DIRECTOR'S PERSPECTIVE

by Saruhan Hatipoglu sshatipoglu@beri.com

THE TWISTED INVISIBLE HAND & OIL PRICES:

To the Victors Belong the Spoils

Man-Made Crisis: Oil prices came close to hitting US$50/bbl in mid-August, embarrassing experts who claimed that the year-end cost would be under US$30 in 2004. Adam Smith’s invisible hand was operating freely, and supply and demand functions were working as expected during the first quarter of the year when the prediction occurred. Then, human nature twisted the invisible hand.

First, sporadic attacks in Iraq encouraged speculators to react swiftly and raise the price of crude oil. People are nervous about consistent supplies of oil from the Middle East regimes and the scope of oil exports in a region held hostage by terrorism. Then, the infamous Yukos saga added salt to the bleeding wound. Speculators were worried about the potential bankruptcy of the company and its adverse impact on oil prices. This concern was exaggerated but, with daily production of about 1.7-1.8 million b/d, the problems of Yukos were seen as a potential threat to oil prices. In reality, whether Yukos is in the hands of its original owner or government officials, Russia will do its utmost to maintain production.

Current Impact on Developed Countries: The United States is clearly more adversely affected by the high cost of oil than Europe and Japan. U.S. consumers paid an estimated US$60 billion during the first half of 2004 because of high energy prices. Furthermore, American business incurred a bill close to US$40 billion for not passing on higher costs to consumers in this competitive environment. The impact during July-August was severe.

Europe has been cushioned against high oil prices largely because of the appreciation of the euro and other currencies against the US$. European consumers did not feel any large impact until the second quarter of the year. It is estimated that during June-August, energy prices took 0.5% from European disposable income, less than US$10 billion. Japan consumes 7% of world oil supplies and imports all its oil. Although the country was also partially insulated from high energy prices in the first half of the year due to a stable currency, the high cost of oil is slowly beginning to hurt domestic business and consumers. The price of crude oil is up 31.2% from a year earlier.

Clearly, in the short-term, oil prices will inflict damage on economies and threaten global recovery, but the question is: What is the future of crude oil and the five-year trend of oil prices? What we are witnessing now is not any different than previous fluctuations dictated by the supply/demand function, and aggravated by speculators. However, there is certainly room for concern because long-term price dynamics are in the process of shifting.

Supply Is Adequate: Supply in the next 5-10 years is not jeopardized by the volume of crude in the ground and the facilities in place to produce and transport it, despite the recent statement from OPEC that its members drilled 6.5% fewer wells last year. Some analysts believe that lack of investment in the past decade will constrain capacity in the coming years, but proven oil reserves were at 1.2 trillion barrels in 2003, compared to 1 trillion five years ago and under 650 billion in 1980 according to Oil & Gas Journal. OPEC will stick to its promise of raising production by another 2 million, if recent past is any indicator: OPEC lifted total oil output by 10.5% in 2003 from 24.32 million bpd to 26.88 million. It is already producing 15% higher than its quota, and new production is not costly. The decision on new quotas will be made in mid-September, but the organization has been sending strong signals of a production increase since early June. With 78% of the world’s oil and half of natural gas reserves, OPEC’s declaration should have been heeded by the market, which would have constrained steep price increases.

In addition, other suppliers will have growing influence in oil production in the near future. In late August, President Vladimir Putin announced that the country will increase output 5.9% to 9.1 million b/d. This preceded the statement of the Economy Minister that Russia will export 250 million tons (5.035 million b/d) of oil this year, 11.6% more than a year earlier. The inability of the existing pipeline network to pump more oil will curtail production, but sustained investment activity will raise capacity to an expected 475 million tons (9.565 million b/d) by 2007.

Long term supply is potentially jeopardized by the U.S.’s inability to establish peace and stability in Iraq and by the enmity in the Muslim world created by the presence of Western forces (mostly American) in Afghanistan and Iraq. These developments have been catalytic in recruiting extremists and suicidal zealots. It is now less certain that the sheikhdoms will survive in the coming years. Alternative governments in the Middle East, guided more by ideology and religious fervor than the economics of supplying the marketplace, could limit shipments to the infidels in the West.

Rising Demand Is Real and Lasting: Human judgments on the supply-side is one variable of the price equation, but the impact of steadily increasing demand is a crucial factor and will be the primary reason for real long-term oil price increases. Total demand for oil is currently about 79.7 million bpd. The International Energy Agency expects global oil demand to rise by 2.5 million to 82.2 million barrels this year and by another 1.8 million to 84.0 million barrels in 2005.

The U.S dominates consumption, accounting for nearly 25% of oil usage, while Europe consumes close to 15%. Emerging markets such as China and India (constituting10% of global demand) are also putting considerable upward pressure on demand. In fact, China passed Japan last year to become the world’s second largest oil consuming country. Although growth in China will slow as a result of measures taken by the government, economic activity in the long term will remain robust, and the country’s appetite for energy will be huge. Emerging and developed countries alike intend to expand rapidly to create jobs and maintain socioeconomic stability, and energy needs are an important factor in that equation placing immense upward pressure on global demand.

Conclusion: Slowing economic growth in key markets, partially caused by high oil prices and interest rate increases to control inflation, will limit crude oil costs in the coming year, but the long-term outlook is grim. The adverse impact of oil prices on economic expansion in the short-term is undisputed, but the long-term trend of oil prices has shifted from the low US$20s to low US$30s, not as a result of short-term behavior but rather because of changing dynamics of supply and demand. The much-talked about dearth of investment has a short- and maybe medium-term impact on oil prices, but the pace of growth in demand is the primary cause of the structural shift.

If the sheikhdoms fall and are replaced by governments hostile to the Western world, lack of adequate supply becomes a major concern in the long-term. New supplies are being discovered in West Africa, Siberia, Central Asia, West Canada, and Venezuela, but these additions to global capacity will not offset reductions in the Middle East. Mega-mergers among the major energy companies will provide more capital for additional exploration and development, but a decade is often required to go from oil discovery to commercial production. It is certain that the pace of increase in supply of oil will not match robust demand, especially if Muslim countries limit shipments.

In the short term oil prices will average about US$38.50 per bbl in 2004 (US$33.88 per bbl in the first half, US$43.25 in the second half). If the invisible hand is allowed to operate freely without interference from profiteering speculation and religious zealots, the average in 2005 will be US$33.50/bbl. "In the long-run, we are all dead," said John Keynes. He was right, but if irrational oil speculation cannot be prevented and religious fervor replaces the market place, the judgment day might even come sooner.

DIRECTOR'S PERSPECTIVE Last Updated September 2004