The Wall Street Journal: The Global Oil Market Offers Plenty of Reasons for Caution

WSJ: Is a new hegemony developing in Russia in which the country’s energy infrastructure and resources, rather than military might, are used against its detractors? This is what many analysts were saying after the Putin government recently took control of the big gas project on the Russian island Sakhalin from Royal Dutch Shell.

“Where the Russians went wrong is instead of going to Shell and saying let’s renegotiate the production-sharing agreement contract, they said all sorts of other things about the environment, which is all beside the point. The original sin was to sign the contract based on the poor conditions at the time.”

THE ARTICLE

By SPENCER SWARTZ
February 12, 2007; Page R2
THE JOURNAL REPORT

The global oil market has gone from one set of clement conditions to another in recent months with barely a hitch.

A quiet U.S. hurricane season last autumn posed no risks to oil-production facilities. And although cold weather has recently boosted heating demand and energy prices, oil inventories remain healthy after a mild start to winter in the U.S. and Europe allowed oil inventories to swell.

The price of oil is down about 2% so far this year, at about $60 a barrel, having recouped nearly $10 a barrel since prices hit two-year lows in January when prices tumbled on mild winter weather. Oil prices closed 2006 at $61.05 a barrel.
 
For years, the big criticism of alternative energy was cost: It was too expensive. Now the equation is showing significant signs of change. Plus, utilities typically have had little incentive to reduce demand for their product. States are trying to change the math.
 
But, as always in the never-static world oil market, there are plenty of reasons to be cautious.

Issues that have hogged the headlines over the past year — Iran’s nuclear program, oil-supply availability, and global warming, to name a few — will continue to influence the direction of oil prices and set the tone of the energy-policy agenda in 2007. Iran and the U.S., for instance, have gone from throwing rhetorical darts at one another over the Islamic Republic’s nuclear program to taking more substantive actions this year, such as the U.S. move to deploy a second aircraft carrier to the Persian Gulf region.

There is no sign that attacks on oil facilities in Iraq and Nigeria will abate, and heavy-handed government meddling with energy resources is unlikely to wane in places like Russia and Venezuela, much to the dismay of international oil companies.

Another reason for prudence: The Organization of Petroleum Exporting Countries, whose output meets about 40% of the 85 million barrels a day consumed globally, is cutting production to stem the slide in oil prices.

At the same time, unforeseen events can exert a big influence on prices, no matter what OPEC does. The Israeli-Lebanon conflict last summer and the 2003-2004 surge in Chinese and Indian oil demand are two examples that didn’t register on analysts’ radar screens until after the fact and drove oil prices sharply higher.

The Wall Street Journal recently discussed these and other issues that will shape energy markets in 2007 with top oil analysts Daniel Yergin and Robert Mabro, who each has more than three decades of experience analyzing world oil markets.

Mr. Yergin is chairman of Cambridge Energy Research Associates and the Pulitzer Prize-winning author of “The Prize: The Epic Quest for Oil, Money and Power.” Mr. Mabro is honorary president of the Oxford Institute for Energy Studies and 2004 recipient of the OPEC Institutional Award for his work in energy economics.

Both men agree oil prices will remain volatile this year amid various unresolved geopolitical issues, although Mr. Yergin sees an average 2007 U.S. oil price of $57 a barrel, well-below an average price of $66 a barrel in 2006.

While Mr. Yergin emphasizes the role of technological developments in helping Western oil companies boost future oil and gas reserves — the primary assets by which investors judge oil producers — Mr. Mabro believes Western oil firms should look beyond profits and work more closely with host governments in order to improve access to oil acreage and increase reserves.

Here are excerpts from the discussion:

Price Trends

THE WALL STREET JOURNAL: What reasons are there for and against believing the bull run in oil prices is over in light of their tumble, so far, in 2007, and where do you stand?

