Lands of confusion

Oil

Recent events in Russia and continuing problems in Venezuela and the MiddleEast have left the oil markets in greater doubt than ever about where crude pricesare headed. But, for the time being at least, prices are riding high.

While market watchers report a growing oil supply surplus, with stocks – atleast in non-Organisation for Economic Co-operation and Development (OECD) countries – rising,the Brent crude price remains bullish, at just over $28 a barrel (bbl) at theend of October. This is at the top of the Organisation of Petroleum ExportingCountries’ (Opec) target range of $20–28/bbl.

If the Opec crude oil basket price remains above $28/bbl for 20 consecutive tradingdays, the organisation may consider raising output. Equally, if the basket pricestays below $22/bbl for 10 trading days, Opec may look at reducing the productionquota.

Production cut
So when Kuwaiti energy minister Sheikh Ahmad al-Fahd said in late October thatOpec would make a 900,000 barrels-a-day (b/d) cut in production from November1 (see Market Focus, page 19), oil market participants were confused. Why reducethe quota when prices are at the top of the target range?

The statement seemed all the more suprising, given that al-Sabah recently saidthat the $20–28/bbl price band should be defended. That was his responseto Venezuelan president Hugo Chávez’s October 1 proposal that Opecshould raise its target price band to $25–32/bbl.

Opec secretary-general Alvaro Silva Calderón later appeared to refutethe notion of a production cut, saying the organisation would make any such decisionat its scheduled December meeting.

This confusion has arisen due to widespread perceptions that oil production frommany countries is set to rise over the next year, thus causing downward pressureon prices. Such an increase would throw into doubt Opec’s position in – andpower to manipulate – the oil market.

“What will happen to Opec?” asks Luis Giusti, senior fellow at Washington,DC-based Center for Strategic and International Studies (CSIS) and a former headof the Venezuelan state oil company Petróleos de Venezuela. “Itis approaching its day of reckoning. Opec now has its lowest oil market sharesince 1980.”

Opec accounts for 27 million b/d of oil production, compared with a total globaldaily oil output of just over 79 million barrels. Giusti says current high oilprices are anomalous and propped up by a war premium reflecting uncertainty inIraq and problems in Venezuela. Late-October world consumption was 78 millionb/d, with the excess going into stocks, albeit in non-OECD countries.

But a high oil price was only to be expected, says Peter Gignoux, head of thepetroleum desk at London-based investment bank Citigroup, given that North Seaoil production is falling and energy conservation in the US is at a 20-year low.

Iraqi oil exports stood at between 1.1 million and 1.2 million b/d at the endof October, well below the 1.7 million b/d official level of exports before thefall of Saddam Hussein. But Iraq was at that time also smuggling out 400,000b/d of crude via the pipeline between Iraq and Syria.

The Iraqi oil ministry plans to complete a restoration programme for the oilsector by April next year and then implement a new capital investment policy,said the ministry’s chief executive, Thamir Ghadban, at a late-Octoberconference in Geneva. But the country faces serious difficulties in achievingits pre-1990 oil export level of 3 million b/d.

The planned restoration of Iraq’s oil industry will involve several yearsof repairing infrastructure and rebuilding production capacity before the countrycan proceed with its longer-term aim of exploration and development of new fields.

Jim Phillips, senior fellow at Washington, DC-based policy think tank The HeritageFoundation, says: “The Iraqi oil reservoirs are in a horrible shape inmany places because of over-production.” He refers to the situation wherefor over 20 years Saddam forced oil firms to hit targets rather than maintainthe optimal output of their reservoirs.

But he feels that eventually this problem will be solved. “My impressionis that Iraq will put a major downward pressure on oil prices,” says Phillips. “Itsproduction will grow over time.”

Russian developments
Similar politically motivated damage was inflicted on oil field reservoirs inthe former Soviet Union, when oil production was forced to meet targets. Thiswas in addition to harm resulting from terrorist sabotage and war. These problemsled to a slump in output from the late 1980s until a marked increase began inthe mid- to late 1990s. Recent Russian oil production has topped 9 million b/dand has averaged 8.36 million b/d in 2003. Valery Nesterov, oil analyst at Moscow-basedbank Troika Dialog, says this is an 11.2% increase over 2002 output.

