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(Good-bye) party time
Fault lines as oil rises above $50 a barrel

October 20, 2004

During the first eight months of this year, the price of oil has risen to nearly $55 from just under $29. For the last 30 years, the price of oil has been the single most important determinant of the economy and the stock market. However, there is something amiss in this whole equation of steep oil price rise. Whilst in the short term it provides opportunity, to me, in the long term, it sounds like a death knell for OPEC.

Oil pricing is a two-edged sword, as I recently explained to an OPEC country oil minister, which is hard to manage. Let it drift too low and quota-cheating necessitated by the single commodity- dependent economies of OPEC take the bottom of the oil prices like, oil at below $10; keep it too high, long term impacts are disastrous.

Thus, rich oil nations like Saudi, Iran, Iraq and Kuwait are caught up in a quandary. They need to maintain oil at a price that helps them grow their single commodity dependent economy to a multifaceted economy, but at the same time keep new producers and threatening new tech advance out of the contention. The authors of 'Oil Factor,' a gloomy book about energy, claim that the oil price will soar above $100 a barrel by the end of the decade, and possibly sooner.

The Oil Depletion Analysis Centre (ODAC) is a stunning group convinced that the world is perilously close to an oil shock induced by scarcity, not politics. Thanks to the surge in the price of oil to nearly $50 a barrel, the predictions of OACD and Oil factor authors look realizable. The cartel's export earnings are running at almost three times what they were in 1998, when a barrel fetched only around $10.

OPEC's 11-member states produce 26 million barrels of oil a day - 39% of the world's oil production, which accounts for half of all oil exports. They are swamped with extra $360 billion's by end of 2004. It seems Russia that produces equal barrels to Saudi should one day become the swing producer, but if one scratches the surface a little, he would realize that on reserves Saudi and their closest allies in OPEC belong to different breeds of oil producers. The two groups as a result should have conflicting oil pricing policy.

Saudis and their allies represent nearly 25 percent of the global reserves of more than 800 billion barrels. Nations with miniscule reserves within OPEC like Venezuelans, and Indonesians, need higher price now that they may be running out of oil in the next twenty years.

However, Saudis, Iranians, Iraqis and Kuwaitis with much larger reserve base extending beyond five decades need balanced prices that may continue the 'party of oil' a bit longer until their economies' dependence on single commodity is shifted. This fault line within OPEC where OPEC is divided into rich reserve nations and poor reserve nations would lead to a rethink within OPEC, as Saudis and their allies definitely support a more balanced regime of oil pricing.

Those who remember the oil-price shocks of 1973-74, 1979-80 and 1990 should now be suffering restless nights. On all three occasions crude oil prices tripled, inflation soared and the world economy went into recession. However markets reacted positively to Greenspan's recent comments. "While high oil prices (a whopping $54.86 per barrel today at the close) have sliced about 0.75 percent off GDP growth, the effect won't be nearly as bad as the 1970s oil crisis and the global economy will adjust."

It is imperative to reconcile the gloomy and rosier pictures. Ironically, in inflation-adjusted terms, a barrel of oil is cheaper than it was in 1980, when it cost $81 in today's money (in 1864 newly-discovered oil hit a giddy $8 a barrel - $92 in 2004 dollars). Post first oil price crisis the global response was on the demand side-notably energy efficiency, including vehicle fuel economy.

To write an article with contrary logic is a difficult uphill task, but when Economist wrote that infamous piece predicting oil below $10 for eternally, it was premature; like predictions of below $10 were unsustainable. Today, oil at post $50 would be equally untenable.

Hedge funds have made the situation even worse by making big bets that oil prices will continue to rise because of the imbalance in supply, demand, stocks and continuing political uncertainty in the Middle East. OPEC officials say this speculation accounts for up to 20% of the recent oil price. It is in the interest of OPEC to keep prices low otherwise the future prospects of oil, as a commodity, looks very bleak as global uncertainties come down and technological advancements bring efficient use of oil in the forefront.

The world's apparently unquenchable thirst for oil is fuelling a boom in exotic kinds of exploration technology for use in much deeper waters; five to ten years ago, if you came up with the idea of a directional well that stretched 25,000 feet, the oil man would have said you're dreaming. But today, they are just kicking them down one after the other.

The world has consumed 78.7 million barrels a day in the second quarter of this year. The three big industrialized economies, the U.S., Europe and Japan, are all growing in harmony, a rarity event and indicator of global prosperity despite all the pessimism inherent. China, India, Russia and Brazil known as BRIC'S collectively referred to as 'sick man of global economies' in the 70's are now booming economies sucking in oil to power their manufacturing and make gasoline to fuel their industry.