MR. MABRO: Commodity markets, like all markets, have a tendency to overshoot and undershoot. In oil, the range of possible fluctuations is very wide. After all, we saw a move from $10 a barrel to $78 a barrel in a period of seven years. We cannot infer from the recent fall in oil prices that they will necessarily fall further and, more to the point, that they will never rise again. Geopolitics, peak oil [the debate over whether available oil supplies have peaked], and demand growth may bring the bulls back in ascendancy, perhaps in a year or three years’ time. Who knows? Fluctuations, exaggerated corrections, and cycles are the many names of the game [in the global oil market].

WSJ: Do you expect oil supply and demand fundamentals to turn in favor of consumers in 2007 to the extent that oil prices fall below 2006 levels?

MR. YERGIN: At this point, we’re looking for an average of around $57 a barrel oil in 2007 and expect it to be about $4 lower in 2008, but there are two very large variables that could impact the direction of prices. One is what happens with geopolitics, in particular the Middle East. Second is what happens with the U.S. economy. A third is what OPEC countries themselves choose to do [with production].

MR. MABRO: I have learned over 40 years that those who make predictions about oil prices usually get it wrong. But on fundamentals, there is no supply problem. The problem is the sentiment of traders. If these people decide to go and put their money somewhere else, the price is going to collapse.

Then and Now

WSJ: What are some of the big differences with today’s high-price environment relative to, say, the late 1970s and early 1980s?

MR. YERGIN: What you had in the early and late 1970s were two very large supply shocks. That’s not what’s happened this time. Rather it’s a very strong demand shock, and the best economic performance in over a generation helped by the emergence of China and India. The market today has really been driven by the success of globalization. At the same time, the U.S. and other industrialized countries are also much more energy-efficient, and so oil has much less leverage over the economy than in the 1970s.

The global climate-change debate also hangs over the entire energy industry today. You didn’t have that type of environmental concern in the 1970s.

One similarity you’re seeing is renewed emphasis on energy conservation around the world.

WSJ: And yet many of the huge strides in energy efficiency that followed the oil spikes of the 1970s faded after oil prices returned to lower levels.

MR. YERGIN: We certainly saw some of that. Gasoline prices in the U.S. reached their lowest level ever in real terms in 1998. In the U.S. it was a pretty clear message: Don’t worry about fuel efficiency when you buy a vehicle. And you saw this enormous growth in large sport utility vehicles. [But] we just did a study, “Gasoline and the American People,” and it is striking to see the movement away from large SUVs toward more fuel-efficient SUVs. Fuel efficiency is a real question on people’s mind.
 
MR. MABRO: There is another difference in the geopolitics with the Iranian Revolution in 1979. As a result of the revolution, production in Iran fell a lot, oil prices jumped. International oil companies working in Iran had to [notify] their Japanese customers because they were not sure if they could get oil in Iran. We haven’t had that level of turmoil this time around.

MR. YERGIN: A similarity between the 1970s and now is the feeling that the world is going to run out of oil soon. To some, 1973 and 1979 seemed to be proof that the era of permanent shortage was at hand although it was quickly followed by a very large glut. There are some circles that once again fear a near-term shortage, and they have the tendency to understate how markets respond and how technological innovation works to increase efficiency and bring forth new supplies.

State of Renewables

WSJ: How much of a role do you expect renewable fuel sources, like wind and solar, will play in the decades ahead in supplementing the overall energy-supply mix?

MR. MABRO: It depends. Long-term, their share will increase, but it starts from such a low point that you need a very high rate of growth to raise the share to a bigger part of the overall mix.

Wind and solar are used for power generation. Oil has a very small share of power generation in the world today and some of it will be displaced. Whenever some people talk about renewables, they can give the impression that they will kill oil. No. If many renewables, like solar and wind, are successful, they will have a big impact on their competitors, which are coal and natural gas.

MR. YERGIN: There is a tremendous policy push around the world to promote renewables, and the incentives and subsidies and mandates are working. I think the most successful has been wind. When you add up all the money being invested in renewables it’s becoming a significant business. In 2006, over $40 billion was spent on wind and solar world-wide. But as Robert points out, solar and wind address the question of electricity generation, not motor fuel, which is totally dominated by oil.

