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The Economist predicts low oil prices for foreseeable future

An article in this week's Economist magazine predicts that oil prices
are likely to remain low for the foreseeable future. This does not bode
well for the economies of oil-dependent nations burdened with debt (and
other problems). It also speculates as to the other Gulf States'
possible future response to the low prices, which will determine the
monetary value of Iraq's oil exports. I am sending out the article in
full as background information, though there are few direct references
to Iraq. One of these, however, consists of the old refrain: "OPEC
members fear that Iraq, whose UN-constrained output rose by 1m barrels a
day in 1998, may some day be able to raise production further." 


"WHAT", sneered Abdurrahman Salim Atiqi, Kuwait's one-time oil minister,
"is the point of producing more oil and selling it for an unguaranteed
paper currency?" In 1973, when most people feared that nothing could
stop greedy OPEC members from raising oil prices as much as they
chose-though not this newspaper, which forecast an oil glut-the
producers affected to accept western cash for their black bullion out of
charity. Now the long oil-price odyssey seems at an end. Since its peak
in 1980, the price has fallen erratically. It has plunged by half in the
past two years alone. In real terms, oil now costs roughly what it did
before 1973. Crude is gushing from the ground at the rate of 66m barrels
a day, half as copiously again as in OPEC's prime. The world is awash
with the stuff, and it is likely to remain so. 

That is good news, is it not? For consumers, certainly, especially those
in poor countries whose lives will be improved by the warmth, light and
mobility that cheaper energy brings. It  would be progress, too, to get
away from the notion that oil is scarce-an assumption that led to two
decades of energy-policy mistakes, such as subsidising coal and nuclear

But do not imagine that the bad dream is over. It is worse than ever for
some of the world's most populous and poorest countries that make their
living from oil. Petroleum provides over half the government's income in
such places as Iran and Nigeria. OPEC's oil revenues last year were, in
real terms, only a fifth of their peak in 1980, so most oil producers
are beset by huge budget and current-account deficits. If cash-strapped
producers cut expenditure faster than consumers spend their windfall,
the effect of lower oil prices might even be to slow world economic

Cheap oil could cause instability as well as poverty. As a result of
last year's low prices, the Mexican government has revised its budget
three times and increased borrowing. Mexico is hardly a paragon of good
government, but, thanks to the diversification of its economy since the
1980s, it at least has an alternative to oil. Many other oil-producing
countries are ill-placed to cope with low prices. Cheap oil might merely
aggravate the twin evils of corruption and bad government. 

No naked flames, please 

The bigger fear is that consumers will one day suffer, too. Hydrocarbons
and political volatility seem to go together. The Middle East has the
world's cheapest and most abundant reserves of high-quality oil. Russia
supplies most of Western Europe's natural gas. The dependence that this
implies has been obscured in the past decade because OPEC's high prices
in the 1970s and 1980s paid for the development of oil and gas fields in
such expensive regions as the North Sea. 

But low prices will gradually put most such areas out of
business-especially if cash-strapped Gulf states conclude that the best
way to increase revenues is to boost production, which could drive
prices from today's $10 to as little as $5 (see article). The world will
then again depend on a few Middle Eastern countries for half its oil, up
from a quarter now. 

At least for the moment, three of these countries-Kuwait, Saudi Arabia
and the United Arab Emirates-are staunch western allies. But Iran and
are not; and the whole of the Gulf is unstable. All the region's
governments are suffering from the decline in the oil price. Most are
repressive and unpopular. None has a sure hold on power. 

If the Saudi royal family, in particular, were overthrown, it would send
oil markets into turmoil. Once low prices move more production back to
the Middle East, even a toppled emirate or two might be enough to cause
disarray. It is no use hoping that a rebel government would keep the oil
flowing at any cost. Remember the revolution that overthrew the shah of
Iran in 1979. It cut supplies for only a few months-but was enough to
trigger the second oil shock. 

