Is The Current Price of Oil (High $20s) Sustainable?

TIE asked five distinguished experts.

JAMES SCHLESINGER

Senior Advisor, Lehman Brothers. The writer was also Secretary of Energy when the Shah fell, and Secretary of Defense during the Arab oil embargo.

Is the price of oil sustainable in the high $20s or low $30s for the next twelve months? Answer: unquestionably. Will the price of oil be so sustained over the next year? Answer: it is very dubious.

The key is inventories. Inventories are now at their lowest level for the last quarter century. As inventories shrink, prices rise -- and vice versa. In 1997, after the Asian financial crisis and the Organization of Petroleum Exporting Countries' (OPEC) subsequent "mistaken" decision to increase quotas, oil inventories swelled inordinately. By the end of 1998, prices had dropped to around $10 per barrel. Through a series of cuts, OPEC and its allies responded by pushing production below consumption. Accordingly, inventories have been falling rapidly, which is where we stand today. The OPEC powers were badly burned and have learned their lesson (at least temporarily).

Inventory levels remain a matter of dispute. Suitable inventory levels for consumer nations may be excessive to producers. But once burned, twice shy: The OPEC nations will be cautious about increasing supply so that theprice of oil does not slip back into the teens.

Today, only the Saudis have the requisite spare capacity to provide added supply for a robust world economy. The Saudis are keenly aware that a price in the high $20s is unsustainable in the long run since it will induce substitution, conservation, and, most importantly, an expansion of non-OPEC production. The Saudi Minister of Petroleum Ali al-Naimi has said that the appropriate price should be $20-$25. But the Saudis also wish to achieve consensus within OPEC. They are determined to avoid increasing supply to such an extent that prices slip back into the teens. And they want to avoid, as their partners do, the appearance of buckling under American pressure.

The upshot is a very cautious increase in production, one that is unlikely to bring prices down quickly -- so that prices could linger in the high $20s for a while. Discipline can, of course, always break down. But that remains the most probable outcome.

Nonetheless, it is likely that oil prices will be down in the low $20s by the end of next winter's heating season, if not earlier.

What can the United States do about it? Answer: little or nothing. We kid ourselves if we believe we have that much influence. Saddam Hussein continues to rail that producers must not yield to American pressure. The Kuwaitis, for one, are notoriously unsusceptible to pressure (save when their country's existence is at stake). And again, the Saudis would be embarrassed to be perceived as yielding to overt American pressure.

So until such time as additional capacity is developed or cartel discipline cracks or the international economy craters, we should get used to OPEC's renewed control of the oil price.

LUIS E. GIUSTI

Senior Advisor, The Center for Strategic and International Studies, and former Chairman and CEO, Petroleos de Venezuela, S.A.

Last year at this time, wildly inaccurate predictions ran rampant among analysts. Trying to control or predict the price of oil within a supply management system has proved to be slippery territory. The $30 per barrel price was an overshoot of the $20 to 25 per barrel target, resulting from the difficult assessment of elasticity within a managed supply. Contributing factors such as weather, economic cycles, and non-compliance of production agreements cannot be discounted in the future of price fluctuations.

The most recent challenge was to finalize the supply agreement without a big price fall. The 1.7 million barrels a day production increase announced in March by 0PEC, plus the 1.5 million barrels a day over-production beyond OPEC's quotas, seem to provide the recipe for meeting the $20-25 per barrel range. In the wider picture, we might conclude that increased price stability is helped both by intense dialogue between producers as well as by the active participation of consumer nations, as exemplified by U.S. Secretary of Energy Bill Richardson's efforts. Also, renewed relations between Iran and Saudi Arabia can add strength to the original triumvirate of Mexico, Saudi Arabia, and Venezuela.

The upper price ceiling, according to the traditional law of supply and demand, is set by the ever-present but elusive ghost of price driven substitution. Abundant statistical information indicates that if price is consistently above $25 per barrel (West Texas Crude), oil will begin dropping from its 40 percent market share. In addition, price stability is threatened when more expensive barrels enter the market, thereby increasing supply and pushing the prices down. While the possibility for substitution and loss of market share -- as well as the expansion plans and upstream opening projects announced by several countries -- suggest that prices will decline from $25-30 per barrel, low stocks, bad weather, strong economic growth, and the uncertain future of Iraq's Oil for Food program could help sustain these prices for some time.

DANIEL YERGIN and ANN-LOUISE HITTLE

Daniel Yergin is Chairman of Cambridge Energy Research Associates (CERA) and author of the Pulitzer winning The Prize. Ann-Louise Hittle is CERA's Senior Director for World Oil and chief author of World Oil Scenarios to 2020.

