By:
Professor Thomas Wälde,
Jean Monnet Chair for EU Economic and Energy Law
Executive Director, CEPMLP/Dundee
1) Comment on the current increase in the price of crude oil
Crude oil has been on a generally rising tend since the very low prices achieved in 1998. This long trend has been accelerated currently by short-term influences on the market. First the longer-term perspective: Oil has become a commodity that is subject to cyclical developments, i.e. regular ups and downs both in the short term and the longer term. A significant increase tends to trigger, as with other commodities, a serious correction, usually with a considerable time-lag as sunk investments delay a rapid reaction of supply. Any long-term depressed oil price is likely to provoke over a time new demand and relaxation of energy-savings measure. Similarly, marginal operations will be closed, often forever, existing wells badly maintained and new projects be at least delayed and sometimes suspended. This is what happened since 1998: Oversupply then a hit lack of demand exacerbated by the financial crisis in Asia. Prices dropped to a very low not seen since 1986. Some complacency with respect to energy efficiency set in as well, in particular probably in the US where gasoline prices have never been subject, as in the EU, to massive surcharged imposed by the governments. So the rebound up to summer 2000 is a natural event, reflecting the cyclical nature of oil prices since price control both by producing countries, oil companies and governments have been disappearing.
This upward trend seems to have been helped by a greater ability of producing countries in OPEC to agree on and comply with restrictions on production, though most of them still are reported to produce beyond their quotas - a fact that is less significant if this quota excess is implicitly factored into and accepted by the official quota policy. OPEC countries control the cheapest oil reserves, and as a result their action in increasing or limiting production has most impact on prices, as reduced production will lead to price signals being influenced by the higher costs of producers outside OPEC. It has also been asserted that there is much less cheating over OPEC quotas because real capacity is less than is officially reported - in other words: Producing countries are not that much loyal to OPEC production ceilings as technically unable to exceed them. If this is correct, then much of the US efforts to persuade major producers to increase production are pointless in the short term and will only work once necessary re-investment, maintenance and expansion into new facilities has taken place. But in anyway, the demise of OPEC - which is in a period of low oil prices usually regarded as rather the shadow than a cartel - has been announced far too prematurely. In a period of high oil prices as now it is rather seen as an effective cartel, or a mechanism for effective concertation among the major, influential producers.
Other demand factors have equally helped the price to move upwards: The US economy has been continuing its longest-ever growth cycle, with no signal of sudden end in sight at this moment. The European economies have, with a time lag with respect to the US, entered into the growth cycle, helped, like the US, by the increasing impact of deregulation, privatisation and internet-backed productivity growth. Asian countries - apart from Japan - are recovering from the 1998 financial crisis and its slow-down effect on economic growth. As a result of these developments in the important parts of the world economy, demand for oil has been rising; it has not been checked by greater production as OPEC production controls seem roughly to hold, US oil production continues its terminal decline and new production (e.g. West African offshore or the Caspian) will take several years to fully enter the market. While Iraqi production has come close to pre-Gulf-war levels - with the lifting of UN sanctions on Iraqi oil sales, Iraq's capacity in comparison to its neighbours, in particular Saudi Arabia, is less than it was in 1990. So Iraqi President Saddam Hussein and the US-led sanctions policy should also take some credit for the current high price of oil benefiting all oil producers. Both, together, merit an OPEC award. A full entry of the Iraqi potential without corresponding effective decrease of OPEC quotas could risk causing a decline of the oil price.
These general market factors, some exacerbated by politics, are intensified in the short-term by market reactions. Reportedly, shortages of stock in the US and the markets reaction to President Chavez of Venezuela's declarations which seem to qualify the current Chairman of OPEC as a price hawk contribute to current short-term gyrations, usually upward. The market's current perception tends towards highlighting news implying shortage, and downplaying news implying increased supply or reduced demand. But that is in the nature of markets to overshoot objectively given directions.
2) Forecast for the Future
Most experts who forecast the oil price future tend to be wrong as the future is rather in God's hand than in the wisdom of man. The most sophisticated computer programmes have not been able to predict the developments of the stock markets or the oil price of tomorrow and certainly not in a year. So we can only engage in informed speculation by pointing out to up or down factors for the oil price. As these factors become stronger or weaker, they will exercise an influence on the oil price.
First, the oil price can certainly rise further in the short-term. As the market is anxious and notices the growth of demand and signs that OPEC production controls (even if 5 or 10% above quota) hold, any indications of reduction in inventories, localised and temporal shortages, political incidents with some perceived relation to oil production (e.g. in countries such as Indonesia, Russia or Nigeria) or hawkish signs from OPEC (where President Chavez is currently the most articulate hawk) can bring the price further up. Oil prices could explode even further if speculative fever enters into the oil and financial markets, in particular with respect to forward trading without physical delivery. This is in contrast to the expectations of oil companies and stock markets where the current oil price (and certainly an even higher one) is considered as an aberrations and likely to fall to a level around 20 $ - otherwise valuations of international oil companies should be much higher than they are now and oil companies would commence projects with economic feasibility based on a 30 $ per barrel price level and not, as they currently seem to do, on a 18-22 $ per barrel price level.
