Oil and Gas: A Real Bummer for Anyone Owning a Hummer

By Scott B. MacDonald

NEW YORK (KWR) Energy prices have been on the rise. Although there was considerable speculation that oil prices would fall in 2003, they did not. And in 2004, oil and gas prices are still high and the ongoing higher cost pressure for oil and gas is not likely to go away any time soon. For anyone thinking the world is still awash with cheap and easy oil and gas, wake up and smell the coffee. The days of easy energy are gone. The next wave of energy politics is going to be driven by lower levels of reserves, greater sensitivity to geopolitical factors, and increasing demand.

Oil prices have been on the rise lately, with crude oil for April delivery settling above $36.00 a barrel on the New York Mercantile Exchange for several days in March. The major driver in the recent price hike is growing concern that gasoline supplies in the United States will not increase fast enough to meet peak demand during the summer driving season. U.S. refinery efforts to re-supply low gasoline supplies this spring may also be negatively effected by a recent accord to reduce production during the second quarter of the year. According to U.S. government data, the country's motor fuel supplies in the week ended February 20 fell for the fourth week in five. The bottom line is that the United States is heading into its peak demand period, with a backdrop of stronger economic growth and low inventories. In addition, there are a number of new state and federal fuel regulations, which add to costs. The combination of these factors is expected to keep oil prices high during the months ahead.

There are other, longer-term factors at work. Outside of the United States, there are five other key factors likely to maintain a period of higher-than-originally planned oil prices. These are:

1. Strong and unrelenting demand from China and India. As these economies continue to expand at rapid growth rates, their demand for energy is also expanding. China was a net oil exporter during the 1980s. By the early 1990s it shifted into a major oil and gas importer. It is now in the process of developing a strategic oil reserve and plans have recently been announced for the construction of a third liquefied gas import terminal to meet rising energy demand. The first two terminals – one in Guangdong and the other in Fujian provinces – are in construction and will take in natural gas from Australia and Indonesia.

2. Constraints on supply are being caused by 15 years of insufficient investment. According to a December 2003 released study by the World Energy Council, oil production may have reached a plateau outside of the Middle East. Over the past three decades the development of North American, European, Asian and African sources of oil has helped reduce world dependency on OPEC countries. However, many North Sea and North American fields are in decline and the rate of non-OPEC oil discovery is considerably down. There are also questions as to the real level of Saudi reserves. Saudi Arabia’s five giant fields that have produced around 90% of the country’s oil, were drilled during 1940 and 1965. Although there are new fields, questions exist as to how much oil is contained. Significantly, much of the optimism about an ever-lasting supply of oil comes from the view of Saudi Arabia as a large bottomless barrel of oil.

3. Overstatement of reserves. One of the things becoming apparent for oil producers is that in the past there has been an overstatement of oil reserves. In some cases this was done to play well with stockholders; in others it was poor methodology. No matter what the reason, oil reserves are not as high as what was commonly thought. In late 2003 and early 2004 a number of companies surprised the market with news that they were taking their reserve levels down to more conservative (and accurate) assessments. Among the companies doing this were Shell, Forest Oil, Nexen and El Paso. There are others that are also likely to reduce their reserve levels.

4. Over the last few years, OPEC has regained a grip on markets. Although it is not entirely dominant, it has managed to maintain the key role as the swing producer in global production, largely due to Saudi Arabia's still considerable reserves. OPEC has also worked to develop a closer relationship with two major non-OPEC producers, Mexico and Russia.

5. Politics is also playing a role in higher oil prices. Venezuela's political problems are likely to get worse soon as the government is seeking to avoid going to a referendum vote on President Hugo Chavez. The opposition is threatening violence - again. Venezuela is currently in the middle of three days of riots. Adding to the questionability of Venezuelan oil, President Chavez has stated that his country would halt all oil shipments to the United States if Washington seeks to blockade or invade the South American country. Venezuela shipped 1.32 million barrels of oil a day to the United States in December, making it the fourth largest supplier to the United States, after Mexico, Canada and Saudi Arabia. The higher level of rhetoric from President Chavez comes from the fact that he is under pressure at home in the form of an articulate and motivated opposition (which has also been somewhat disorganized) and concerns generated by the March U.S. military intervention (through the United Nations and with French troops) in Haiti.

While Venezuela has its issues, Nigeria's oil and gas production is vulnerable to ongoing labor-management problems and ethnic tensions. Although not as complicated as either Venezuela or Nigeria, Indonesia's oil and gas production is rapidly declining as corruption and nationalism is resulting in the departure of many multinational companies that have badly needed capital and expertise.

We have also seen strong natural gas prices, reflecting ongoing demand in the United States and declining domestic North American supplies. While the U.S. demand for natural gas is a constant, other energy-hungry countries, like China, Korea and India, are also looking for new sources of natural gas. It is in this environment that a ministerial level meeting of natural gas producers will meet in Cairo on March 14-16. Officially called the Gas Exporting Countries Forum (GECF), this group includes Algeria, Brunei, Indonesia, Iran, Libya, Malaysia, Nigeria, Norway, Oman, Qatar, Russia, Trinidad and Tobago, United Arab Emirates and Venezuela. GECF was initially created in May 2001 in Teheran with the purpose of discussing technical issues, upstream industries, transportation, marketing and technological implications of gas-to-liquids. Additional meetings took place in Algiers in February 2002 and in Osaka in September 2002. At the Algiers meeting, Russian President Vladimir Putin called for an "alliance" of Eurasian gas-exporting countries " ... to exercise effective control over the volumes and directions of Central Asian gas exports".

While we are a long way from the creation of a natural gas cartel along the lines of OPEC, we could see an informal Organization of Gas-Exporting Countries (OGEC). Certainly this group of countries is far-ranging and on the surface has little in common beyond natural gas. OPEC was created to help promote oil-producing countries and help them deal with the major multinational oil companies. Adding to the glue in this group was a sense of Third World nationalism. That was then; this is now. Third World solidarity is not what it used to be and it is difficult to see how Russia would control its gas production and exports for the sake of quotas that are supportive of Norway, Algeria or Venezuela. What GECF could develop into is a more regular natural gas producers forum, providing a broad-gauged body helping to push prices in one direction or another. Considering the current spike in energy prices, anything resembling a cartel could spook the market - be it a real cartel or perceived.

Considering all of the above, we see a world energy market that is undergoing a structural change – ongoing demand, falling production, less than expected reserves, and better coordination among producer nations. While this does not necessarily mean that the global market will have a shock along the lines of 1973/74 and 1979/1980, it does point to the potential for a decade of higher oil and gas prices – something that has not yet really hit policy-makers in many of the more developed countries. It is, however, gradually making itself felt in the stock and bond market, where a number of energy companies continue to gain in value – something not likely to go away any time soon.