Over the last year, the oil exporting nations were much more successful at boosting oil prices than they themselves had expected. Worldwide petroleum in ventories fell from overflowing to below traditional "minimum operating levels." But prices went in the other direction, rising from as low as $10 per barrel to as high as $34 per barrel.

Now the oil exporting nations face the challenge of redefining success away from squeezing down inventories to coordinating increases in supply. Their success will have much to do with where oil prices are a year from now. But the other key factor is the state of world oil inventories. These low levels put a floor in the oil market of about $20 per barrel for the next year.

First, a couple of misunderstandings need to be cleared up. In the headlines, the media refer to "OPEC." In fact, the core players who have orchestrated the successful production restraint regimes of the last two years are two OPEC countries -- Saudi Arabia and Venezuela -- and one resolutely non-OPEC country -- Mexico. Secondly, while $30 plus prices are high, they are not sky high. Oil prices in 1980 were, in year-2000 dollars, almost $70 on an annual average basis. In 1985, just before the big collapse, prices were over $40 on annual average basis in today's money.

That said, oil prices in the first few months of 2000 were certainly high enough to ignite concerns about possible effects on the strong global economy. With inventories so low, the prospect of still-higher prices has been very real, and the negative economic impact would likely become more prominent if prices stayed high through the second quarter. As it is, the market will remain vulnerable to further price shocks until stocks are built back up to more comfortable operational levels. The timing of that will depend on OPEC and non-OPEC Mexico's decisions in the follow-up meetings after the March session that agreed to increase output in the second quarter.

The main reason for the high oil prices of 2000 was the low oil prices of 1997 and 1998. More than anything else, the low prices resulted from the Asian financial crisis. Asia was then the region of strongest growth in oil demand. When Asia went into sharp decline, the oil business was perhaps the first major business to feel the effects. Asian demand had been expected to grow by a million barrels per day in 1998; instead it fell by 600,000 barrels per day. Worldwide production, however, remained geared to the anticipated demand levels, and the extra supply went into inventories, which were soon overflowing.

The oil exporters were driven to act by the dire reality of a low oil-price world. Exporters could see the risk in the Russian economic crisis in August 1998, a main cause of which was the collapse in prices (though Russian politics and policies deserve their due as well). Russia is a major oil-exporting country and depends upon oil and gas for a substantial part of government revenues.

All the exporters' own national budgets were being devastated. A striking example is Mexico. It has done a remarkable job since the early 1980s in reorienting its exports away from dependence upon oil. But petroleum still provides up to 40 percent of the national budget. The collapse in prices meant cuts in spending on education, health, and social needs. This was tree of all exporters. To put it bluntly, for most of the major exporting countries, prices in the $10 per barrel realm portended social and economic instability.

All this was enough to get the exporters together. OPEC countries not only agreed to new production restraint but also demonstrated a much higher degree of adherence than the frequent OPEC obituaries had suggested. And a few non-OPEC countries, led by Mexico, collaborated.

But grim desperation would not have necessarily been enough. The exporter's new cooperation and discipline was facilitated by three political developments: Mexico has assumed a new, activist role. The political change in Venezuela has meant a government much more sympathetic to production restraint. And a detente has been growing between Saudi Arabia and Iran. One key to the oil price outlook for next year is the volatile nature of politics. If these political developments are undone, the new-found cooperation would be lost, which in turn would have a destablizing effect on prices. To paraphrase mutual fund prospectuses, current success is no guarantee of future performance.

In order to answer the question, "Is the current price of oil largely sustainable," one has to focus on the dilemma for oil producers: If prices are sustained in the high $20s or above, the world economy would be affected and oil demand growth would slow, which, in turn, would undo price strength. OPEC's unwitting partner in its success over the last year was the strong oil demand growth in Asia and the United States. South Korea has played a key part in this equation: A year ago, the consensus view on economic growth in South Korea, the world's sixth largest oil market, was for zero economic growth in 1999. At it turned out, economic growth was almost 11 percent, helping to turn around Asian oil demand in 1999.

The United States government left no doubt about its concerns over the impact of high oil prices on the U.S. economy. Indeed, the renewed focus on petroleum underlined the fact that oil prices are one of the few prices -- along with the price of labor and the price of money (interest rates) -- that can move the economy and spook the stock market.