China, now the world's No. 2 oil consumer after the U.S., is importing 20% more oil by volume than it was a year ago.The IEA forecasts the world will consume 80.6 million barrels a day on average in 2004, up from 78.7 million barrels a day in 2003 and 77 million barrels a day in 2002. One thing that major pundits of the hedge funds are missing in this blind pursuit of ever-higher oil prices is the impact of petroleum intensity on pricing. The United States has in fact been following the path of lowering oil intensity-oil consumption per dollar of gross domestic product (GDP)-since the late 1970s.

Global economy was consuming around 65 million barrels of oil in the early 80's; however, the total size of the global economy was only 12 trillion dollars. Today, a global economy of nearly 50 trillion dollars consumes slightly higher oil. The world is becoming a very efficient user of oil. If lessons from the first oil crisis are to be learnt, then we need to appreciate that these price rises will ultimately reduce the consumption of oil.

Thoughts are now turning to reducing oil, not producing it, even more spectacular results can be ensured. With new technology, new energy forms are possible, not that they don't exist, they are very uneconomical at $35 /barrel, but at $55, even some form of fuel cell becomes an attractive option.

On top of that anyone who underestimates the potential of exponential growth of development and research would do that at his own peril. The biggest and most efficient consumer, the U.S., consumed about 6.2 billion barrels, up 4.2% from a year earlier. It is expected this year the US consumption to be 6.8 billion barrels.

Now let's look closely at the US petroleum intensity for which the date is easily available - from 1950 to 1980 it would take 1.6 barrel of oil to produce 1000 dollars of GDP, in 2004 it takes .8 barrel, nearly half the consumption of 1980's, to produce $1000 of GDP.

In 1978, the total consumption of oil in a much smaller GDP of $2.2 trillion in 1998 was 6.6 billion barrels of oil; presently, for slightly higher consumption of around 7 billion barrels of oil, US GDP has grown to 11 trillion dollars. Reduced gasoline demand plus price-induced conservation has reduced U.S. oil consumption by 2.8 million barrels per day.

Oil in the medium term, as it breaks new highs, can continue this manic one-way move up, however, the best way to break the high price of oil is to have this high price for some time, bear in mind the silver mania. Commodity traders can sometimes well overstate the fears of disruptions; right now it is generally believed that Alqaeda is planning a global terrorist attack on major installations in Saudi Arabia so as to choke Saudi oil.

Recent violence in Saudi Arabia, including a deadly attack by Islamic militants in the Saudi oil city of Khobar, and a fear that al Qaeda-linked forces are attempting to provoke civil war in the kingdom have raised fears about interruptions in oil supplies. Combine these worries with Russians trying to cow Yukos, which accounts for 2% of the world's oil supply. Other doubts like the future of new discoveries add a new dimension of uncertainty; new oil finds are proving intangible.

Some other fears that dominate the rumor mongering oil markets are that new production has been low in the two biggest oil-producing regions, the Persian Gulf and the Caspian Sea, that they are short of pipelines and ports. It is also argued that U.S. refineries are presently running at near-full capacity, providing a chokepoint for gasoline supplies to American consumers.

It is argued that oil companies found an average 6.8 billion barrels of new oil a year in 2001-2003, compared to 11.4 billion barrels a year in the previous five years, since it takes take three to 10 years from discovery to production.

Saudis as swing producer is the key to oil prices; most OPEC members produce nearly at full capacity already. Only Saudi Arabia and the United Arab Emirates have spare capacity. Saudi Arabia remains the kingpin of oil. It has a quarter of the world's proven reserves, about 262 billion barrels of oil, under its vast desert expanses. Add in the reserves held by the country's allies in the OPEC cartel, and the total is a whopping 815 billion barrels-some three-quarters of world reserves.

Most of the extra oil in case of global crisis would have to come from Saudi Arabia, the world's largest oil producer, by far its largest exporter and OPEC's traditional swing producer. It has an estimated two to three million barrels a day of spare capacity. When doubts are cast on Saudi swing production, all bets are off.

That 'concerted terror attacks' is a daredevil kind of planning, in my humble opinion, but in a milieu where sensationalism sells, this story has a top seller. Oil Age will end one day, as Zaki Yemani said. Oil was dirt cheap below $10's, it is now $53's above what it takes to produce in Saudi Arabia. Even OPEC realizes the long term impact of high prices on the ability of inefficient oil nations to produce a lot more at around $30-32 a barrel.

The present state is very tentative; new productions which are high cost production and were, until very recently, uneconomical to produce would need ample reassurance to come back to life. Current levels of pricing are quite attractive and highly incentivised for 'dull producers' to go back on an investment spree. The reason less oil was found in 2001-2003 was not due to lack of fields, but lack of investments (who would want to discover more oil at $20-25 a barrel?).

