Re: [A-List] Oil (was no subject)

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Since the Russian oilsector has largely been privatized, the Russian oil companies
have no incentive or obligation to support government oil policies.  Russian oil
companies are now driven by return on investment which greatly restrict their
ability to reduce production.  Thus Rusia's inital response ro OPEC's request for a
200,000 barrels-a-day with a counter offer of a mere 30,000 bpd was a reflection of
reality.  The final Russian agreement of 150,000 bpd was merely face-saving for
Suadi Arabia and has not pratical meaning. In the Vienna meeting in November 200,
OPEC announced that it would further cut production, which had already been cut by
3.5 million bpd in 2001, only if non-OPEC prtoducers agrre to reduce their export by
500,000 bpd.  With OPEC produce some 600,000 bpd over quota (Nigeria taking up
half), OPEC needs to cut 2.1 mbpd, plus Non-OPEC cut of 500,000 bpd to stabilized
oil prices from a potential collapse to below $10/barrel.  This will limit OPEC
production to 21.7 mbpd.

The potential effects of rising oil prices on price stability in oil-importing
countries id of great concern.

Prices for crude oil, used in everything from gasoline to asphalt to plastic garbage
bags, tripled from December 1998 to more than $30 a barrel in 2000. They climbed to
a 10-year high of $37.80 in New York in September 2000.

For Korea and Japan, which import all their oil, the stakes are high. Oil prices at
$35 per barrel would reduce Korea's economic growth by 2%.

Japan's minister of international trade and industry, Takeo Hiranuma, said oil
prices should drop to between $22 and $25 to benefit both consumers and exporters.

The 10-member Asean group includes oil exporters such as Indonesia, Malaysia and
Brunei.

``What's important is the `stable' level, not so much the `good' price level -- that
both producers and consumers can benefit from,'' said Rafidah Aziz, Malaysian
minister of international trade and industry.
Unstable supplies of resources are bad for producers as well as consumers.

The euro's continuing fall has dampened US corporate multinational profits which in
turn has hurt US equity markets.  The lesson from this is that trade deficits are
not without benefits.  When the yen fell to
174 per dollar, it did not affect US export much because of the deficit in US-Japan
trade.  With the euro, it is a different story because US-Euroland trade is
relatively balanced.  Also, it had been widely expected that the euro will be
supported by the ECB, so most US firms did not bother to hedge their euro earnings.
In this case, derivatives would have saved the day. So structured finance is not
always destructive.

I have suggested that $35 oil is not an economic disaster but a political problem.
$35 oil needs not be damaging to the global economy,  as many studies have shown, it
nevertheless forces a restructuring of
the global economy that has political reverberations.  To begin with  $35 oil will
in the long run stimulate more exploration and production, and reactivate idle wells
that are uneconomic at $10/barrel.  Also the
global economy is growing more energy efficient with new technology and the effect
of oil price on the economy is much less than the 1970s.  And $35 oil prevents a
return to the era of abusive waste of energy caused by excessively low oil price.
Like low wages encourages misuse of  labor, unreasonably low oil cost creates
incentives for misuse of energy and for discourages the search for alternative
energy  sources.  The only trouble is that $35 oil takes money from the pocket of
consumers and delivers it to the oil producers (not just Arabs), who then reinvest
it in Wall Street.  The net result is a transfer of wealth from the "working
families" of the world to capitalists the world over.  Consumer demand will shift,
with more money spent on fuel and utilities and less for other types of consumption,
but equity prices will rise because there would be more dollars chasing the same
number of shares. A reduction of oil taxes will leave more money in consumers'
pockets.  Governments should make up the gas tax shortfall by increasing tax rates
on oil asset appreciation. Governments resist fuel tax reduction because of the
bogus ideology that moves that hurt capital hurt the poor also, if not more.  This
ideological fixation is increasing inoperative in a world saddled with
overcapacity.  Any development that reduces demand is deadly for the
current global economic structure.  Therein lies the key issue of the coming oil
crisis - ballooned equity price unsupported by earnings and a dampening of consumer
demand.  The world has been enjoying a boom from $10 oil for a decade.  During this
boom, income disparity has increased both domestically and globally.   Now, a return
to normal market price for oil should not be allowed to continue this trend on
widening income disparity.

Tire trouble and falling profit from Eouroland have forced Ford to scuttle the
pending Daewoo deal to preserve cash.  Now Ford is in deep financial trouble with
its huge lease financing debts. That development has spooked Asian markets which
transfer the damage immediately to the most liquid exchange: Hong Kong, which has no
exposure to oil price fluctuations because the small island entity's traffic is all
short hauls.  Thus liquidity, as evident in 1998 already, has its penalties.  In
Asia are two major oil producers and OPEC members: Indonesia and Malaysia.  Yet the
windfall from oil is not being reinvested in these two economies, but instead heads
for Wall Street, thus making Asia excessively impacted by high oil prices.

The fall of the euro exacerbated Euroland's burden from higher oil prices, since oil
in denominated in dollars.

The Central Banks of the US, EU, Japan, intervened on behalf of the euro on
September 23, 2000, with the half hearted participation of that British and Canadian
counterparts.  The announcement was a confused and unconvincing policy gesture.