The exporters certainly do not want their structure of cooperation to fall apart. Nor do they want to appear too compliant with Washington. At the same time, they recognize -- at least countries like Mexico and Saudi Arabia recognize -- how integrated their economies have become with the United States. Post, NAFTA Mexico worries a great deal about the health of the United States economy. Exporters have also assimilated the great lesson of the 1980s: Customers count, and you do not want to risk losing market share. The exporters could see that prices at recent levels could well damage their interests in two ways. First, high prices could lead to a slowing of economies, reducing demand and thus creating new problems for the exporters. Second, although the oil industry has been cautious in its upstream spending, the persistence of high prices could end up stimulating the development of new supply.

Also, the exporters have no interest in seeing oil prices turn into a big campaign issue in the United States. Only last summer, Saudi Arabia, Mexico, and Venezuela were being charged with dumping oil too cheaply into the United States! Now there is talk on Capitol Hill of placing sanctions on them because prices are too high; and one piece of proposed legislation would indirectly put Congress back into the business of price controls.

Much has happened since the 1970s, when confrontation characterized relations between producers and consumers. Countries were nationalizing then in order to break the links to the consumer countries. Today, they are opening up to attract investment and technology and assure market access. The emphasis, for the most part, is on cooperation. Oil and its price are only one element -- albeit a very large one -- in a dense network of interdependent political and economic relations.

The current supply picture is taut, which means that the market could be subject to a great deal of volatility in the year ahead until stocks build. With low inventories, prices could be driven up again by everything from such matters as another Iraqi showdown with the United Nations, political or technical problems in a major exporting country, or political tensions among exporters, to the pace of Asia's recovery and the strength of the U.S. and European economies. But the exporters are clearly trying to build flexibility into their agreements in order to keep prices from persisting in the high $20s or above, and yet prevent them from falling too low. At this point, Cambridge Energy Research Associates is using $26 per barrel for West Texas Intermediate as the expected average for 2000. If prices are in the high $20s or low $30s for any period of time, we think the impact of slowing economies will provide the inevitable if unappealing corrective. Many of the exporting countries suggest that an "appropriate" range for oil prices is $22-26 per barrel -- a price that "works" for consumers and for producers. But the much wider band of $10 to $34 per barrel within one year underlines the inherent volatility in the world's most important commodity market and the difficulty in managing supply to get the price "right." The price for getting it "wrong" in either direction is high.

FRIEDRICH WU

Head of Economic Research, Development Bank of Singapore. DBS senior economists Sim Poh Kheng and Lee Wee Liat contributed to this article.

In an attempt to end the downward spiraling in oil prices, which plunged to an all-time low of less than $10 per barrel in February 1999, members of the eleven-nation OPEC, as well as the four non-OPEC oil producers Mexico, Oman, Russia, and Norway, reached an accord in March 1999 to reduce oil production significantly. Total market supply of crude oil was effectively slashed by 4.3 million barrels a day. The same oil producers subsequently extended the cutback through to March 2000. Owing to the overwhelming 85-90 percent compliance rate from world oil producers, the production restraint succeeded in pushing up oil prices. By end December-1999, oil prices reached around $25 per barrel.

Since implementing the production cuts, the increase in oil prices has been unabated. Crude oil prices surpassed the $30-a-barrel level to scale new heights on the New York Mercantile Exchange in February 2000, the steepest climb since the Persian Gulf War in 1990-91. Recent price hikes have sparked concerns of an imminent reversal of sanguine global economic conditions as soaring oil prices could threaten recoveries in the Asian, Euro, and Japanese economies. However, a recent OECD study has revealed that the effects of a year-long $10-a-barrel increase in oil prices from $22 per barrel in October 1999 on major in dustrialized economies would by no means be devastating, reducing real GDP growth of the U.S., Japan, and the EU by only 0.2-0.4 percentage points, while raising their inflation rates by merely 0.4-0.6 percentage points. With daily world oil demand estimated at about 75 million barrels against the current supply of 73 million barrels, the gap would widen in the months ahead as Asia's recovering economies embark on expansionary plans. Higher demand for oil products would operate to increase inflationary pressure and threaten to reduce trade balances of Asian oil-importing countries.

