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En route to $75
oil
By Scott B
MacDonald
NEW YORK - Oil prices are high
and likely to climb higher through 2005 and
probably into 2006. Despite ongoing comments about
the market actually having enough supplies, the
reality is that international oil markets are not
driven by anything rational. Rather, fear and
loathing sit at the back of each upward oil trade.
A confluence of increased demand and questionable
limits to supply have resulted in a runaway oil
market during the summer of 2005, with oil
crossing $65 a barrel. The idea of oil hitting $75
a barrel is no longer so farfetched.
High oil prices - why?
High oil
prices are likely to be around for a while. On the
supply side, nagging points of concern include the
expectation that non-OPEC oil supplies, mainly in
the Gulf of Mexico and the North Sea, are set to
fall. According to the International Energy Agency
(IEA) in August, non-OPEC oil supplies are
forecast to fall 200,000 barrels a day. Part of
the reason for this is that political factors and
less attractive investment regimes are hurting the
discovery and development of new oil sources in
countries such as Mexico and Russia. This puts
much more pressure on Middle Eastern oil
producers, in particular Saudi Arabia. Yet, there
is concern about the true level of Saudi Arabia's
oil reserves. Considering that there is a debate
over the quality of transparency and disclosure of
Saudi reporting, this only adds another factor to
market nervousness.
Adding to the stew
over oil prices is the nature of global refinery
capacity utilization. During the early and
mid-1980s, global refinery capacity utilization
was around 75%; today it has risen to above 95%.
US refineries have seen especially heavy use, with
capacity utilization reaching a little over 98%.
Historically, the refinery sector was a
problematic area for oil companies to make money,
and the long-term effect of this was that the
sector is now largely defined by underinvestment
and aging equipment. In addition, for
environmental reasons, there have not been any new
refineries built since the 1980s. This set of
conditions has meant that existing refineries are
under stress, breaking down or stopping operations
to make repairs. Since July 20, there have been 14
refinery breakdowns.
The US refinery
system is being pushed beyond its sustainable
limits. As Richard Savage, global head of
commodities research at Bank of America recently
stated: "There are clearly issues in both
production and refining capacity, because the
plants have been running so hard that accidents
keep happening."
Add to the above factors
a damaging hurricane seasons in the Gulf of Mexico
and the added weight of Chinese and growing Indian
oil demand, not to mention the threat of
geopolitical factors, and a bet on higher oil
prices does not seem unreasonable. At the same
time, the global economy has not taken a major
nosedive. In the past, oil prices spikes have
resulted in economic downturns or recessions. Thus
far, we have strong economic growth despite higher
oil prices, largely due to lower energy use
intensity. Indeed, the International Monetary Fund
is projecting 3.6% growth for the US in 2005 and
again in 2006, along with increased economic
growth in both Japan and Europe.
As a
result, demand for oil is not likely to relent.
That makes oil the key swing factor in the global
economy over the next couple of years. Although we
still have questions about oil breaching the
$100-barrel mark, the general nervousness in the
market, the ability of hedge funds to push prices
up, and the existence of many geopolitical
wildcards all translate into upward pressure.
The new world of higher oil prices has
considerable implications for the structure of
international relations. It has already added a
degree of tension between the United States and
China over the Chinese state-owned oil company
CNOOC seeking to purchase US-owned Unocal. It has
generated new tensions between China and Japan
over potential oil and gas reserves in the seas
between them and over access to Russia's energy
sources. Competition for oil and gas has also
stimulated a return of big power interest in
Africa and a new scramble for that continent's
resources, allowed Venezuela's populist leader
President Hugo Chavez to pursue an anti-US foreign
policy in the Americas that includes generous oil
aid to Cuba, and provided an opportunity for China
to develop closer ties with a number of Latin
American countries.
The new flow of
funds
Venezuela's Chavez enjoys theater.