Of course, any such shock would be different today. Economies depend
less on oil than they did. The development of markets to trade oil and
oil futures means that price signals are relayed faster and more
efficiently. Oil-producing capacity outside OPEC could be brought back
on stream should oil prices ever blip up again. Yet any interruption to
oil supplies would be hugely damaging to the world economy. That is why,
even as prices fall, governments of consuming countries should be
guarding against the dangers of oil dependence. 

One way of doing this is to keep researching into alternatives to the
petrol-powered internal combustion engine, such as fuel-cell systems,
which can derive hydrogen from natural gas. Another is to curb
consumption through higher petrol taxes. The country best able to make a
difference is America, which consumes a quarter of the world's oil,
almost all of it for transport. American petrol taxes are so low that
they do not even take account of environmental costs such as pollution.
There is no better time to perform the politically awkward feat of
raising taxes than when oil prices are low and the money can be quickly
handed back in lower taxes elsewhere. 

Yet even this would serve only to mitigate the future risks. By all
means, welcome the return of normality to oil markets and the end of
OPEC's power. But just as oil's scarcity seemed a fact of life in the
1970s, its abundant flow might be too easily taken for granted today.
Normality could last a while; but it is unwise to assume that it will
endure for ever. 


Cheap Oil: The next shock? 

The price of oil has fallen by half in the past two years, to just over
$10 a barrel. It may fall further-and the effects will not be as good as
you might hope.

OIL is cheaper today, in real terms, than it was in 1973. After two
OPEC-induced decades of expensive oil, oil producers and the oil
industry as a whole have more or less given up hope that prices might
rebound soon. The chairman of Royal Dutch/Shell, Mark Moody-Stuart,
three months ago unveiled a five-year plan that assumed a price of $14 a
barrel. He has since publicly mused about oil at $11. Sir John Browne,
chief executive of BP-Amoco, is now working on a similar assumption. 

Consumers everywhere will rejoice at the prospect of cheap, plentiful
oil for the foreseeable future. Policymakers who remember the pain of
responding to oil shocks in 1973 and in 1979-80 will also be pleased.
But the oilmen's musings will not be popular with their fellows. For if
oil prices remain around $10, every oil firm will have to slash its
exploration budget. Few investments outside the Middle East will any
longer make sense. 

Cheap oil will also mean that most oil-producing countries, many of them
run by benighted governments that are already flirting with financial
collapse, are likely to see their economies deteriorate further. And it
might also encourage more emissions of carbon dioxide at just the moment
when the world is trying to do something about global warming. 

Yet here is a thought: $10 might actually be too optimistic. We may be
heading for $5. Thanks to new technology and productivity gains, you
might expect the price of oil, like that of most other commodities, to
fall slowly over the years. Judging by the oil market in the pre-OPEC
era, a "normal" market price might now be in the $5-10 range. Factor in
the current slow growth of the world economy and the normal price drops
to the bottom of that range. 

That the recent fall in prices has been so precipitous merely confirms
that, for the past 25 years, oil has been anything but a normal
commodity. Although the Middle East contains two-thirds of the world's
proven oil reserves, it produces less than a third of the world's oil.
If production were determined by cost and quality alone, most oil would
come from these countries. Oil in the Gulf is cheap to extract-barely $2
a barrel, a quarter of the cost in the North Sea. Unlike the heavy
crudes of Mexico or Venezuela, it is of high quality and high value.
Much of the world needs fancy technology and expensive rigs to extract
oil; in Arabia, as the old hands say, "you just stick a straw in the
ground and it gushes out." 

The Gulf countries are to blame for their small share of the market. By
nationalising their oil industries and doing their best through the OPEC
cartel to keep prices high in the 1970s and 1980s, they encouraged oil
development elsewhere. With oil so profitable, prospectors searched
inhospitable parts of the world. The perverse result is that high-cost
regions (such as the North Sea) have been exploited before low-cost ones
(such as Iran). 

The oil industry is like a ship with its centre of gravity above the
water line, says Jeremy Elden of Germany's Commerzbank. It can sail
smoothly for years, but capsize suddenly in rough seas-and do so quite
rapidly. An unprecedented combination of excess supply and weak demand
has created just such rough seas in the past year. The finances of the
Gulf states are suffering, as budget cutbacks and recent talk of defence
cancellations have shown. 