On the practical side, it was an empty gesture. The CBs bought between $3 to 5
billion of euros.  The daily turnover in the global foreign exchange market hovers
around US$1.6 trillion.   This volume dwarfs the combined resources of the G7 CBs in
terms of long term market influence.  All CB's, except the US has a finite supply of
dollars.  The  Fed, under its own rules, cannot dump dollars into the market without

raising interest rates, not to mention contradicting the Treasury's policy of a
strong dollar.  When the ECB buys euros with dollars, it is essentially shrinking
the euro denominated economy.  The new euros held
by the ECB must be unloaded to either the Fed or the Bank of Japan who then must
invest or spend it in Euroland.  But if investment opportunities in Euroland do not
improve, then these euros must then be
held in reserve to collect interest, making it difficult for the ECB to raise
interest rates, a move that is needed to fundamentally strengthen the euro.  The new
dollars held by the euro sellers, mostly Euroland
residents and US and Japanese multinationals and exporters, must be spent or
invested in the US or spent on oil which, despite all the noise, remains only a
minor drain in the flow of funds.  Oil money returns directly to the US anyway.  The
unabated appetite for dollar denominated assets determines the international flow of
funds.  Thus the only condition that will sustain a long-term  rise in the euro's
exchange value is the reduction of euro in circulation in the global financial
markets.  Everyone who finished Econ 101 knows what happens to an economy when money
supply is reduced by fiat - recession.

Summers/O'Neill reiterated the policy that a strong dollar is in America's national
interest.  This  ntervention, Summer asserted was merely to cushion the drastic and
excessive fall of the euro, not to pop it up fundamentally.

Principle aside, the release of 30 million barrels (in 6 releases of 5 million
barrels each) in November 2000 from the SPR represents merely 8% of US monthly
demand. November crude future fell but only to
$32.68, a $1.32 drop, with an impact of less than 5 cents drop in gasoline and zero
impact on heating oil.  The bottleneck is in US refining capacity which is already
running at 98%.  One of the chief weaknesses of non-US producers is their exclusion
to downstream operations.

Conceptually, intervention is deemed an exercise in futility for those who subscribe
to market fundamentalism. Summers had to eat his hat twice: in retreating from his
opposition to release from the
Strategic Petroleum Reserve to intervene in oil market prices and to make
concessions in his policy of a strong exchange rate for the dollar.  He explained
his turnaround as necessary response to "a rapidly evolving situation", words that
Rudier Dornbush characterized as famous last words of someone who had just lost his
virginity.  Summers was driving the dollar toward a cliff.  One shoes has already
dropped - below expectation corporate profits; and the market is expecting the other
shoe to drop soon - rising cost from the exaggerated impact of high dollar
denominated oil cost to non-oil producers who export to the US, which had been
keeping US inflation in check.

We now appear to be heading towards a replay of the early 1980s when a widening
trade deficit and a soaring dollar led to a precipitous fall of the dollar that
triggered the 1987 collapse of the equity markets.
Greenspan's strategy of reducing market regulation by substituting it with crisis
intervention is merely swapping the extension of the boom with increased severity of
the bust down the road.  A soft landing does not do much good when the aircraft has
already overshot the runway.

Oil is both an asset and a consumable commodity. Within AEI definitions, asset
appreciation is not inflation, while higher prices of consumable are counted as
inflation. For oil, this presents a dilemma. The volume of oil reserve is
exponentially greater of the annual flow of oil to the market. Thus while a rise
in the retail price of oil adds to inflation, the corresponding rise of asset
valueof oil reserve creates a wealth effect that neutralizes the inflationary impact
of oil prices. Why should one care about an added percentage point in inflation if
one's asset will appreciate 17% as a result? In fact, a deflationary impact
can be claimed because of the vast imbalance between reserves and production. For
the US economy, since the US is a major possessor of oil assets, both on and off
shore, higher oil price must be in the US national interest. What we have is not an
inflation problem, but the pricing problem that distributes unevenly the pains of
adjustment.

Back in March 2000, I posted on Post Keynesian Thought list: OPEC punctures the
Greenspan Bubble? I noted that the FOMC (Fed Open Market Committee) was watching the
rate of inflation, held down recently by declines in oil prices.

However, oil prices climbed 17 percent in March 2000.  Crude oil rose for the fourth
time that week, jumping briefly above $15 a  barrel for the first time in five
months, after oil producers agreed to cut
output.

In a follow-up post also in March I wrote:  Oil is not included in the WTO because
it is not a commodity that can be produced at will by any nation, regardless of
efficiency.

OPEC is a cartel. As such, it will eventually conflict with the competition policy
thrust of the WTO. Under WTO rules, it is conceivable that oil producing nations
will be charged with price fixing, if they continue to intervene in market prices. A
major key to understanding OPEC is the battle for market share within OPEC.
Discontinuities in the production of Iraq and Iran were caused by the Iraq-Iran
conflicts in 1979 and 1980. A third discontinuity, in 1990, was caused by Iraq's
invasion of Kuwait and the ensuing Gulf War.

OPEC came into existence in 1960, but emerged as an effective cartel only following
Arab Oil embargo which started October 19-20, 1973 and ended March 18, 1974. During
that period the price for benchmark Saudi Light increased from $2.59 in September
1973 to $11.65 in March. OPEC has since been setting bottom benchmark prices for its
various crudes. (Oil price immediately before the current crisis dipped below $10
after the Asian Financial Crisis of 1997.)

By 1981 the effects of seven years of increased prices had had taken its toll on
demand in the form of more energy efficient homes, industrial process, and in
substantial increases in automobile gasoline mileage. At the same time crude oil
production was increasing in the rest of the world, simulated by
higher prices. OPEC's total production stayed relatively constant during this period
around 30 million barrels per day. However, OPEC's market share was decreased from
over 50% in 1974 to 47% in 1979, to the current 40%.  The loss of market share was
caused by production increases in the rest of the world. Higher crude prices had
made exploration more profitable for everyone not just OPEC and many rushed to take
advantage of it.