Given that many Asian countries are net oil-importers, some have worried that Asia's nascent economic recovery would be cut short if a continuous increase in oil prices were to spur inflation and interest rates, hence dampening growth. Raising interest rates to curb inflation may drive up domestic currencies and make Asian exports less competitive, further stunting economic expansion. To analyze how sensitive domestic inflation is to surging oil prices, we have performed a simple econometric test. China and Hong Kong have been excluded from the simulation since oil imports constitute only a meager 5.0 percent and 2.0 percent of their respective total imports. Likewise, Indonesia and Malaysia have also been excluded as these countries are net oil exporters in the region and stand to benefit from higher oil prices. Our simulation shows that the overall effect of oil-price hikes on Asian inflation would not be significant. Every U.S. dollar-a-barrel increase in oil prices would lead to less than a 0.1 percentage-point increase in inflation for most Asian countries, except for the Philippines, where higher dependence on crude oil products would add 0.48 percentage-point to its inflation level, or 2.44 percentage-points higher should oil prices rise by $5 per barrel. However, the impact of an oil-price hike from $25 to $30 per barrel on the inflation levels of Singapore, South Korea, Thailand, and Taiwan should be tame since these economies are currently experiencing very low inflation of between 0.5 percent and 1.6 percent. A $5-a-barrel increase in oil prices would only add between 0.15 to 0.45 percentage-point to these four countries' consumer prices.

The magnitude of oil price effects would also depend on the assigned weightages of oil components in the respective Asian CPI baskets. In addition, the existence of various forms of "price controls," such as producers' subsidies or administrative measures, to prevent the full impact of higher oil prices from trickling down to consumers directly could lead to a delayed effect on inflation. For instance, authorities in Thailand and the Philippines monitor retail oil prices closely and would prevent domestic suppliers, either via formal notifications or moral suasion, from raising oil prices too quickly and too steeply. The more effective the price-control measures, the greater the pricing distortion, and the slower inflationary effects would enter the price system. Moreover, aggressive price competition among rival firms might lead oil-product suppliers such as traders, oil refineries, and gas stations to absorb part of the imported oil costs and sacrifice profit margins in the short run to retain market share. Though cost increases would eventually be passed on to consumers if price hikes persist, the immediate effect would be diluted. Thus, we believe that higher oil prices would only have a moderate accentuating impact on inflation among Asian oil-importers in year 2000.

But rising oil-import bills would erode trade surpluses of Asian economics. A key feature in Asia's remarkable rebound last year was the large trade surpluses amassed as a result of surging exports and slower imports. Weak Asian currencies had catalyzed trade growth and helped generate substantial foreign exchange earnings for Asia's export-oriented economies. As their currencies strengthen in year 2000 amid economic recovery, a repeat of last year's huge surpluses is unlikely. Momentum of import growth is expected to outstrip that of exports due to stronger domestic consumption. Higher oil prices would inflate oil-import bills and further erode trade surpluses. Export competitiveness would also be affected since higher oil prices could result in inflation-adjusted appreciation of Asian currencies as the region's central banks could raise interest rates pre-emptively to contain inflation.

To examine the eroding effect of higher oil prices on trade surpluses, we have estimated the impact on annual oil import bills of selected Asian countries. Our estimations indicate that every 1.0 percent hike in oil prices would raise oil-import bills of Asian economies by about 1.16-2.29 percent. Thailand would see the largest increase in oil-import bills of 2.29 percent since its economy still relies heavily on oil inputs. Comparatively, Singapore's oil-import bills would rise by 1.16 percent since a substantial portion of crude oil imports would be processed and re-exported. Should average oil prices remain at $30 per barrel for year 2000, projected Asian trade surpluses for the year would drop substantially. The extent of trade-balance erosion for different Asian countries would depend on their respective levels of dependence on oil imports and export growth momentum. In general, oil imports as percentages of total imports have declined among most Asian net oil-importers, except for South Korea where the share of oil imports had actually risen from 15.6 percent in 1991 to 18.3 percent in 1999. During this period, oil imports as percentages of total imports in the Philippines, Singapore, and Thailand declined while that of Taiwan edged up only marginally. Thus, a jump in oil prices would have a more significant impact on South Korea's projected trade surplus, which is estimated to dwindle from approximately $11.64 billion to $3.44 billion if average oil prices hit $30 per barrel in year 2000. Singapore might also post a trade deficit instead of a surplus, but impact on the Philippines', Thailand's and Taiwan's trade balances would be less severe, with reductions in their annual trade surpluses estimated at between $0.76 billion and $2.03 billion.

While the impact of oil prices on oil-import bills may be pronounced in a country, the effect on inflation may not be correspondingly great. For instance, oil price increases may have a relatively greater impact on Thailand's oil-import bills (up 2.29 percent for every 1 percent rise in oil prices), but less so for inflation (up 0.06 percentage-point for every $1.0 increase in oil prices). Oil market conditions are closely monitored by the Thai authorities, and guidelines are set out for oil companies to determine retail prices. Thai oil traders may be required to adjust marketing margins if prices deviate from the official guidelines. Thus, as explained earlier, "price-control" measures, which tend to be more prolific in emerging economies where oil remains an important input for heavy industries, would delay the impact of oil prices on consumer prices, although up-front import costs incurred are high.