Motor-fuel sources are becoming more diverse and alcohol-based fuels are going to have a growing role in the U.S. There is a tremendous increase in the amount of money going into research and development into what’s called “clean tech” in the U.S. Venture-capital investment in the first three quarters of 2006 in the sector was $1.7 billion.

Political Equations

WSJ: OPEC recently accepted Angola as a new member and said Sudan and Ecuador may soon join. Should consumers fear a bigger OPEC?

MR. MABRO: It may actually make things more difficult for OPEC by making it harder for the group to reach decisions with more members.

MR. YERGIN: It gives OPEC an increased African tilt and brings one of the most dynamic oil-growth countries to OPEC, but the expansion raises questions about future production [in Angola] because of OPEC quotas.

WSJ: Is a new hegemony developing in Russia in which the country’s energy infrastructure and resources, rather than military might, are used against its detractors? This is what many analysts were saying after the Putin government recently took control of the big gas project on the Russian island Sakhalin from Royal Dutch Shell.

MR. YERGIN: Energy is the instrument that has restored Russia’s economic stability and the country’s position in the world.

The Russians define energy security in terms of reasserting state control of energy resources, which they see as strategic resources, and in gaining control of critical infrastructure, especially pipelines.

Energy is central to their revenues and to the country’s rehabilitation. The message is clear that these are central state objectives.

MR. MABRO: Look at the recent history. You had the collapse of the Soviet Union. That’s pretty dramatic to go to that after being a superpower. That is then followed by a period of chaos where every guy who could put his hands on any asset stole it. The Sakhalin production-sharing agreement with Shell reflected the difficult position Russia was in in the 1990s.

Where the Russians went wrong is instead of going to Shell and saying let’s renegotiate the production-sharing agreement contract, they said all sorts of other things about the environment, which is all beside the point. The original sin was to sign the contract based on the poor conditions at the time.

New Frontiers

WSJ: How optimistic are you that international oil companies will continue to build and replace oil reserves in coming decades?

MR. YERGIN: I think it’s a big challenge. Obviously, reserve replacement is how the financial community values companies, so there is tremendous pressure. That means you need access [to explore in countries] which is harder than it was a few years ago. You also have rising costs.

But another part is the definition of “proven reserves” used in U.S. Securities and Exchange Commission regulations, which are woefully out of date. They are based on technology from the 1970s and haven’t kept pace with where the technology is today.

In the 1970s, the deep-water frontier was 600 feet. Today it’s 12,000 feet. The current reserve-disclosure system is not up to date.

WSJ: Why has the SEC lagged behind in revising its metrics on this matter?

MR. YERGIN: There’s a growing recognition that it needs to be updated. I think the SEC has a lot of other issues on its agenda right now and it’s a question of resources and focus.

MR. MABRO: The real problem for the international oil company today is access to reserves. But in order to get better access, the culture has to change in the relationship between international oil companies (IOCs) and national oil companies (NOCs).

We talk a lot about technology and innovation, but you also have to focus on how you manage the relationship. And I am afraid to say that the IOCs have made a mess of this.

The IOCs see everything from the shareholder perspective. They have a single-minded objective in profits only. But the world is more complicated than that.

MR. YERGIN: In this era of resource nationalism, the relationship between IOCs and NOCs and how they are going to work together is of front-and-center importance to the companies. There are a lot of problems and issues right now.

WSJ: Should IOCs take a page out of the NOCs’ book and perhaps, for example, build more public infrastructure in particular countries as the cost of getting access to oil acreage?

MR. MABRO: You have to build trust. You have to cease being single-minded. This idea that the only people you answer to are the financial people, shareholders, causes problems.

MR. YERGIN: It’s a very interesting time for the international oil companies because, on the one hand, the demands of the host countries have become stronger and stronger, but at the same time the demands from the institutional investors have also gotten stronger. That creates real challenges when you are trying to run a business that has a 15- to 20-year time horizon.

–Mr. Swartz is a staff reporter for Dow Jones Newswires in London.

Write to Spencer Swartz at [email protected]