The rapid price increases of 1979 and 1980 served to accelerate consumer's moves
toward efficiency. They also fueled an increased non-OPEC production. This was
compounded by the deregulation of domestic crude oil prices in the United States.
U.S. producers enjoyed the effects of increases in world prices plus the additional
increase brought on by price deregulation.

Demand had peaked in 1979 and it became clear that the only way to for OPEC to
maintain prices was by reducing OPEC production. OPEC reduced its total production
by a third during the first half of the 1980s. As a result OPEC's share in world oil
production dropped below 30 percent.

Looking at OPEC member's share within OPEC and not their share of total world
production, Saudi Arabia acted as swing producer for OPEC during the first half of
the 1980s in an attempt to shore up declining prices. By 1986 the Saudis got tired
of playing this role. Other OPEC member countries were
cheating on their quotas. In response, Saudi Arabia rapidly increased production
causing a major price collapse.

It took almost three years for prices to recover. The lower prices did have a
positive result for OPEC. It encouraged increased consumption and halted production
increases in much of the rest of the world, causing among other things, the oil
depression in Texas. By the end of the decade of the 1980s, OPEC and prices seemed
to have stabilized. In the 80s, when oil prices plummeted, oil drillers dragged
local Texas banks under, causing the state's entire economy to go into convulsion.
Today, if a major borrower goes bust in Texas, it would be just a small unit of
commercial mortgage backed security bonds in some money managers' portfolios all
over. The effect would be so diffused that no one would even notice. Securitization
of debt  now stand at over $3 trillion up from $375 billion in 1985. (see my post on
Saving Rates and Banks.)

OPEC, or any other cartel, faces a problem of optimization in their attempts to
control prices. The problem is to determine the level of production which meets
their collective goals of highest price with the biggest volume. For OPEC, this
means maintaining production levels which insure the highest prices possible without
encouraging competition outside of OPEC or significant conservation measures on the
part of consumers.

In January 1990, Saudi Arabia and Kuwait had 24 and 9 percent of OPEC's total
production. Iraq and Iran had 13 percent and 12 percent respectively.  Iraq was
involved at this time in a territorial dispute with Kuwait.  Negotiations between
the two countries were not successful. A meeting on July 25, 1990 between Saddam
Hussein and April Glaspie, United States Ambassador to Iraq, was a major factor in
Iraq's decision to invade its neighbor. In that meeting Hussein was assured that the
United States would
not become involved in the dispute. A week later on August 2, 1990 Iraq invaded and
occupied Kuwait.

The United States reversed itself and became the major player in restoring Kuwait's
sovereignty and oil ownership early in 1991. At this point Iraq could  no longer
export and Kuwait's oil fields were devastated. Iraq and Kuwait had virtually no
production and the slack was taken up by other OPEC members, primarily Saudi Arabia.
In February 1991 Saudi Arabia's production accounted for over 35 percent of OPEC
output. The Saudis had increased production sufficiently to compensate for the loss
of Kuwait's production as well as some of that of Iraq. The Saudis were forced by US
pressure to pay
for the cost of the Gulf War and by Arab pressure to provide financial aid to
defeated Irag under the table, all from the windfall revenue.

In December 1998 Saudi Arabia's market share was 29.7%, Kuwait 7.4%, Iran 13.0%,
Iraq 8.4% and Venezuela 11.0%. Saudi Arabia has the greatest increase in market
share compared to the pre Gulf War period. Venezuela is next. In addition the Saudis
have always had the largest volume of production. At most times the Saudis produced
at least twice as much as the second largest OPEC producer. Those who followed OPEC
will recall that, especially in the 1980s, many of the negotiations over production
quotas
included discussions of what was equitable for the member countries. Among the
factors considered were population, per capita income and the dependence upon crude
oil exports.

By the end of the 1980s most of the problems about who received what share of the
pie had been solved. All of the explicit and implicit agreements in place at that
time were disrupted by Iraq's invasion of Kuwait and the ensuing Gulf War. It is
probable that OPEC will move in the direction pre Gulf War agreements in splitting
up the pie and will return to the old method of doing business.

Some consideration will have to be given to the economic needs of OPEC members as
well as non OPEC members such as Mexico.

Venezuela is a case in point. The country is on its economic knees or worse.  In
spite of the fact that Venezuela increased its share of OPEC production
significantly over the last decade. It is unlikely in any OPEC agreement that
Venezuela would be asked to give up its gains. When OPEC agreed on another cutback
in production to boost price, it is not unlikely that Venezuela will not have to
share proportionately in that cut. Venezuela said last week that oil prices are
still to low. Even if it did, it would not be required to give up its gains in
market share. There was a lot of pressure on Saudi Arabia to  shoulder a
disproportionate share of the cuts after 1997.

The current oil price is an inventory problem rather than a long term pricing issue.
There is of course no, and has never had, a supply shortage problem in oil. The
world is awash with oil even after oil is rendered obsolete by technology. When
Clinton threatened to release US strategic reserve, OPEC signaled its decision to
increase production immediately more than once, not because of market fundamentals,
but as political gesture. Many economists think that U$35 dollar oil in the long run
is good for the global economy. At any rate, oil is no longer is critical factor for
the US economy which is increasingly less dependent on oil for growth. GE announced
in February 2000 its new turbine which is 60% more efficient than current models in
generating electricity. Did not help GE stock prices.