Where will oil prices trend? Pressure to increase world oil supply is building up, particularly from industralized nations, as global inventories continue to decline and higher oil prices cut into the summer season. January's compliance rate of oil production cutback is estimated to have fallen to 76 percent from over 80 percent at end-1999. With oil producers deciding to raise output from April, oil price futures now reflect a gradual decline in prices in the coming months, falling to below $25 per barrel by September. Given these more favorable developments, we believe that high oil prices at the current level will be unstainable and, therefore, will not inflict significant damage to the Asian economic recovery story.

PHILIP K. VERLEGER, JR.

Principal, Brattle Group, President of PKVerleger LLC, and former senior official at the Council of Economic, Advisers and Treasury Department.

Credit for the increase in crude prices from $10 per barrel in March 1999 to $34 per barrel belongs to the members of OPEC and the governments of Mexico and Norway. Last year these countries jointly agreed to cut production by two million barrels a day (roughly 2.5 percent of world consumption). The purpose of the cut was to draw down world inventories. OPEC succeeded beyond its wildest dreams. Inventories -- the primary determinate of oil prices -- fell from near record highs to record lows. Oil markets reacted by pushing prices to levels not seen since the Gulf War.

In March, ministers representing OPEC nations met to readjust output. Pressed by Secretary Bill Richardson they agreed to modestly boost output. Unfortunately, the increase will not allow stocks to be rebuilt between April and September -- the period when oil inventories traditionally increase. Instead, the steps taken by OPEC will force consumers to continue to operate with tanks empty. Prices will accordingly remain high - in the $20s.

This fall, prices will return to and possibly pass the high levels recorded in March. World demand for crude will increase, as it always does with the approach of winter in the northern hemisphere. Prices must increase because the supply of oil will almost certainly not match the growth in consumption.

Prices will rise because a traditional source of incremental supply, inventories, will not be available. The alternative source of incremental supply, OPEC, will also be unavailable. The petroleum industry will be unable to draw down inventories because OPEC policy has prevented stock replenishment. OPEC nations will not boost production to meet the growth in demand because the countries interested in preventing price surges lack the capacity to meet demand. In fact, production will be cut.

The country most likely to reduce production is Iraq. Iraq is currently producing roughly 2 million barrels a day. However, the country's oil minister has announced that Iraq will suspend production in the fall if Iraq's demands to be freed from UN sanctions are not met. OPEC cannot replace the lost production. Prices will rise to balance demand and supply. The increase could be very large, especially if other oil exporting countries such as Libya reduce output as well. (Many have forgotten that the 1980 price increase was partially the result of random cuts by different oil exporting nations with each cut timed to achieve the maximum market impact. Ministers from smaller oil exporting countries have longer memories.)

Oil ministers have not forgotten the lessons of history even if consumers have. The most recent OPEC meeting established a price stabilization scheme guaranteed to keep stocks low and leave the world vulnerable for a price increase in the fall. The scheme involves a floor and ceiling price for oil. (Readers of The International Economy will recognize the scheme as a very primitive "target zone" proposal.) If crude prices fall below $22 per barrel, exporting countries, led by Saudi Arabia, have agreed to cut production. If crude prices rise above $28 per barrel, exporting countries promise to boost output if they have the capacity. The stabilization scheme will limit oil production during the spring and summer, preventing an increase in stocks. Capacity constraints will then prevent producers from boosting output. In a phrase, OPEC has offered investors a "one way bet." Those countries seeking higher prices (Algeria, Libya, Nigeria, Iran and possibly Kuwait) will recognize that they temporarily enjoy market power. They will cut production to push prices higher just as they did in 1980.

While circumstances in 2000 differ from those in 1980, the outcome will be the same. Today, consuming countries have the capacity to prevent the impending rise in oil prices. The industrialized nations hold 1.2 billion barrels of oil in "strategic" stocks. These stocks could be used to frustrate Iraq's effort to raise prices. However, the word "strategic" seems to be synonymous with the word "sterilized." Strategic stocks are to be seen, not used. Energy agencies of consuming countries could prevent a price surge if they were to follow the example of their more sophisticated central bank brethren and lend the inventories. Such an enlightened effort has the potential to stabilize prices between $20 and $25 per barrel. It is unlikely, though, that energy ministers will take such advice. Strategic stocks are, unfortunately, to be reserved for the next "shortage," despite the fact that the evolution of the international economy makes it unlikely that a shortage will ever occur.

I am pessimistic. Crude oil will trade between $22 and $28 until September. From September to March 2001, the sky is the limit.