It may well be that both stock markets and oil companies - having been burnt by the 1998 steep and very painful decline of the oil price - are overly pessimistic. So shorter-term moves up towards 40 $ should not be altogether excludable. One needs to realise nevertheless that in real US $ terms even an oil price of 40 US$ is appreciably below the 40 US$ mark reached 19 years ago! The 1981 price would, in real terms, have to be somewhere around 60 US$ in 2000.
On the other hand, a prolonged maintenance of the oil price at levels beyond 28 $ will inevitably, though with a time lag, lead to the self-corrective dynamics of the markets. While demand is not very flexible for oil prices in the short term, it is responsive to such price levels in the middle-to long-term. Projects that require an oil price over 25 US $ are likely to be considered at this moment. There should be many exploration results which were economically not feasible in 1998, but are now looking attractive again - with Caspian, Russian and West African oilfields particular targets. Much well maintenance must have been neglected in the past low price period so it will take a prolonged higher price to carry out such long-term oriented maintenance and therefore to increase capacity and reverse production declines. Much of Western oil interest has departed from Russia and the Caspian as the compounding of political risk, corruption, bureaucratic mismanagement and inter-country transit conflicts was not compensated by a high oil price - but with a high oil price, there is now money to assume the higher risk and transit premium in such countries. Similarly, demand is likely to be curtailed. Energy efficiency programmes may be pursued more vigorously. US consumers - traditionally the least responsive to oil price hikes in a country where the gasoline prices are traditionally the lowest in all developed countries - are now reported to move for the first time for decades towards public transportation. They may even consider at some time to look at fuel consumption and car size - with very-low fuel consumption cars now being available (e.g. a new Volkswagen Lupo). The movement towards energy efficiency and replacement of oil in transportation will certainly be accelerated by the current high price of oil, for example in the very promising field of fuel cells. The long-term decline of the importance of oil as the energy source of choice for transportation will be given now an additional push.
There are two imponderables: First, we do not know if the US economy will have a soft landing allowing it to grow its energy consumption continuously. Similarly, we do not know if the Japanese economy will, following restructuring of its companies, re-start economic growth - something that seems less likely for the time being. Second, the influence of politics on the oil price is hard to gauge. Whatever government comes to power in the forthcoming US Presidential elections, they are likely to continue the economic blockade of Saddam-ruled Iraq - which fits neatly with the interests of Texas oil producers, and virtually all OPEC states and even Russia. A President Bush will pay more attention to US oil producers, a President Gore more to US consumers; one needs to bear in mind that President Gore's father was intimately associated with Occidential Oil (though perhaps the son wishes to distance himself from this affiliation). Both candidates, though perhaps Bush more than Gore, are likely to relax the US relationship with Iran.
On the OPEC side, there are serious differences in interest. All OPEC countries are desperate to avoid another price collapse as in 1986 or 1998, but the producers with a huge political pressure for oil money spent on deprived people as Venezuela or Iran are keenest on short-term maximisation of their oil income to relieve political pressure and to be able to deliver on the many spending promises made to their people. Their rulers badly want as much money as possible right now. Countries like Saudi Arabia will have a longer-term interest in the maintenance of a more stable oil price at middle levels (e.g. 15-25 US$), and this interest should be shared by the small, but high-production countries like Kuwait and UAE. All, though - including Russia - have a strong financial interest to see the US-led limitation of Iraq's oil potential continued. So current, and even higher price levels, would suit best Venezuela and Iran (and Iraq), and be detrimental to the stability concern of the other major oil producers. They, and in particular Saudi Arabia, would see their current ways of living seriously affected if the oil prices following its cyclical tendency would collapse again, without that a current oil bonanza would bring them much benefit as they have difficulty absorbing short-term excess earnings and have not developed that well systems of storing excess income in high-price years to balance out income shortfalls in low-price years.
The implication of these interests is that there is likely to be US pressure on Saudi Arabia, Kuwait and UEA to increase production - or work within OPEC for increased production, and such persuasion may well meet an open door. Saudi Arabia and the Gulf states are dependent on the US as their - sole - protector, both in the past and for the future. If such protection were withdrawn, they are essentially defenceless against Iraq. So US persuasion will be heeded, though both the persuasion and the response need to be camouflaged. But there is currently no interest in sight to see another collapse of the oil prices from any party which could well happen if OPEC's production control would fade and Iraq would re-enter the international oil markets at full steam.
A sustained higher oil price will benefit foremost governments (including non-OPEC countries such as Russia, the Caspian states, Norway, the UK, Mexico and others) through greatly enhanced tax revenues. Given the profit- and high-marginal take-based nature of modern petroleum taxation, tax income to producing governments may increase to a much higher extent than the increase of the oil price itself, in particular once existing losses and investment are recovered. There should therefore be much more demand for goods and services from such, in particular heavily populated, countries, e.g. Iran and Venezuela. A new oil boom would portend higher prices in the oil services industries, higher expenditures by the oil companies and oil producing countries and an asset and cost inflation in oil provinces (services; salaries; house prices; import demand; financial services). The wise decision would be to build up investment stocks for use in balancing out low price periods and future generations (e.g. Alaska, Abu Dhabi, Kuwait, Norway), but the political pressure and perspective in countries such as Iran and Venezuela would make such long-term policy not very realistic in practice.
