Tough Year? Maybe It'll Get Better

2002 Outlook Brighter

Who needs a roller coaster for thrills when you can get just as light-headed by watching the ups and downs of oil and gas prices — and without the risk of bodily harm?

Only a year ago, crude oil prices that hovered near $30 a barrel and natural gas trades in the $10/Mcf range were conducive to beefing up cap-ex budgets, and the drill bits were spinning all over the place. Today, the world seemingly is awash in oil once again, and the WTI tab per barrel plummeted to less than $17 at one point in November.

Global crude oil inventories basically looked good until the Sept. 11 attacks, when they began rising with the ensuing hit on demand. The NYMEX traders stay fixated on inventory levels to determine prices, relying heavily on forecasts by the IEA even though many industry veterans contend the agency historically underestimates consumption and overestimates non-OPEC production.

Last winter's high prices came on the heels of OPEC actions to dry up some of the previous crude oil glut that triggered the 1998 price collapse. Now, however, the cartel's once-comfy position as kingpin of production quota setting is being tested severely by some non-member countries.

Indeed, the game of "chicken" between OPEC and Russia — its chief competitor as the world's second largest oil exporter — has thrust yet more volatility into pricing, as the markets try to get a read on Russia's willingness to implement the bulk of the 500,000 Bopd cut OPEC is demanding of non-OPEC producers. The cartel then would implement its own 1.5 million Bopd reduction.

Expectations of Russian compliance of a quasi-acceptable cut of 150,000 Bopd combined with renewed violence in the Middle East early in December quickly bumped crude futures prices back above the $20 a barrel mark.

If all this makes you feel a lack of control, don't despair.

There's good reason for optimism, according to Steven Pfeifer, first vice president and senior international and domestic integrated oil analyst at Merrill Lynch.

"We're positive on the general outlook for the energy industry," Pfeifer said. "We think the real issue now is the economy, and as this improves, as we anticipate it will," he said, "the supply/constraint issues in the system that were evident in 2000 in terms of capital investment and production declines will re-emerge.

"We think this will be evident in the second half of 2002."

Image Caption

Natural Decline Rates by Country
Graphics courtesy of Steven A. Pfiefer

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Who needs a roller coaster for thrills when you can get just as light-headed by watching the ups and downs of oil and gas prices — and without the risk of bodily harm?

Only a year ago, crude oil prices that hovered near $30 a barrel and natural gas trades in the $10/Mcf range were conducive to beefing up cap-ex budgets, and the drill bits were spinning all over the place. Today, the world seemingly is awash in oil once again, and the WTI tab per barrel plummeted to less than $17 at one point in November.

Global crude oil inventories basically looked good until the Sept. 11 attacks, when they began rising with the ensuing hit on demand. The NYMEX traders stay fixated on inventory levels to determine prices, relying heavily on forecasts by the IEA even though many industry veterans contend the agency historically underestimates consumption and overestimates non-OPEC production.

Last winter's high prices came on the heels of OPEC actions to dry up some of the previous crude oil glut that triggered the 1998 price collapse. Now, however, the cartel's once-comfy position as kingpin of production quota setting is being tested severely by some non-member countries.

Indeed, the game of "chicken" between OPEC and Russia — its chief competitor as the world's second largest oil exporter — has thrust yet more volatility into pricing, as the markets try to get a read on Russia's willingness to implement the bulk of the 500,000 Bopd cut OPEC is demanding of non-OPEC producers. The cartel then would implement its own 1.5 million Bopd reduction.

Expectations of Russian compliance of a quasi-acceptable cut of 150,000 Bopd combined with renewed violence in the Middle East early in December quickly bumped crude futures prices back above the $20 a barrel mark.

If all this makes you feel a lack of control, don't despair.

There's good reason for optimism, according to Steven Pfeifer, first vice president and senior international and domestic integrated oil analyst at Merrill Lynch.

"We're positive on the general outlook for the energy industry," Pfeifer said. "We think the real issue now is the economy, and as this improves, as we anticipate it will," he said, "the supply/constraint issues in the system that were evident in 2000 in terms of capital investment and production declines will re-emerge.

"We think this will be evident in the second half of 2002."

Possibilities

Pfeifer looks at three scenarios to determine projections going forward:

  • With the demand hit following the Sept. 11 attacks and the weak economy, there could be excessive inventories coming out of winter if OPEC does not institute cuts and keeps pumping at current output. Inventories could become sufficiently high to push prices below the $14 per barrel level.
  • If OPEC implements anticipated quota cuts, inventories can be kept where they need to be despite the weakest economy in 20 years.
  • Should Iraq go offline, the supply/demand balance will change dramatically. Inventories will de-stock, prices will escalate and the power to increase volume to avoid price spikes clearly will be in OPEC's hands.

