Last year's sharp drop in oil prices was the warning bell: The oil industry is facing radical changes and tough challenges in the foreseeable future that will likely permanently alter the face of the business.
All these changes will ultimately put even more control of the world's oil supply in the hands of Middle Eastern countries and change the make up of both private and state oil companies all over the globe.
That was the message of Manuel Suárez-Mier, a professor of economics at the Technological Institute of Mexico and former minister of economic affairs at the Mexican Embassy in the United States, when he spoke at the All Convention luncheon during the AAPG annual meeting in San Antonio.
OPEC's inability to curb production last year was devastating, he said.
"Oil inventories began to build up at alarming rates in the first quarter of 1998 while the economic crisis in several countries, particularly in Southeast Asia, severely reduced the growth in demand," he said — and the combination resulted in plummeting oil prices.
Suárez-Mier also warned that the International Energy Agency and other organizations see a long-term trend toward lower global demand for oil.
"The only enduring alternative to correct the market's imbalance has to center on reducing production by one of the following means," he said.
"First, relying on the market to lessen supply as the result of prices that have become lower than operating costs for many producers. However, the disappearance of high-cost oil is slow and takes time to affect overall supply, as new projects already in progress when prices started their decline are still in the pipeline to start producing.
"The second alternative is voluntary cutbacks."
The solution to the production glut in OPEC will not be easy to achieve, he said, because several of its members are going through new and difficult political circumstances that will make the reduction of their output quotas hard to achieve.
For example, he cited the case of Venezuela, where there is a heated argument within the new government of populist President Chavez whether to support the production cutback that had been approved by the previous public administration.
Iran, he observed, accuses Saudi Arabia of having taken advantage of the demise of Iraq's production after the Gulf War when the United Nations decreed its embargo on Iraq. In addition, Iran claims the base figure for the cutback that it is suppose to fulfill has been underestimated since its production in February 1998 was higher than the one considered in the statistics used to determine the quotas.
"Representatives of the countries involved in trying to set new production limits within OPEC have met recently to explore grounds for fresh agreements while they have been the target of frantic lobbying by other producers, such as Mexico, trying to persuade them to reach effective cutbacks," he said. "These diplomatic efforts are the cornerstone for the hope of a more balanced oil market in 1999 — and the only hope to reverse additional price reductions or maintain the increases witnessed in the last few weeks."
He described three courses of action OPEC can take to impact prices:
First, if the 27.3 million barrels of oil a day OPEC supply registered in the fourth quarter of 1998, with only an 80 percent fulfillment of cutback commitments, is assumed to prevail throughout 1999, and the level of demand is estimated to be 74.7 million barrels per day, there would continue to be a small production surplus.
This means that the vast amounts of accumulated oil would be maintained or increased slightly which would result in persistently low prices.
- Under the second scenario OPEC members achieve a complete fulfillment of the 2.6 million barrel a day reduction that was established in 1998, resulting in half a million barrels a day less output in 1999.
Accumulated inventories would fall to about half their present level and prices would remain relatively unchanged compared to the 1998 average.
- In the final course of action OPEC decides an additional one million-barrel a day cutback, taking the total OPEC reduction to 3.6 million barrels daily. A complete fulfillment of this production level would wipe out the 500 million barrels of accumulated inventories. Such measures would drive prices substantially upward.
Regardless of what future action OPEC might take, this most recent collapse in oil prices and the global marketplace is driving new corporate trends that will forever change the face of the industry.
Two of the most important trends is the recent round of mega-mergers and the relaxing of guidelines that heretofore have kept international companies out of some countries.
"Mergers and access to low-cost fields are the primary means by which oil companies can survive and recover profitability margins," he said. "We are witnessing a wave of mega-mergers between major corporations like BP with Amoco and Exxon with Mobil. This is happening not only in the private corporate world but also in the public one as well where, for example, Rosneft, Slovneft, and Onaxco, all owned by the Russian government, are merging.
"The revision of the public property regime of the oil industry has also been proposed in a growing number of countries such as Norway," he continued. "The Duma, the Lower House of Russia, passed a resolution to increase private company participation in its national reserves from 20 percent to 30 percent for development under a production participation regime with private corporations."
International companies may find opportunities in countries that long have been closed to outside participation, he added.
"The largest reserves at the lowest cost continue to be in the Middle East. With sustained low price levels, mounting financial pressures and dwindling idle capacity in the region, the countries of the Middle East — even the wealthiest ones like Saudi Arabia and Kuwait — will have to rely on the major world oil corporations to expand productive capacity."
Such a migration to low-cost fields, he said, "would increase the odds for companies to remain competitive and help them offset the losses that they face by prospecting and development already underway in high-cost regions."
Suárez-Mier said two challenges still bar entry by outside companies into the Middle East.
"The appropriate definition of property rights and the legal environment that will allow access and permanence to foreign companies must be addressed," he said. "If these changes don't take place, much greater flexibility in operation and payments schemes are required.
"The best deal for companies is to participate in production," he continued. "However, Middle East governments seek to maximize their own revenues and hand out as little control as possible. This implies the need to balance the length of the contract, the base profit rate and exposure to risks."
While the long-term future of the oil industry is still in flux, there is no doubt that in the short-term low oil prices have started to affect certain fields, while the development of new supply outside of OPEC regions is starting to decline.
"For example, in the United States, low prices have forced a production shutdown amounting to half a million barrels of oil a day, equal to 6 percent of the country's total production and involving mostly marginal fields exploited by stripper wells in Kansas, Oklahoma and Wyoming," he said.
"Furthermore, in 1998 prospecting efforts in the U.S. totaled barely one-fourth of their 1997 levels, a trend which heralds even deeper reductions in the future."
All these elements, he concluded, suggest that the oil industry is facing radical changes as well as tough challenges, particularly in medium and high cost areas.
"Such a conclusion implies that there will be a growing dependence of the major consuming countries on low cost fields that happen to be concentrated around the Persian Gulf," he said.
Does that set the stage for a new price embargo by Arab countries somewhere in the next 20 years?
"It is difficult to say and certainly the economics profession is not equipped to predict such an event with any degree of certainty," he said, "but history shows us that human development tends to move in cyclical ways."