3) chain reaction effect on consumers
The impact of the doubling or even trebling of the 1998 oil price in summer 2000 on consumers is different from the oil price hikes in 1973 and 1981. First, the Western economies economic growth is much less energy-intensive than it used to be. It seems mainly consumers and in particular car usage that is seriously affected. But even here one should bear in mind that energy efficiency of cars has greatly increased - in particular in Europe - and that - again particularly in Europe - governments still take a multiple of the producer price as tax before the final gasoline tax is reached. US petrol prices are about 1/3 of the UK's. Energy efficiency policies which were most pronounced in the EU now appear well justified, and a continuation of the current oil price is likely to give them an additional impetus - towards lesser use of oil in home heating and private and public transportation in particular, with new technologies for non-oil energy production now given an extra impetus. It is therefore in particular economies striving to reach industrialisation - i.e. in Asia - and US consumers living in a much more energy-wasteful culture which are hit in particular, while Europe, with its greatest level of energy efficiency, high and continuously increasing taxes on energy use and great reliance on nuclear power, natural gas and still coal should be least affected. US clamour is highest, but then US energy policy in the past was unwisest and most complacent. Wasters are being punished most by the high oil price, and this seems to be both morally right and a proper market sanction. The current oil price is therefore mainly a domestic US political problem related to excessive and inefficient gasoline/ oil consumption. Higher inflation, in particular in the US, has been influenced by the high oil price, though it is not certain that the oil price component of inflation itself will trigger the US Federal Reserve Bank to trigger growth- and inflation-dampening interest rates. It is rather the fragile recovery in Asia that may be hit - and such impact may in turn have an impact on substantially lower demand from Asia.
4) President Chavez of Venezuela and the oil price It is useful to remember that Venezuela, and its oil minister, was instrumental for the birth of OPEC in 1961. President Chavez who seems characterised by a strongly nationalist and populist tradition and a belief in the command-control methods of military management seems to have an inclination, at present, to continue the role of nationalist leaders of Third World nations prominent in the 1960s and by now fallen largely into disrepute under the impact of the move from state power and legitimacy to global markets. But apart from ideological influences --which are subject to change, pragmatic re-interpretation and not always serious in practice - one needs to understand the political logic of a Venezuelan president backed by the majority of his people following large-scale promises of prosperity made. Any president would under these conditions be compelled to seek to maximise state revenue then available for redistribution to develop political legitimacy. So a high-price policy for OPEC oil is a logical consequence, in particular if the commensurate risk of a price collapse is probably several years away - i.e. we have here a more short-term perspective than in the Gulf monarchies where the interest of the ruling families is for long-term stability to preserve their role rather than for a short-term display of wealth to satisfy political expectations now. A President elected with large promises is therefore subject to much greater pressures for performance. It would be an exceptional feat if President Chavez would manage - contrary to historical precedent in virtually all developing countries, and in particular in Venezuela - to avoid corruption, spending of money for short-term political gain and social consumption rather than investing oil wealth into long-term national economic investment if now the oil income comes rolling in. The latter is the economic philosophy of the wise man - but hardly practical in a political environment where winning requires excessive promises and keeping excessive promises eats up the income from an oil bonanza.
While President Chavez has his own situation in Venezuela to care about, he may have, as current chair of OPEC, some influence towards a more price hawkish policy, i.e. advocacy of strict production limits rather than relaxation. He may also be somewhat exempt from harder US political pressure as President Clinton would not wish unnecessary trouble in his last year in office and the new US president will require some time to develop his strategy. But ultimately it is the situation of global markets, the self-interest of the OPEC countries and their ruler and the interest and ability of the US to project influence on OPEC production policy which will determine the oil prices in 2001 and beyond. Here, a prolonged high oil price probably implies a collapse several years hence. If the US re-thinks its policy towards Iraq, it has a lever to move the oil price downwards, whatever the Heads of OPEC states, based on their own situation, desire. It would be in the interest of virtually everybody - except perhaps consumers - to see oil prices stabilise at a level between 25 and 30 US$ in order to encourage new investment, correct the stagnation of production capacity, but also to prevent a cyclical collapse a few years hence by over-investment, much higher production from high-cost fields and sharply contracting demand. My advice to OPEC countries would therefore be to work towards a gradual increase of production in line with market demand and I would expect, if this happens, to see an oil price around 25 US% plus/minus 20 % from March 2001. The message for consumers is to look and choose cars and household heating systems with greatest energy efficiency, the message for governments is that energy- and carbon-related taxes make sense and that diversification of energy supplies through market instruments is the best way forward. The higher the oil price, the more rapid the transition towards a non-oil or at least much-less-oil economy in the developed market economies.
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Professor Thomas Wälde
Jean Monnet Chair for EU Economic and Energy Law
Executive Director, CEPMLP/Dundee
Email: Thomaswalde@Cs.com
tel. direct: 44 1334 880-599 (and manual fax)
office fax: 44 1382 322578
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