There was solid evidence that the 70s recycling of Petrodollars, which mostly ended
up in the US anyway, contributed to US inflation, as much as retail price of
gasoline. It essentially siphoned off additional global funds used to purchase
higher priced oil for investment in US real estate which was the only sector the
then unsophisticated Arabia managers thought they knew enough to handle. They are
now more sophisticated. May be a new injection of new Petrodollar is what is needed
to sustain the collapsing new economy equity market. Even at $35, oil is still
behind its pre 1973 price visa vie the NASDAQ, the equivalent of which would bring
$120 oil.

The drop in oil prices since 1997 was mostly a cyclical effect of the drastic
reduction of demand from the Asian financial crisis. There was zero pressure even in
the U.S. to raise oil prices at that time, because of the effect its has on keeping
inflation low. Even oil companies were not really upset by this condition because,
until oil prices drop below $7 per barrel, it is not a big deal because that is the
production cost at the North Sea. The well-head cost is less than $4/barrel, the
rest are market induced leasehold cost. North Sea oil is higher because of off shore
drilling investments. Oil can stay at anywhere above $7 for quite a few year without
doing any harm to the U.S. or Europe.  It will go back the $35 oil by the end of
2000, and a lot people will get rich along with it. OPEC is touting this line of
argument, (threats on new exploration) to get the non-OPEC economies to get behind
higher oil prices.

In the long run, less new exploration is good for OPEC. Before 1973, the whole world
was happy with $3 oil. As for America, cheap oil keep inflation (as measure by the
Fed) low, the dollar high and interest rate low. These benefits outweigh the
sectored problems created by a collapse in oil prices. In oil, no one has told the
truth for over 80 years, or since its discovery.

There were all kinds of reasons why Clinton bombed Iraq, oil prices was very low on
the list. If Iraq oil re-enters the world market, OPEC will reduce production quota,
so the real impact on prices would be minimum, most market analysts estimated the
price movement to be less that one dollar.  Many of the Arab producers will curb
production and make up the loss of revenue from a reduction of current
under-the-table aid to Iraq.

So at the post 1997 price of $10+/barrel, only the profit margin was reduced and
some idiot oil brokers in Chicago holding high future contracts, or  high-rolling
investors in oil rigs in Texas got wiped out. But the good news for  the oil
industry was that it gave a big boost to oil mergers to consolidate markets and
reserves and downsize employment which in better times the governments would have
never approved. If and when Asia recovers (and bogus recovery is much in the news
now), the oil industry will be in the
position to command $35 oil in the next cycle, and enjoy the inflated value of their
global reserves which they bought up at low cost. The low prices of the past years
have also puts the OPEC countries (mostly Arabs) in their places,  including the
bonus of Indonesia and Russia which are living exclusively on
oil exports (not really living, because all of the revenue goes to service foreign
debts). With globalization, America, the center, is enjoying the rotting of the
outer limbs of the global economy, but it has yet to realize that gangrene kills the
whole organism.

Iraq is not an oil problem as far as Washington is concerned. In fact, the low oil
price worked against Saddam in the black market. Saddam is only currently America's
worst enemy. He has not always and will not always be wearing that honor, given the
unpredictability to Iran. The reason America fails to kill Saddam is not because of
incompetence, but because Saddam may not be the worst alternative. He is just a bad
boy. What Washington wants is for Saddam to be its bad boy. Saddam has a major
advantage over
Clinton, as he did over Bush. Saddam has a focused purpose whereas Clinton, and
American policy, is diffused with complex incentives that are at times
contradictory. Oil political economy is no intellectual tea party. There is no price
economics in oil. It all politics.

It is often overlooked that the US is a major oil producer. In fact, before the
discovery of oil in the Middle East in the 30s, the US was the world's biggest
exporter of oil. "Oil for the lamps of China" was a slogan of the Standard Oil
monopoly.

It is not clear that cheap oil is in the US's national interest. It unconstructively
distorts the US economy. In recent years of cheap oil, conservation measures have
all been abandoned. US consumers are buying
10 cylinder SUVs that delivers only 8 miles per gallon, as well as air-conditioned
convertibles. Even with 2 dollar gas, commuters face only a US$500 annual increase
in their gas bills. Vehicle prices have risen faster than gas price in recent
decades. Of course, the rest of the world outside of the US has been operating on $4
gasoline for a long time.

It is an economic axiom that excessively low commodity pricing breeds abuse of that
commodity. This truth can be observed in water, air , petrochemicals and energy. It
holds true even for labor and capital. Higher labor cost drives productivity growth.
Greenspan: "Bad loans are made in good times."

OPEC had been permitted to assume an effective cartel role primarily by US and
Western policies. The existence of OPEC serves several convenient purposes. It
deflects political opposition to the international oil regime toward a mostly Arab
"demonic" organization, yet the health of OPEC is inseparably tied to the health of
the energy corporations of the West. OPEC is an example of how economic nationalism
can be co-opted into Western dominated globalization.

Excessively high oil prices are of course as detrimental to the economy as
excessively low oil prices.

The most recent downturn in crude oil prices had immediate impacts on the
exploration segment of the industry. Coincident with that was a decline in sales and
manufacture of oil and gas equipment. The next segment of the industry that felt the
pressure of the price decline was oil and gas services.