Seeking to bait the United States, he has steadily
announced that Washington plans on invading
Venezuela. He is also making use of higher oil
prices to consolidate his position internally as
well as providing help for other leftist leaders
and organizations throughout Latin America. In
2002, Venezuela's foreign exchange reserves stood
a little over $8 billion; as of mid-2005 they
stand around $20 billion. Having eroded the
control of the central bank over the country's
foreign exchange reserves, Chavez can benefit from
the rise in reserves by increasing social spending
and offering to buy back debt to help Ecuador and
Argentina. The former is also likely to help
Chavez win re-election in 2006 for another six
years.
Chavez is not alone in benefiting
from the oil boom. The Gulf States, including
Saudi Arabia, Kuwait, Bahrain, Qatar, and United
Arab Emirates, are currently pumping oil at the
highest rate in 25 years to keep pace with the
growing demand. Throughout the region this trend
is evident in faster growth rates, improved fiscal
positions and rising foreign exchange reserves.
According to the Washington-based Institute of
International Finance: "Gulf state countries will
buy about $360 billion in foreign assets from
bonds to property in 2005 and 2006 - 50% more than
their total purchases of the past five years." A
lot of this money is heading to US and European
markets, but also into the rest of the Middle
East.
The geopolitics
Although
the antics of Chavez make colorful copy, the major
geopolitical concerns are largely centered on the
Middle East. This is because three of the world's
four largest oil reserves are located in the
Middle East - Saudi Arabia, Iran and Iraq. Each of
these has problems. Iraq remains locked in a civil
war, with its oil industry a target of sabotage.
Its level of production is well below its
potential.
At the same time, neighboring
Iran has just elected a hardline government under
President Mahmoud Ahmandinejad. One of the
cornerstones of the new government is the pursuit
of nuclear power. Despite negotiations to prevent
the emergence of a nuclear Iran, Tehran is
determined to join the ranks of nuclear powers.
This is especially the case now that North Korea,
India and Pakistan already have nuclear weapons.
Iran's policy, therefore, is set to put it on a
collision course with the international community,
which could conceivably lead to United Nations
sanctions.
Saudi Arabia, the world's
leading oil country, also faces major political
challenges going forward. The Middle Eastern
country is a closed society, confronted by
difficult problems of extremist Islamic
fundamentalism and increasing demands for economic
and political reform. And then there is the issue
of political succession. On August 3, the Saudi
religious and tribal leaders gathered in Riyadh to
pledge allegiance to new King Abdullah bin
Abdel-Aziz al Saud following the death of his
half-brother King Fahd.
The smoothness of
the succession appeared to show a Saudi royal
family well entrenched in power. The network of
family relations, firm control over the state
security apparatus and ability to tap the
country's oil wealth give the appearance of
control and stability. But in reality, Saudi
Arabia is a restless society, with a young,
relatively well-educated and generally
underemployed population. Caught between
influences from the West via satellite TV and a
strict Wahhabist Islamic code, Saudi society has
become more volatile, and its future path less
certain.
Saudi Arabia's new king has been
the real ruler of the country since 1995 when King
Faud suffered a debilitating stroke. While this
means continuity in policies, Abdullah is already
82. This means that another political succession
sits out on the horizon, probably sometime in the
next 10 years. The problem of an aging leadership
elite is compounded by the fact that the next
three leaders in line of succession are likely to
be Crown Prince Sultan, a spry 81 years, Interior
Minister Prince Layef, 71, and Riyadh Governor
Prince Salman, 70. So even in the event of
succession in this sequence, frequent transitions
will make the system instable.
Thus oil
markets are likely to remain volatile, with more
pressure for prices increases than declines. The
global economy has thus far been able to absorb
the price increases due to past improvements in
technology, which augmented energy efficiency.
However, somewhere out there is a point where oil
prices are simply too high, and become disruptive
to economic activity.
Scott B
MacDonald is Senior Managing Director at
Aladdin Capital and a Senior Consultant at KWR
International.
Posted with permission
from KWR International Inc, a
consulting firm specializing in the delivery of
research, communications and advisory
services. |
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