Australian Views: How serious is the oil crunch?

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How serious is the oil crunch? The industry is at a critical stage but the experts have their own views, writes Steve Burrell.

How high and for how long? They're the questions consumers and policy makers alike are asking as the Millennium Oil Shock oozes its way through the nooks and crannies of the global economy, cranking up inflationary pressures and threatening growth.

The answers vary widely, depending on which expert you talk to.

Some say that current high prices are a temporary spike and will fall back to their longer term equilibrium level - generally thought to be around $US21-$US23 a barrel - in the not-too-distant future.

Others are already contemplating the possibility of oil at $US50 a barrel and the likelihood that, because the supply demand imbalance which has driven the oil shock cannot be quickly corrected, today's high prices of $US30-$35 a barrel, or even higher, could continue for several years.

Who turns out to be right has profound implications for world growth, inflation and the course of global interest rates.

The Oil Pessimist school has a number of adherents, including the Professor of Petroleum Engineering at the University of Houston, Michael Economides.

He argues that the OPEC oil cartel, which has been painted the villain behind this price surge, is not the real cause, or solution, of the problem.

He says that despite claims that OPEC could bring prices down by expanding production, the reality is that its excess capacity is now virtually nil.

And a huge drop off in investment in oil exploration, production facilities and distribution infrastructure, a response by the global oil industry to the $US11 a barrel prices that prevailed less than two years ago, has squeezed supply capacity globally, pushing up prices.

(Aggregate investment by the mega-oil companies, Exxon Mobil, Shell and BP, was down 23 per cent in the first half of 2000 - while crude oil prices tripled.)

In effect, the world is now paying the piper for enjoying artificially low prices as a result of the Asian crisis.

Even if OPEC could produce significant new supplies, Economides says, prices would not necessarily fall quickly because of capacity and transport bottlenecks throughout the supply chain.

World oil tanker capacity has already been badly eroded and other distribution infrastructure is inadequate and refinery capacity barely enough to meet demand.

In this environment, Economides says there is a real possibility that prices could spike much higher - well into the $US40-$US50 a barrel range. More significantly, prices above $US30 will persist for at least two or three years due to lags in investment and capacity expansion.

However, a more optimistic scenario was painted in a speech last week by none other than US Federal Reserve chief Alan Greenspan, who sees a "new economy" transformation in this quintessentially old economy industry allowing supply demand imbalances to be equilibrated more quickly.

"What has changed dramatically in recent years is the production side of oil, which is likely to be a substantial factor in determining the extent and duration of any oil-price spike. Oil, in this regard, has truly become at least an associate member of the new economy," he said.

" The development of seismic techniques and satellite surveillance to discover promising new oil reservoirs has more than doubled the drilling success rate for new field wildcat wells during the past decade. New techniques and the use of oil rigs that have more computer chips in them than most modern office buildings facilitate far deeper drilling of promising pools, especially offshore. The newer recovery techniques reportedly have raised the proportion of oil reserves eventually brought to the surface from a third to nearly a half in recent decades.

"One might expect that, as a consequence of what has been a dramatic change from the old hit-or-miss wildcat oil exploration and development of the past, the cost of developing new fields and, hence, the long-term marginal cost of new oil have declined."

He notes that one measure of this decline is the fall in the prices of the most distant forward contracts for crude oil. While spot prices have been on a roller-coaster, these contracts, which cover a timeframe long enough to seek, discover, drill, and lift oil, have moved lower over the past decade. The current six-year futures contract has risen over the past year, but is still only about $US21 per barrel.

This long-term marginal cost of extraction anchors the long-term equilibrium price, to which, over time, spot prices are inexorably drawn as the balance between underlying supply and demand is restored.

"But in the short run, the price of oil, as that of all commodities, inevitably is influenced importantly by inventory levels, especially when stocks become critically short," Greenspan says.

The world oil industry has historically run on a thin buffer, roughly a thirteen-day stockpile.

This meant that when OPEC cut back oil production by more than 3 million barrels a day in 1998 and 1999, while world demand rose, the existing buffer of more than fifteen days worth of oil rapidly shrank to a little more than ten days. As a consequence, the price of crude oil tripled.

"OPEC has since more than restored its output, bringing world production now to record levels - levels that exceed reported demand by nearly 1.5 million barrels a day ... Inventories of usable stocks are building but have yet to regain normal levels," Greenspan noted.

"It would certainly seem that, with inventories building and the spot price of crude oil well above its long-term equilibrium, spot prices would shortly be under significant downward pressure."

Time will tell who's predictions are right. But it's comforting to know that the man with his hands on the most important interest rate levers in the world appears to be on the side of the Oil Optimists for now.

http://www.smh.com.au/news/0010/27/business/business6.html

-- Carl Jenkins (Somewherepress@aol.com), October 27, 2000


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