.S. is probably more than we will ever see again. Even with rapid Chinese or Indian growth, which is helpful for OPEC producers, for the next ten years, it is not so much as to put pressure on the resource base and keep prices high. People in OPEC would love to raise production 50% over the next ten years and that would be enough for China. It only sounds like a big number.
Q: You said that Japanese companies tend to prefer longer-term contracts paying, in effect, extra money over the market price. Does this relate to the "Asian premium?"
A: No, I was thinking more of Japan National Oil Corporation (JNOC) and Arabian Oil Company (AOC) and other cases where the Japanese government provided aid as a way of encouraging deals. I think the contracts are usually closer to market prices. I have seen instances where companies were paying large amounts for residual fuel oil above the market price, justifying it as security of supply. When I asked whether there has ever been a time in history where fuel supply was short of supply, they finally started putting their fuel supply up for spot bid auctions on a regular basis and getting lower prices. By being more flexible, companies have brought their prices down, but there are a lot of ways to raise the price above the spot price.
*This summary was compiled by RIETI Editorial staff.