Yet if the Gulf producers thought that oil prices would remain low for
some years, it would pay them to abandon all attempts to boost oil
revenues by propping up prices, and instead to increase production. The
result would be a world in which supply and demand were determined not
by geopolitics and cartels, but by geology and markets-meaning that, in
today's conditions, the price would head down towards $5. That sounds
appealing. But it carries also a less happy corollary of a world that
depends upon a highly unstable region for half its oil, with the
proportion rising all the time. 

A new report by Arthur Andersen, an accounting firm, and CERA, an energy
consultancy, argues that the present price collapse is fundamentally
different from the previous one, in 1986. Then, high prices had choked
off demand; but as soon as oil became cheap again, the thirst for it
returned. This time demand has barely picked up, even though the price
has fallen by half. 

One short-term reason is yet another unseasonably warm winter in the
northern hemisphere. A more lasting one is the economic troubles of
Asia, the region that had been expected to drive oil-company profits for
years to come. Even such sceptics as David O'Reilly, one of Chevron's
bosses, who continues to pooh-pooh what he calls a temporary "price
siege", still worry that, because of Asia's crisis, demand might not
rebound. Demand may fall further if and when America's record-breaking
growth comes to an end. 

There is another threat on the demand side: worries over global warming.
Although the science remains inconclusive, rich countries agreed at the
Kyoto summit in 1997 that it is worrying enough to warrant pre-emptive
action. So they have agreed to binding targets to reduce their emissions
of greenhouse gases. Whether or how countries will hit these targets is
unclear. But demand for oil (though not for cleaner gas) in the rich
world is likely to be one casualty. 

The supply situation is even gloomier for producers. Unlike 1986, oil
supplies have been slow to respond to the past year's fall. Even at $10
a barrel, it can be worth continuing with projects that already have
huge sunk costs. Rapid technological advances have pushed the cost of
finding, developing and producing crude oil outside the Middle East down
from over $25 a barrel (in today's prices) in the 1980s to around $10
now. Privatisation and deregulation in such places as Argentina,
Malaysia and Venezuela have transformed moribund state-owned oil firms.
According to Douglas Terreson of Morgan Stanley Dean Witter, an
investment bank, this has "unleashed a dozen new Texacos during the
1990s", all of them keen to pump oil. 

Meanwhile OPEC, which masterminded the supply cuts that pushed prices up
in the 1970s and 1980s, is in complete disarray. The cartel will try yet
again to agree upon production cuts at its next meeting, on March 23rd,
but, partly thanks to its members' cheating on quotas, the impact of any
such cuts will be small. OPEC members fear that Iraq, whose
UN-constrained output rose by 1m barrels a day in 1998, may some day be
able to raise production further. Last week Algeria's energy minister
declared, with only slight exaggeration, that prices might conceivably
tumble "to $2 or $3 a barrel." 

Nor is there much chance of prices rebounding. If they started to,
Venezuela, which breaks even at $7 a barrel, would expand production; at
$10, the Gulf of Mexico would join in; at $11, the North Sea, and so on
(see map). This will limit any price increase in the unlikely event that
OPEC rises from the dead. Even in the North Sea, the bare-bottom
operating costs have fallen to $4 a barrel. For the lifetime of such
fields firms will continue to crank out oil, even though they are not
recouping the sunk costs of exploration and financing. And basket-cases
such as Russia and Nigeria are so hopelessly dependent on oil that they
may go on producing for some time whatever the price. 

And $5? 

All this explains why oil prices will remain low. But there needs to be
a shift in the policy of the world's biggest producer, Saudi Arabia, for
them to be halved again. The kingdom has for years restrained output to
support prices. However, if its rulers think prices are going to remain
low anyway, their calculation may change. 

"If it weren't for politics," insists Euan Baird, head of Schlumberger,
the world's biggest oil-services firm, "every barrel of oil would be
pumped out of the Gulf-especially Saudi Arabia." Politics is not dead
yet, as troubles in so many oil countries, from Venezuela to Russia to
Nigeria have made plain-indeed, it may be the very prize of oil that has
created these countries' problems. But a new kind of politics may now be
at work to make Mr Baird's assertion come true. 