The increase is due to better field management and modern production techniquesintroduced by foreign oil service companies, he says. Some optimists have predictedthat Russia could produce between 11 million and 12 million b/d by 2011, overtakingSaudi Arabia as the world’s leading oil producer.

The potential for this to happen was one reason market observers gave for theSeptember visit of Saudi Arabia’s Crown Prince Abdullah to Moscow. Thetwo countries signed an oil industry co-operation accord under which each nationwould encourage its domestic companies to invest in the other’s oil sector.

Although Russia has never expressed any intention of joining Opec, the Saudi-Russianagreement prompted sighs of relief in Opec countries, whose representatives hadhoped Russia could be persuaded to cut its own oil production to defend worldoil prices.

Meanwhile, US and Russian government officials have had talks over investmentopportunities in Russia for US companies and the possibility of Russian oil suppliesto the US replacing those from the Middle East. The contradictory nature of Russianofficials’ meeting with the Saudi and Americans is not surprising, saysTroika Dialog’s Nesterov.

“Russia is seeking co-operation with Opec and consumers,” he says. “It’sin a comfortable position as a mediator. In any case, Russia is always interestedin stable and high oil prices.”

However, he feels the forecasts of increases in Russian oil production of 11million to 12 million b/d are unlikely to be realised. A slowdown in growth isinevitable, Nesterov says, since growth rates as high as last year’s 11.2%are not sustainable. Furthermore, there are too many bottlenecks in the country’sexport pipeline infrastructure for crude exports to rise significantly, he adds.

Russia’s total crude oil production may see modest growth in the next twoyears, says Nesterov, which will then flatten out to a plateau. The country’soil sector will need significant new investment to see further spectacular productiongrowth.

But investment prospects have been dealt a heavy blow by the controversy surroundingthe arrest of two executives from oil company Yukos, including its chief executive,Mikhail Khodorkovsky. The firm was due to complete a takeover of rival oil companySibneft by the end of this year.

Yukos, of which Khodorkovsky is the principal shareholder, has been under investigationby the Russian public prosecutor since the start of 2003. Government criticssay the company’s funding of political opposition groups and non-governmentalorganisations brought Khodorkovsky into conflict with the government.

Khodorkovsky’s arrest also contributed to a 17% drop in Yukos’s oilprice and nervousness among potential investors in the sector. Oil giants ExxonMobiland ChevronTexaco are reportedly interested in acquiring stakes in Yukos, andBP merged its Russian assets with those of Russia’s TNK International ina $7.7 billion deal earlier this year.

Yet Citigroup’s Peter Gignoux feels the Yukos episode is not a major concern. “Theoil market scarcely wobbled at the news [of Khodorkovsky’s arrest],” hesays. “Exports seem to be holding up.”

But Troika’s Nesterov is less optimistic. “There is a big questionmark over the BP deal and an Exxon acquisition of Yukos,” he says. It willtake time to work out the effects of the Yukos-Sibneft merger, as well as theinvestigation into the company by the prosecutor’s office, adds Nesterov.

Venezuela
Another major oil producer, Venezuela, has suffered such political uncertaintyfor some years. Venezuelan government spokesmen have predicted that the countrywill export more than 3 million b/d by next year, although the political oppositionestimates that national oil output has fallen to around 2.4 million b/d.

CSIS’s Luis Giusti says the Venezuelan government lies about oil exportstatistics. Anyone can look at the Venezuelan central bank revenues and workout how much the country is earning from oil exports, he says, and these figuresdo not tally with government claims.

Meanwhile, to further increase the confusion in the oil market, an Iranian pressagency reported in late October that Iran may consider leaving Opec. Market observersinitially believed this to be a scheme by some traders to move prices.

But it turned out to be a statement by a middle-ranking energy ministry officialwho said Iran would consider leaving Opec if it could attain an oil productionlevel of 7.5 million b/d. This is well over double the country’s presentcrude output. As Iran is having difficulty maintaining its current oil productionlevel and in attracting sufficient investment to increase it, the oil marketdismissed the statement as wishful thinking.

But while any analysis of the physical realities of the oil market may pointto a major downturn in prices next year, the market’s perception suggestshigh prices. “If I were an oil producer,” says Citigroup’sGignoux, “I’d be selling into that market like crazy.”
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