Lets look at the causes for the precipitous drop in prices in an historical context.
Oil Prices behave much as any other commodity with wide price swings in times of
shortage or oversupply. Domestic oil price has been heavily regulated through
production or price controls throughout much of the twentieth century. In the post
World War II era oil prices have averaged $19.27 per barrel in 1996 dollars. Through
the same period the median price for crude oil was $15.27 in 1996 prices. That means
that only fifty percent of
the time from 1947 to 1997 have oil prices exceeded $15.26 per barrel.  Prices have
only exceeded $22.00 per barrel in response to war or conflict in the Middle East.
In 1972, $3.50 oil translates to $11.50 in 1996 dollars.

The long term view is much the same. Since 1869 US crude oil prices adjusted for
inflation have averaged $18.63 per barrel in 1996 dollars. Fifty percent of the time
prices were below $14.91. Using long term history as a guide, those in the upstream
segment of the crude oil industry structure their
business to be able to operate profitably below $15.00 per barrel half of the time.

Pre-Embargo Period Crude Oil prices ranged between $2.50 and $3.00 from 1948 through
the end of the 1960s. The price oil rose from $2.50 in 1948 to about $3.00 in 1957.
When viewed in 1996 dollars an entirely different story emerges. In 1996 dollars,
crude oil prices fluctuated between $14 - $16 during the same period. The apparent
price increases were just keeping up with inflation.

>From 1958 to 1970 prices were stable at about $3.00 per barrel, but in real terms
the price of crude oil declined from above $15 to below $12 per barrel in 1996
dollars. The decline in the price of crude when adjusted for inflation was further
exacerbated in 1971 and 1972 by the weakness of the US dollar.

OPEC was formed in 1960 with five founding members Iran, Iraq, Kuwait,  Saudi Arabia
and Venezuela. By the end of 1971 six other nations had joined the group: Qatar,
Indonesia, Libya, United Arab Emirates, Algeria and Nigeria. These nations had
experienced a decline in the real value of their product since foundation of the
Organization of Petroleum Exporting Countries.

Throughout the post war period exporting countries found increasing demand for their
crude oil and a 40% decline in the purchasing power of a barrel of crude.

In March 1971, the balance of power shifted. That month, the Texas Railroad
Commission set pro ration at 100 percent for the first time. This meant that Texas
producers were no longer limited in the amount of oil that they could produce. More
importantly, it meant that the power to control crude oil prices shifted from the
United States cartel (Texas, Oklahoma and Louisiana) to OPEC.

In 1972 the price of crude oil was about $3.00 and by the end of 1974 the price of
oil had quadrupled to $12.00. The Yom Kippur War started on October 5, 1973. The
United States and many countries in the western world showed strong support for
Israel. As a result of this support, Arab exporting nations imposed an embargo on
the nations supporting Israel. Arab nations curtailed production by 5 million
barrels per day (mbpd) about 1 mbpd was made up by increased production on other
countries. The net loss of 4 mbpd extended through March of 1974 and represented 7
percent of the Western world production (less former USSR block).

If there was any doubt that the ability to control crude oil prices had passed from
the United States to OPEC, it was removed during the Arab Oil Embargo. The extreme
sensitivity of prices to supply shortages became all too apparent, though obviously
unsustainable. Prices increased 400 percent in six short months. The abrupt jump
caused the damage to the economy, not  the high price.

>From 1974 to 1978 crude oil prices increased at a moderate pace from $12 per barrel
to $14 per barrel, mostly due to adjustment in demand and  increases in alternative
sources of supply. When adjusted for inflation the prices were constant over this
period of time.

Events in Iran and Iraq led to another round of crude oil price increases in 1979
and 1980. The Iranian revolution resulted in the loss of 2 to 2.5 million barrels of
oil per day between November of 1978 and June of 1979. In 1980, Iraq's crude oil
production fell 2.7 MBPD and Iran's production by 600,000
barrels per day during the Iran/Iraq War. The combination of these two events
resulted in crude oil prices more than doubling from $14 in 1978 to $35 per barrel
in 1981. (A personal note: this was the period when I got my exposure to the oil
business, playing an advisory role to the Chinese government on energy policy,
getting quick crash courses from both US oil executives and OPEC ministers.)

The rapid increase in crude prices in this period would have been much less were it
not for United States energy policy during the post Embargo period. The US imposed
price controls on domestically produced oil in an attempt to lessen the impact of
the 1973-74 price increase. The obvious result of the price controls was that U.S.
consumers of crude oil paid 48 percent more for imports than domestic production,
while U.S producers received less.

In the short term, the recession induced by the 1973-1974 crude oil price rise was
made less painful by oil price control. However, in the absence of price controls,
U.S. exploration and production would certainly have been significantly greater,
counterbalancing the economic decline. The higher prices faced by consumers would
have resulted in still lower rates of consumption: automobiles would have had higher
mileage sooner, homes and commercial buildings would have been better insulated and
improvements in
industrial energy efficiency would have been greater than they were during this
period, thus cushioning the recession. As a consequence, the United States would
have been less dependent on imports in 1979-1980 and the price increase in response
to Iranian and Iraqi supply interruptions would have been significantly less. Not
that I am arguing against government intervention, but for more intelligently
selective intervention.

OPEC has seldom been effective as a cartel. During the 1979-1980 period of rapidly
increasing prices, Saudi Arabia's oil minister Ahmed Yamani repeatedly warned other
members of OPEC that high prices would lead to a reduction in demand. In a 1984
meeting in Paris I attended, Yamani warned that Armand Hammer's Occidental Oil joint
venture with the PRC Ministry of Coal to export coal derivative fuel based on $50
oil was heading for financial disaster. His warnings fell on deaf ears. The coal
project failed by 1986.

