Re: OPEC & Oil Prices

["ÁÎ×Ó¹â Henry C.K.Liu ¹ù¤l¥ú" <hliu@xxxxxxxxxxxxxx>]

Paul, we do not disagree as much as you imagine.  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 1966 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 1966 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 1966
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 (as you and Barkley have pointed out) 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 proration 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 free-world production.

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.

>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 painlful by oil price control.  However, in the absence of price
controls, U.S. exploration and production would certainly have been significantly
greater, counterbalancing the ecnomic 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 intervetntion,
but for more intelligently selective intervention.

As has been suggested by Paul, 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 subsudies 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 roll, 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 in1974 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 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 farflung 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, as discussed in my other
posts on the list.

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 increases 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. 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 and analysis combined
with horizontal and and directional drilling. Most dramatic is the improvement in
the 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.

OPEC met 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 days 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 for 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 trem 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 the 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 thier
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.

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, Paul, is why I said cheap oil may not be in the US's national interest.  Of
course, neither am I advocating or projecting $100 oil.  $18 oil in 1966 dollar
will do very nicely for all concerned.

As for Greenspan, I am probably more critical of his views and policy than most on
this list.  I have submitted many posts to that effect. The quote was more in the
line of : even Greenspan allows....

Henry C.K. Liu

Paul Davidson wrote:

> At 12:54 PM 03/11/2000 -0500, you wrote:
>
> >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 gas for a long time.
>
> Henry, here you are repeating the old-misguided slogans of the 1970s where
> many orthodox economists argued that OPEC was doing the world a great
> service by raising the price of crude oil -- so that "we" profligate
> consumers would stop wasting  a depletable resource.
> "?  What do you mean.  As an expert witness in some antitrust cases filled
> against ARAMCO (the oil company that produced oil in Saudi Arabia in the
> 1970s),  the plaintiff's lawyers were able to obtain confidential
> information on each well in Saudi Arabia and the cost of production plus
> estimates for still unexploited fields.  The public price of 10 cents per
> barrel for crude was a generous overestimate of actual costs including
> capital costs/.
>
> So when Gunnar writes
> ":As best I can recall it, the study concluded (a) that then-current oil
> prices, at some $2-3 per barrel, were excessive relative to production costs
> of perhaps $1 per barrel in the major oil producing countries of the Middle
> East,"  he is underestimating the mark-up over full-costs-production costs.
>
> So what do you mean by "cheap" Henry?  And what do you mean by "excessively
> low commodity prices"?  In fact, as I have written in several places (see
> Bruce MacFarland's inquiry on the pktnet several months ago), When Drake's
> well was discovered in Pennsylvania, the price of  whale oil (please note a
> reproducible-i.e., non depletable resource), the primary source of energy
> for lighting in those days, was $100 per barrel in 1972 dollars.  Think of
> how much energy prices decreased in the century following Drake's discovery
> -- and what it did to the whaling business!!
>
> I can imagine someone  writing at the beginning of the 19th century,  as
> Henry did 100 years later "
>
> "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.
>
> Really Henry do you believe that if energy prices had stayed at $100
> dollars a barrel (in 1972 dollars for the last half of the 19th century
> and  through the 20th century we would have more productivity growth and
> greater economic growth than we did experience?
>
> Henry goes on to quote that Delphic oracle:
>
> >  Greenspan: "Bad loans are made in good times."
>
> What nonsense!! A more reasonable homily in my humble opinion is that "Most
> loans made in good times systematically go bad because central bankers
> believe in preemptive strikes:. Or as Keynes puts it [GT p. 323] "the
> remedy for the boom is not a higher rate of interest but a lower rate of
> interest!"
>
> Paul
> Paul Davidson
> Holly Chair of Excellence in Political Economy
> Editor, JOURNAL OF POST KEYNESIAN ECONOMICS [JPKE]
> Economics Department -- 523 SMC
> University of Tennessee
> Knoxville, Tennessee 37996-0550
> email: Pdavidson@xxxxxxx;   phone: (865)974-4221;    fax: (865) 974-4601
> http://econ.bus.utk.edu/Davidson.html