In my opinion, the biggest threat to oil future comes from the GDP growing efficiently on lesser and lesser oil. This also signals that consumers are shifting towards cleaner economies whereas producers are loaded with old economy consumption pattern. On the security side, lesser revenue from oil creates havocs for economies like Russians and OPEC, even terror becomes difficult to handle if free jobs of paper-pushers in ministries of Saudi and Kuwait are denied. Higher oil prices can buy loyalties in commotion-prone Saudi Arabia. Nicely tied to these handouts, the same people become bigger terrorists if denied the handouts.

On the other hand, OPEC countries' higher commodity prices make them great consumers. If the West keeps producing cleaner service economy with lesser consumption, and commodity-rich OPEC countries fail to understand energy efficiency impact, the dependence of commodity rich countries on the West will further increase as higher oil revenues make OPEC populace addictive to products of the west, as if that has not happened already.

When taps on oil are turned off the repercussions on OPEC would be huge. Extreme swings in oil pricing create structural imbalances and false cradle to grave social demands, they are nearly impossible to fulfill at low oil prices. As oil makes new highs, the 'dull producers' by nature of their business as high cost producers, usually come late to the market. But once they bring that additional few million barrels, the speculative bubble can puncture pretty fast. A story based on sensational plots can only fly that much, perhaps it is the initial high cost of production impediment for the dull producers that encourages such speculation even further.

On the flip side of this argument, although the supply size of the dull producers is not more than 2-3 million barrels a day and very miniscule in relation to the 78 million barrels daily world consumption, once market speculators realize that swing production of OPEC held by Saudis is sustainable at these 50 $ level and even in the most unlikely event of knocking of Ras Tanura oil terminal by the terrorists in a coordinated attack will not diminish the ability to satisfy world consumption, then realism comes into play and out goes speculation and sensationalism.

Efficiencies of world commodity markets cannot be understated here. The price levels can be overextended, but the actions in commodities and currency, or for that matter, stock markets, are not a rear window image. It is the sum total of all greed prevalent within the workings of capitalist economies; it is this ever present invisible hand and mind of greed and self-preservation that pushes these global markets to new highs. Boom and bust are inbuilt stabilizers of global capitalist markets.

These speculators take on inefficiencies and iron them out; it is always a war between weak holders and strong holders and in the end, the only survivors are those who are neither over-leveraged nor get too over carried by pessimism. By nature, wealth creation and wealth preservation are safeguarded by 'bodyguards of global speculators.' These speculators, now headed by major hedge funds, fine tune a trend and then appear as complete 'demolition businesses' to remove any physical profligacy or intellectual vanity.

The United States has been a leader in new exploration and production technology that has greatly lowered the supply cost curve here and around the world, and those technical advances are continuing. In the present war between speculator myths and physical realities governing oil price rises, it is the myth of fear that is exacting the right price from consumers.

In capitalist economies, there are no free lunches; too much fear leads to too much of inbuilt profit, a great thing for OPEC in the short run, but a bad omen in the long term. Now if OPEC is overtaken by greed, a few years' highs of these levels of oil will lead to permanence of greater high-cost supplies and with technological advancement on the way, who can say that these high cost producers may come to stay.

In such a scenario, for big underground reserve holders of oil like, Saudi, Iran and Iraq, it would be meaningless to have too much oil in the ground, if new energy-efficient industry in the next two decades knocks gas guzzling machines out and oil becomes a cheap commodity with utilization at far more efficient levels. It is these nightmarish scenarios the producers have to work with.

New non-OPEC supplies developed in the 1980s helped bring the original oil shock period to a close, and prospects are promising now for substantial additional once oil stays at these levels, as forgotten closed down fields become more profitable. Oil price vagaries epitomize 'free market' no price control economy at its best. The reason that global market oil pricing is free from the clutches of OPEC or any cartel of consumer like OECD signals the maturity of the pricing cycles.

The greed inherent within capitalist systems has to stay awake and alive, that is the only difference on how capitalist markets survive every possible assault on its jugular by the ideological left. Price-controlled economies like that of the Russians imploded under their own weight, even Nehruian socialist model failed to address India's woes of poverty.

It was only after free market was allowed to thrive that India's shining came glowing up on the radars of international fund managers. Even the last bastion of the socialist economy China, today, is at the extreme right of the old great leap forward model. Transformations of economies only take place when greed, a product of incentive, is allowed to unashamedly thrive.

To have a huge greed-based rally of oil in late summer/early fall is the best possible preparation for a harsh winter; it is such kind of market inbuilt 'maniac delusions' that has yielded best survivors of the global economies. We all know that it is the shape of a 30-year bond yield curve that indicates the direction of the market economy; it is always the long run that determines the shape of any nation's future. The concerns on higher oil prices can only be mitigated by immediate lowering of oil prices by the OPEC nations for their own benefit.

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