The rapid price increases caused several reactions among consumers: better
insulation in new homes, increased insulation in many older homes, more energy
efficiency in industrial processes, and automobiles with higher mileage, all with
various form of subsidies or tax relief. These factors along with a global recession
caused a reduction in demand which led to falling crude prices. Unfortunately for
OPEC, only the global recession was temporary. Nobody rushed to remove insulation
from their homes or to replace energy efficient plants and equipment -- much of the
reaction to the oil price increase of the end of the decade was permanent and would
not  respond to lower prices with increased demand for oil.

>From 1982 to 1985 OPEC attempted to set production quotas low enough to stabilize
prices. These attempts met with repeated failure as various members of OPEC would
produce beyond their quotas. During most of this period,  Saudi Arabia acted as the
swing producer cutting its production to stem the
free falling prices, as it intends to do now to halt the rise in price. In August of
1985, the Saudis, tired of this role, linked their oil prices to the spot market for
crude and by early 1986 increased production from 2 MBPD to 5 MBPD. Crude oil prices
plummeted below $10 per barrel by mid year. China had a new Minister of Coal that
same year.

A December 1986 OPEC price accord set to target $18 per barrel was already breaking
down by January of 1987. Prices remained weak. The price of crude oil spiked in 1990
with the uncertainty associated Iraqi invasion of Kuwait and the ensuing Gulf War,
but following the war crude oil prices entered a steady decline until in 1994
inflation adjusted prices attained their lowest level since 1973. The price cycle
then turned up. With strong economy in the United States and a booming economy in
Asia increased demand led a steady price recovery well into 1997. This came to a
rapid end when the impact of the financial crisis in Asia was underestimated by
OPEC, being advised by the IMF. In December, OPEC increased its quotas 10 percent to
27.5 MBPD but the rapid growth in Asian economies had come to a halt and reversed
direction by half.

The Rotary Rig Count is the average number of drilling rigs actively exploring for
oil and gas. Drilling an oil or gas well is a high risk capital intensive investment
in the expectation of returns from the production of crude oil or natural gas for an
uncertain market. Rig count is one of the primary measures of the health of the
exploration segment of the oil and gas industry. In a very real sense it is a
measure of the oil and gas industry's confidence in its own future.

At the end of the Arab Oil Embargo in 1974 rig count was below 1500. It rose
steadily with regulated rise of crude oil prices to over 2000 in 1979. From 1978 to
the beginning of 1981 domestic crude oil prices exploded from a combination of the
rapid growth in world energy prices and deregulation of domestic prices. Forecasts
of crude oil prices in excess of $100 per barrel fueled a drilling frenzy. By 1982,
the number of rotary rigs running had more than doubled.

It is important to note that the peak in drilling occurred over a year after oil
prices had entered a steep decline which continued until the 1986 price collapse.
The one year lag between crude prices and rig count disappeared in the 1986 price
collapse. For the next few years the towns in the oil patch were characterized by
bankruptcy, bank failures and high unemployment.   Investors as far-flung as Hong
Kong went under with it. Several trends were established in the wake of the collapse
in crude prices. The lag of over a year for drilling to respond to crude prices is
now reduced to a matter of months.  Like any other industry that goes through hard
times the oil business emerged smarter and much leaner. Industry participants,
bankers and investors were far more aware of the risk of price movements. Companies
long familiar with accessing geologic risk added price risk to their decision
criteria. Financial hedging came into play.

Increased use of 3-D seismic data reduced drilling risk. Directional and horizontal
drilling led to improved production in many reservoirs. Financial instruments were
used to limit exposure to price movements. Increased use of CO2 floods to improve
production in existing wells. Rig count is certainly a good measure of activity, but
it is not a measure of success. After a well is drilled it is either classified as
an oil well, natural gas well or dry hole. The percentage of wells completed as oil
or gas wells is frequently used as a measure of success, often referred to as the
success rate.

Immediately after World War II, 65% of the wells drilled were completed as oil or
gas wells. This percentage declined to about 57% by the end of the 1960s. It rose
steadily during the 1970s to reach 70% at the end of the decade. This was followed
by a plateau or modest decline through most of the 1980s. Beginning in 1990 shortly
after the harsh lessons of the price collapse completion rates increased
dramatically to 77%. These rates are closely watched by investors. Since the
percentage completion rates are much lower for the more risky exploratory wells, a
shift in emphasis away from development would result in lower overall completion
rates. This, however, was not the case. An examination of completion rates for
development and exploratory wells shows the same general pattern. The decline was
price related.

Some would argue that the periods of decline were a result of the fact that every
year there is less oil to find. If the industry does not develop better technology
and expertise every year, oil and gas completion rates should decline. However, this
does not explain the periods of increase. The increase of the seventies were more
related to price than technology. When a well is drilled, the fact that oil or gas
is found does not mean that the well will be completed as a producing well. The
determining factor is price economics
(even though oil prices are fundamentally set politically). If the well can produce
enough oil or gas to cover the cost of completion and the ongoing production costs
it will be put into production. Otherwise, its an economic dry hole even if crude
oil or natural gas is found. The conclusion is that if real prices are increasing we
can expect a higher percentage of successful wells.  Conversely if prices are
declining the opposite is true. So higher price increases supply, regardless of
nature and technology.

