The Real Oil Crisis

February 12, 2003

The Real Oil Crisis

Oil prices are over $30 per barrel (London Brent crude closed at $32.

Oil prices are over $30 per barrel (London Brent crude closed at $32.28 yesterday).  An invasion of Iraq is pending.  Venezuela's production has not recovered from the impacts of the strike (production is at 1.9 million barrels per day (bpd); it was 3.1 million bpd last November).  Oil inventories are at record low levels.  OPEC has admitted its surplus capacity is down to about 2 to 4 percent of world demand levels and it cannot make up for supply shortages caused by a disruption of Iraqi production in addition to the Venezuelan shutdown.  Non-OPEC producers are already producing at capacity.  Even if we squeeze through these near-term shortages, the surplus capacity will disappear in less than 3 years with normal demand growth in recovering economies causing long-term upward pressure on oil prices which will stifle that same growth.  

 So why is the oil industry not expanding its operations?  Why are capital budgets this year predicted to be flat or lower than last year's?   Why is the worldwide rig count and number of active seismic crews lower than they were a year ago?   Why is Houston not eagerly anticipating boom times?

 The answer to these questions is simple: Because investment in oil development is a bad investment.   

Capital commitment for large projects runs in the hundreds of millions, or billions, of dollars.  From capital commitment to significant production, and income, averages about 5 years for large projects.  Prices are volatile and unpredictable and if the projects successfully bring on new production, the price of oil will drop and reduce the rate of return.  Investment has a high degree of political, economic, security, geological, event, fiscal, and technical risk.  The industry has a reputation for capital destruction.  All these factors combine to make an oil development project a hard sell to prospective investors.  

 Besides these direct impediments to investment are more subtle influences. Lulled by economic expansion and unconcerned about oil supply for twenty years, the American public developed several widespread opinions and attitudes that are manifested in political activity.  These political activities make the oil industry the scapegoat for the country's problems, constrain any attempt to formulate an energy policy, and have perverted legitimate public concerns over pollution and the environment for political gain.  Although many of these opinions are inconsistent, outright conflicting, based on unrealistic expectations, or counter to scientific evidence, they have been used to mislead the public and politicians and achieve political objectives that are irrelevant to energy issues.  These attitudes have hardened into an unreasoning vicious fanatical opposition to all activity by the industry and, by adding an additional element of risk, discourage investment.  In addition, people in the industry are leaving in large numbers, fed up with being, as one told me recently, "over-legislated against, over-regulated against, over-litigated against, and vilified in the press - I'm going to cash out and get out".  The exodus of experienced personnel is beginning to stall large projects. 

So we have an imminent threat to the general world economy and well-being.  As yet, little or no action has been taken to prevent or alleviate it.  We have an oil shortage facing us and the investment is not being made to develop additional supplies.  As usual, the United States must take the responsibility of finding a solution; no one else will, or can.   

 Additional investment for oil development to meet world demand by 2015 is estimated at between $800 billion and $1.5 trillion.  Under current conditions, the Middle East is a concentrated source not only of oil but of trouble and instability, so investment should be directed to developing diverse sources in other locations. 

No one expects the United States government suddenly to become a developer of foreign oil fields; it does not have the expertise and such an activity is not consistent with American concepts of the role of government.  The government can, however, through various actions and policies, create a more favorable environment for investment by the industry.   

These activities fall into two categories.  First, a program of diplomatic attention and aid to improve the investment climate in areas and countries where we would like industry to develop additional oil supplies such as Russia and Latin America.  That diplomatic attention and aid will have widespread benefit by improving general economic conditions in those areas with resultant benefits for political stability and improvement of living conditions for the populations.  Second, regulatory steps must be taken to change the mechanism of oil pricing to be more consistent with industry conditions and investment requirements.  Government should not set prices or interfere with the market, but it can change the rules of the oil market to offer more stable, long-term price and market expectations.     

 From a technical standpoint we know where additional large foreign oil supplies can be developed: Russia, Mexico, Colombia, Venezuela, offshore west Africa, and Central Asia.  This is not an optimal set of choices.  Mexico allows no foreign investment in its oil industry.  Investment in the others is hampered by varying combinations of unattractive fiscal terms and working conditions, unstable political systems, and unsafe and insecure working conditions.

 Of all these potential sources, Russia has the greatest potential for short-term significant supply development but is an undesirable investment arena for foreigners.  Russia has increased production by more than one million barrels of oil per day (mbopd) in the last year with the efforts of Russian oil companies who have demonstrated an ability to move aggressively under the right circumstances. Russia can probably increase production by another one mbopd in the next year or so but further increases will be hampered by lack of infrastructure, particularly export facilities, and extremely long and tedious bureaucratic delays.  Vladimir Putin is gradually taking steps to improve conditions for investment by Russians and foreigners, but major obstacles remain; he can certainly use all the help, encouragement, and assistance we can give him.  The announcements of the large merger of two Russian companies with participation by BP and the decision to build two oil pipelines to export Russian oil to China and the Pacific can be expected to have a big impact for increasing Russian exports.  

 Central Asia has the same problems as Russia.  In addition, it is landlocked without a ready export system or access to a system except on a limited basis through Russia.  Fiscal terms of contracts in the region are generally unattractive.  

 Venezuela is currently unpredictable.  Unrest may continue for several months if Hugo Chavez continues to hold on to office.  Production will be reduced for a prolonged period and will require several months to restore.  Unrest also may continue if Chavez leaves and elections are held.  Venezuela has put out discreet enquiries to potential foreign investors but it is too early to tell how soon any contracts can be negotiated.  

 Latin America in general is a major problem area but one in which a concerted diplomatic effort and economic and financial assistance could have a definite positive impact.  Otherwise, we may find it a source of even greater difficulties in the future.

 The current oil pricing system is a major hindrance to investment.  Since the early 1980s, the oil price has been determined in the pit at the NYMEX by trading in 1000-barrel contracts.  At the time trading contracts were introduced they were welcomed as a means of breaking OPEC's pricing control and have worked well as a means of keeping prices low during a two-decade-long period of supply surpluses.  But in a period of shortage, one cannot help but wonder at the wisdom of turning over such a major portion of the world economy to shouting 24-year-olds with 30-second attention spans for whom a long-term outlook is about a week.  Such a system reacts immediately to bad data, rumors, and manipulation.  

 DowJones Newswires recently ran an advertisement claiming that "senior energy reporter Sally Jones was first with the market-moving news January 7th that OPEC was looking to hold an emergency meeting to discuss raising output" and that the "price of oil tumbled following the headline as the market speculated".  DowJones may justifiably be proud of Sally Jones' "persistence and excellent contacts" but this illustrates an unattractive pricing environment.  If oil prices will tumble on rumors of a meeting among a group of production-quota cheaters (and such rumors swing the market frequently) who will invest billions in projects that may not start to pay off for 5 years and when they do, the oil price will tumble due to the added supply?   

The pricing system is inherently inconsistent with the time scale and requirements of the industry.  Government must not set prices nor interfere with the operation of the industry and oil markets with subsidies, incentives, fiscal manipulation, and so on but it can establish a better pricing system in which market forces can work in a more stable environment than the present casino.

 Charles A. Kohlhaas is a former Professor of Petroleum Engineering at the Colorado School of Mines and has worked for, founded, managed, and consulted for major and independent companies in the international oil and gas industry.