The latest oil-price shock has come at a sensitive time for the Saudi
ruling family. Power is passing from the ailing monarch, King Fahd, to
his brother, Abdullah. The autocratic family has had problems with
dissent in radical Islamist quarters. Low oil prices crippled the Saudi
economy in 1998: output shrank by nearly 2%, both the current-account
and the budget deficits soared to nearly 10% of GDP and debt approached
100% of GDP. This year will be worse. 

The choice is simple. Either the Saudis must cut back their welfare
state, by slashing benefits and raising taxes, or they must find a way
of increasing oil revenues. But the ruling family's delicate domestic
situation makes the first option difficult. So instead the Saudis may
now do what once would have been unthinkable: throw open the taps. That,
according to McKinsey, a management consultancy, would certainly herald
an era of $5 oil. 

It would also destroy OPEC. But the cartel is already moribund, and
unless Saudi Arabia can bring it back from the dead, which is highly
unlikely, going for full production is the strategy that makes most
sense for all the Gulf states. Mr Elden has crunched the numbers for the
five main producers (Saudi Arabia, Kuwait, Iran, Iraq and the United
Arab Emirates) at a $10 price. His analysis shows that after a short
period of lost revenues, the Gulf states would enjoy years of strong
cash inflow, as they take market share from high-cost regions. He
reckons that the real rate of return for the Gulf states on such an
"investment" is 13%, well above the cost of borrowing to plug budget
gaps. If Saudi Arabia, on its own, pursues volume, he reckons its rate
of return would be an impressive 15%. 

The catch is finding the money needed to buy equipment and develop
fields now, so as to expand production fast. The strategy Mr Elden
suggests of going for full production might cost perhaps $110 billion, a
good $50 billion more than the Gulf states have to hand. But these
countries will not have to beg for charity: their reserves have a
present value of $1.2 trillion. Foreign oil bosses are already queueing
up, chequebooks in hand. 

Sensitivities about OPEC are one reason why some people doubt that the
Saudis will, say, double output to gobble up a 25% share within a few
years. Plenty of oilmen think that Saudi Arabia is too cautious for
that. The Saudis might instead respond to low prices by increasing
output only slowly and quietly. Such a strategy would serve Saudi
Arabia's political ends by keeping its chums in OPEC afloat, and its
economic ends by forcing many private-sector oil firms to slash output
from high-cost, non-OPEC fields. 

There are signs that the nationalism of Gulf producers is crumbling.
Kuwait is debating opening its oil fields to foreign investment. Even
Saudi rulers have dropped some hints. Prince Abdullah, on his first
visit to America last autumn, met American oil firms to discuss possible
upstream investment in his country, a subject that would once have been
taboo. Every few weeks, another top oilman visits the Saudis. Last
month, Bill Richardson, America's energy secretary, arrived to woo the
royals. Although the Saudis were coy on that occasion, Mr Richardson
says he is confident that a framework for upstream foreign investment,
beginning with gas, but likely to go on to oil, will be in place within
six months. 

The good news . . . 

One might expect a collapse in oil prices to fuel an orgy of gleeful
consumption. Indeed, when the oil price halved in the mid-1980s, world
consumption did soar-by 2.7% a year for three years. But not this time,
argues Joe Stanislaw of CERA, for two reasons. One is, again, the
advance of technology, which has made alternatives to oil, such as
natural gas, cheaper. In the mid-1980s oil consumption surged in part
because when oil fell below $20 a barrel, it was often substituted for
gas. Now, advances in gas turbines have made gas more attractive, even
if oil prices go below $10. 

Another factor is a legacy of previous oil shocks-taxes that are aimed
at conservation. In all rich countries but one, taxes make up so much of
the price of petrol at the pump that consumers hardly notice any drop in
crude prices. In Europe, for example, about 80% of the purchase price
(typically, $1 a litre) is tax. The exception of course, is America,
where taxes make up only a third of the price-but at about 40 cents a
litre, the price is very low anyway. Philip Verleger, a petroleum
economist, reckons that even a prolonged period of low oil prices (below
$10 a barrel) will provide a negligible boost to consumption in OECD
countries, perhaps no bigger than 1%. 