The success rate increases of the 1990s, however, cannot be explained by higher
prices alone. These increases are clearly also the result of improved technology.
The increased use of and improvements to 3-D seismic data an analysis combined with
horizontal and directional drilling. Most dramatic is the improvement in the
percentage exploratory wells completed. In the 1990s completion rates have soared
from 25 to 45 percent.

Workover rig count is a measure of the industry's investment in the maintenance of
oil and gas wells. The Baker-Hughes workover rig count includes rigs involved in
pulling production tubing from a well that is 1,500 feet or more in depth. Workover
rig count is another measure of the health of the oil and gas industry. Most
workovers are associated with oil wells.  Workover rigs are used to pull tubing for
repair or replacement of rods, pumps and tubular goods which are subject to wear and
corrosion. A low level of workover activity is particularly worrisome because it is
indicative of deferred maintenance. When operators are in a weak cash position
workovers are delayed as long as possible. Workover activity impacts manufacturers
of tubing, rods and pumps. Service companies coating pipe and other tubular
goods are heavily affected.

This of course lead to lower supply down the road and higher prices. Higher prices
reverse the process and ends up with lower prices later. $35 oil will keep the oil
sector expanding some time.

OPEC met on November 25-26, 1998 in a failed attempt to reverse the decline in oil
prices. OPEC in 1997 had an earlier failure when it approved a 10  percent quota
increase at a time when the Asian economies were entering a prolonged slump. As a
result, OPEC, until the recent hike in oil prices, was
experiencing the lowest prices for crude oil, after adjusting for inflation, since
the pre-Embargo day of 1972.

Market share and price are recurring themes at OPEC meetings The problem is that you
cannot have both. To increase market share you must increase production sufficiently
to drive prices down to the point that it is not economical of non-OPEC producers to
maintain current production rates.  Unfortunately for OPEC, the full realization of
the impact of lower prices on non-OPEC producers takes several years. The effect of
lower prices is  greatest in countries and areas with the highest finding and
production costs.

Onshore production in areas with high lifting cost are usually the first to show
reduction in activity. Because of long term decisions involved, offshore producers
often take longer to react to lower prices.

The term independent generally applies to a producer of oil or gas which does not
also own downstream facilities such as refineries, gasoline or diesel distribution,
or retail stations.

A survey of 24 of the larger U.S. oil companies indicated that on th average it cost
$4.48 to "find" a barrel of oil and $4.12 to produce it. That means there is no
profit for this group below $8.60 per barrel and no positive cash flow from
operations below $4.12 per barrel.

Of course the average for these companies and the reality for many other companies
are quite different. Average production costs are just that - averages. Many oil
fields have much higher costs. In some cases, as much as four times the average.

Many small independent producers were going under prior to the rise in oil prices.
Independent had reduced its workforce by 20 percent and shut in 50 percent of their
production. Any further reduction in production would cause significant damage to
the reservoirs. One company reported that it reduced
lifting cost to $8.00 per barrel, but is only receiving an average of $6.80 per
barrel.

Traders watch crude prices through the NYMEX or IPE window, but neither the NYMEX
price nor the IPE price is the price that producers receive. The price that a
producer receives is heavily influenced by location and quality, and in almost all
cases the price is significantly less than the prices quoted on the various
exchanges. On December 29, 1998, IPE February Brent closed at $10.61 and NYMEX
February light crude closed at $11.70. On the same date one of the major crude oil
marketers was offering to purchase crude for as little as half that amount.

The impact of low prices on the industry is significant. By October, 1999,
employment in oil and gas extraction was down 7.2 percent from 1997. Over the same
period overall U.S. employment was up 2.3 percent. That is a rate gap of almost 10
percent. When the data comes in for the rest of the year the
rate gap will widen. It would be even more extreme if the statistics could isolate
oil extraction from natural gas extraction. In many companies gas has been
subsidizing oil and gas isn't doing all that well. Now the different positions taken
by Gore and Bush, governor of Texas, began to make political sense.

Companies have been laying off less experienced lower paid workers, but the cuts are
now moving up the experience ladder. If prices did not recover as it did the
industry would have lost valuable human capital. Thus the producers dilemma: lose
talent, lose reservoirs or lose the business? In many cases, it will be all three.
That is why I said cheap oil may not be in the US's national interest.

The immediate caused of the current price problem is the economic boom, and the
Asian recovery, absorbing more than usual of regular commercial oil stocks.
Producers like the North Sea could respond by increasing their uplift-  but the lead
time to do so on a large scale is 5-10 years. Saudi could respond
on a large scale in a matter of months "just drill another hole in the ground"  but
that is a question of understanding the internal politics of OPEC explained earlier.
But in practical terms for the foreseeable future, Saudi reserves alone are for all
intents and purposes infinite.

The position since 1900, the effective beginning of the Oil Age, has been remarkably
consistent. Discount the price for inflation in the meantime, and the real price of
a barrel of oil 1900-2000 has been a very steady graph.  There has been three
dramatic spike on it - 1973, 1979 and 2000. Yet after  the excitement of these spike
subsided, the price of world crude has promptly returned straight back to the long
term trend line.

Oil corporate thinking is to base Exploration and Development on a target uplift
price of around $7 a barrel. That is key. Add on a profit margin, and an exploration
cost margin, and various other contingency sums and you reach about $14 a barrel.
And that today figure of $14 a barrel is - surprise surprise - bang on the that Long
Term Trend Line. When the current excitement is over, the "natural" price for crude
at the moment is $14 a barrel. If the Oil Majors wished, they could decide that the
future was going to be short of oil  and raise their target uplift price to, say,
$10 a barrel. This price will all of a  sudden stimulate all kinds of new
exploration and development deals, and hence uplift capacity, then become a feasible
proposition. But they would have do so with a careful eye on OPEC, just in case OPEC
then swung
round its own output strategy and flooded the market with cheap oil. That would
leave the oil majors with their corporate pants down, nice and ready for OPEC to
give them a real good hiding. Hence the caution.