Current energy market weakness reflects not just the worst global economy in 20 years but also a 20-year period of industry contraction and under-investment that has restrained capacity growth.

The upside to all the years of belt tightening: The U.S. industry finds itself not as vulnerable to a price downturn this time around. Balance sheets are strong, and breakeven points are lower.

Even though the next six months could be a challenge, Pfeifer emphasized the U.S. energy industry is much better prepared than 1986 or 1998 to weather the current storm.

"Right now what is earnings power for the integrateds, if you assume $14 a barrel all over again like in '98," he said, "would be 30 percent higher now if under the same conditions."

What's unnerving is that $14 a barrel could end up looking good, according to OPEC president and Algerian oil minister Chakib Khelil.

A report issued by Salomon Smith Barney in late November quoted Khelil predicting prices could drop dramatically. He indicated it's not so much a matter of implementing cuts on the part of all parties concerned, but the possibility that non-OPEC producers might choose to flood the market with the 3.5 million Bopd that OPEC members held back in 2001.

This would lead to a repeat of the 1986 and 1998 pricing scenarios, where oil went for the fire sale price of $8-$9 a barrel.

Kyle Cooper, vice president and energy analyst at Salomon Smith Barney, doesn't see this happening.

"If there's no cut, then the fundamentals are bearish," he said, "but I don't think with the current levels of production and demand we'll see a return to $8 or $9. But I see in the realm of $14-$15 if a production agreement is not obtained.

"OPEC now has commitments of about 425,000 barrels a day from others," he said, "and it's unclear what they will proceed with if they don't get another 75,000 barrels a day before the end of December."

There's a lot riding on this in Saudi Arabia, which is ill-prepared to weather an oil price collapse.

"To avoid budget deficits, Saudi Arabia needs prices to average $25 WTI-spot," Pfeifer said. "If they average $14.50 to $15, we estimate Saudi Arabia will run a deficit of $16 billion, which will be even greater than their '98 and '99 deficits.

"They've been increasing budgets for medical facilities and education, and they have the option to reduce expenditures," he said, "but that puts pressure on their domestic interests.

"So while $15 is a challenge to the industry, the real challenge is there," Pfeifer said. "The Saudis have their own pressure points."

Indeed, a spokesperson with the Saudi American Bank reported the Saudi economy might slip into a recession next year because of a drop in oil prices and output. It's postulated the economy could contract by as much as one percent in 2002. Even with high oil prices in 2000, growth was below the 6 percent needed to absorb the multitudes that enter the labor force each year.

Oil accounts for 40 percent of the country's economy, where unemployment now stands at 15 percent. The economic fallout from a renewed period of sharply lower crude oil prices has the potential to foster escalating discontent, particularly among some of the more restless younger citizens who often have a different agenda from the ruling class.

Back to the Future?

Although low oil prices provide a sizeable boost to the U.S. economy, cheap oil clearly doesn't mix well with the increasing debt and unemployment of some of our nation's shakier allies.

It is noteworthy in view of the skepticism voiced by many who follow the vagaries of the industry that OPEC has maintained compliance to production quotas comfortably above 70 percent, according to Pfeifer. He noted how inventories have remained near normal despite a weak economy, suggesting the cartel has been successful in maintaining market balance.

When demand does begin to turn around, there will be some scurrying to meet the supply challenge.

"A lot of companies believe decline rates are getting steeper," Pfeifer said. "If we didn't invest another nickel, non-OPEC supply would decline by three million barrels per day. With so many mature fields, it's tough to keep the rate up."

And while the Russian economy relies heavily on oil and natural gas revenue, Pfeifer emphasized the country must maintain a lot of activity to offset underlying depletion.

As for OPEC, he noted spare capacity is concentrated in a few hands, and excess capacity in 2000 saw most OPEC nations tapped out. Only about 28 percent of the cartel's spare capacity is held outside Saudi Arabia and the UAE.

"OPEC is now throttling back and trying to create a bridge to respond to the worst economy in 20 years," Pfeifer said, "but they're strained now, and the bridge is getting some cracks in it as they must seek non-OPEC cooperation.

If his expectations for the near future hold true, brighter days are just around the corner for the oil and gas industry.

"In the next six months, the talk will be about the recession, the economy, demand and so on," Pfeifer said, "but out further in the second half of 2002, it will be much like 2000 all over again.

"Also, we think the administration's energy policy will become much more evident," he said. "I think it's right on the mark and hope to see a large part of it enacted."

He emphasized that at some point the challenge will be for the industry to move forward from a 20-year decline and reactivate itself.

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