In poor countries, where taxes are lower and more new power stations and
vehicles are being built, the effect of cheaper oil will be greater. Low
prices will mean that more poor consumers can enjoy the benefits taken
for granted by their rich-world brethren, although that will also mean
they produce more greenhouse gases. In places like China, most power now
comes from plants using inexpensive, but filthy, coal. Mr Verleger
points out that a $5 world might encourage a shift to oil-fired plants
or, better still, to cleaner ones using natural gas. 

. . . and the bad 

Yet a falling oil price will not be good for everyone. In particular,
the oil companies and the producer countries will suffer. Low prices
have left both screaming in pain-and there may be worse to come . 

The six biggest American oil firms posted grim fourth-quarter results
for 1998: their after-tax profits fell by 90%, or $4.8 billion, compared
with the same quarter a year earlier. The recent mergers of BP with
Amoco and Exxon with Mobil mark a new round of consolidation in the
industry. A big motive is to take costs out of the business: Exxon-Mobil
for example, expects to save $2.8 billion from its merger. With its own
reorganisation and internal streamlining, Shell is hoping to save $2.5
billion a year. 

The big firms are also expecting Gulf countries to open up to investment
and are creating formidable lobbying machines in readiness. This week
two European oil firms, ENI and Elf, signed contracts to help develop
Iranian oil fields. The new BP-Amoco will take its place near the front
of the queue to see Gulf oil ministers, but it will also be able to call
on new American friends to put in a good word. Sir John Browne lobbied
Mr Richardson before his visit to Saudi Arabia. 

If oil companies find that they can adapt, albeit painfully, OPEC
countries will find it much harder. The revenues of the cartel's members
plunged in 1998 to about $100 billion, only one-fifth of their 1980
revenues in real terms, according to Marvin Zonis of the University of
Chicago. All the oil producers are suffering, but some are in better
shape than others. Mexico, for example, has diversified its export base,
though the federal government still gets about a third of its revenues
from Pemex, the state oil monopoly. Britain has a diversified economy
that can weather the price drop. Norway has set aside surplus oil
revenues to pay for pensions for its ageing population as oil income
wanes. Abu Dhabi and Kuwait, with few people and lots of cash, have been
able to stash profits away for rainy days. 

But other countries are heading for big trouble. Nearly half of Russia's
hard-currency earnings come from crude-oil exports; that figure rises to
about 80% for Venezuela and 95% for Nigeria and Algeria. In Russia (and
also in the Caspian) low oil prices may make much production
unprofitable. In Venezuela, where production costs are lower, the
bursting of the oil bubble has helped to propel a populist military man,
jailed for two failed coups in 1992, into the presidency. Prolonged low
prices could trigger social explosions in several other unstable
producing countries. 

As for the country that has most ostentatiously frittered away its oil
wealth, Nigeria, the delicate transition to democracy that took a
further step with last weekend's presidential election could yet be
undermined by economic troubles. Nigeria is a low-cost producer, so it
will still be in business even with low oil prices. But its
mismanagement-Nigerians have recently had to queue for two days to get
petrol-has been so bad that the transition could prove difficult

In the short run, at least, the oil monarchies of the Gulf could also be
in difficulty. Low prices threaten the delicate "ruling bargain" between
dictatorial rulers and coddled subjects. A further plunge in revenues
might put them at great risk. If they slash benefits or raise taxes,
they risk a backlash that could even shove them out. 

In the medium term, however, the Gulf states will find that their
revenues recover and even increase with cheaper oil. So once they have
made the transition to higher production, a $5 world should not hold any
terrors for them. But it may hold more terrors for the rest of the
world-for, just as in 1973, it will find that it is increasingly
dependent on a few unstable and unreliable Gulf countries, notably Saudi
Arabia, Iran and Iraq, for its energy. Cheap oil may not then look quite
so wonderful, after all.

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