As someone on another list said: the big game is a politico-eonomico-technological
game of cat and mouse between OPEC and the Oil Majors. It is a grown-up game in
which tom tiddlers with their 40m barrels strategic reserve or whatever are
peripheral and unimportant, however much they might sweeten American voter opinion
ahead of November.

And the oil/inflation hysteria is only cry wolf.

Henry C.K. Liu


Andre Gunder Frank wrote:

> actually OPEC has never been able to buck the market and hardly ever
> been able to keep its act together, least of all in a
> declining/recessionary market, and I see no good reason to suppose that
> the sun will this time set in the east/rise in the west. besides, OPEC
> supplkies only about 40% of the market and  as
>  this keeps insisting  the russians are bully on the block, even if you
> all contend that their output/power is waning.
> gunder
>
> On Sat, 29 Dec 2001, Mark Jones wrote:
>
> > Date: Sat, 29 Dec 2001 10:03:53 +0000
> > From: Mark Jones <mark.jones@xxxxxxxxxxxxx>
> > Reply-To: a-list@xxxxxxxxxxxxxxxxxxx
> > To: A-List <a-list@xxxxxxxxxxxxxxxxxxx>
> > Subject: [A-List] (no subject)
> >
> > [the significance of this, if it happens, will be that this is the first
> > time Opec have managed to sustain the integrity of the cartel and its
> > armlock on the energy market *during a recession*. For those of us who are
> > doomsayers about oil, this represents a crucial turning point. For the
> > first time, the decline of world oil has accelerated faster than the
> > decline in output during a major recession, thus portending an era of
> > higher oil prices under almost any circumstances, and a vicious descending
> > spiral of economic decline. Time will tell. Mark]
> >
> > FT: Opec to cut output by 1.5m b/d from January 1
> > By Heba Saleh in Cairo
> > Published: December 28 2001 18:20 | Last Updated: December 29 2001 00:52
> >
> > Opec ministers on Friday agreed to cut world oil supply by 1.5m b/d for six
> > months starting next week after the cartel secured the unprecedented
> > agreement of five non-Opec rivals to trim their own production by 462,500 b/d.
> > Brent prices in London strengthened on the widely expected announcement by
> > 54 cents on Friday to trade at $20.88, before closing down 4 cents at
> > $20.30. On Nymex, crude closed down 49 cents at $20.41.
> > Analysts said the size of the reductions and the pact between Opec and
> > non-Opec producers represented a strong message to markets.
> > "The whole idea is to tell markets that Opec and non-Opec producers are
> > serious. They do not like prices to be too low," said Robert Mabro director
> > of the Oxford Institute for Global Energy Studies.
> > Opec is aiming to lift prices as near as possible to its preferred range of
> > $22 -$28, equivalent to about $24 to $30 for Brent.
> > "In normal times we aim for $22-$28 but particularly after September 11 we
> > have to take account of the global economic downturn and its impact on
> > demand," said Opec Secretary General, Ali Rodriguez.
> > The cut is Opec's fourth in a year bringing down the cartel's production to
> > 21.7 million b/d. In total, the cartel has trimmed supply by 19 percent or
> > 5 million b/d.
> > This time, however, Opec made its cut conditional on reductions by non-Opec
> > producers. After some initial resistance, Russia, Mexico, Norway, Oman and
> > Angola agreed, spurred on by prices which had dipped to 17 dollars.
> > "They are all in the same boat. They need the cash," said Mr Mabro.
> > Nonetheless, as ever there is no guarantee that producers both within or
> > outside the cartel will abide by the new quotas. "They usually do not
> > adhere 100 percent," said Mohammed Ali Zainy, a senior economist at the
> > Centre for Global Energy Studies."The end result [ for Opec production]
> > might be a cutback of 800,000 b/d."
> > The centre expects crude prices to be at around $19 dollars for the first
> > quarter rising to $22 in the second quarter.
> > In an effort to set a good example, Opec heavyweight and the world's
> > largest oil producer, Saudi Arabia, said it was lowering crude sales
> > immediately. Iran and the United Arab Emirates are quoted as saying they
> > would do their best to follow suit.
> > However in recent months, Nigeria, a cartel member, has accounted by itself
> > for half of Opec's overproduction. The West African country has been
> > exceeding its quota by 300,000 b/d.
> > Analysts say non-Opec Mexico and Norway have good records of respecting
> > their commitments to the cartel. Overall, however, Mr Zaini said the
> > compliance of non-Opec producers would be "tenuous at best."
> > A particular concern for Opec is Russian compliance. The country has
> > pledged a 150,000 b/d cutback for the 1st quarter of next year. Some
> > analysts are sceptical that this is no more than Russia's traditional
> > winter cutback and that come the spring production will rise again.
> > Also some Russian private sector producers have made clear they would try
> > to get around the restrictions by increased exports of refined oil products.
> > Mr Rodriguez and the incoming Opec President Rilwanu Lukman are travelling
> > to Russia in January where they are expected to try to convince the
> > government to extend the cutbacks until the end of the second quarter.
> >
> > from FT.com
> >
> >
> >
> >
>
>     ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
>
>                     ANDRE  GUNDER  FRANK
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