The Hindu Business Line : Oil: Super spike or crying wolf?

A recent Goldman Sachs report on oil demand explains the essence of a super spike, saying that demand has to fall "because spare capacity throughout the energy supply chain is limited" and "supply additions take a long time to complete." The authors' suggestion: Oil exporting countries must reinvest cash flows into building "a diversified economic base that can allow the majority of their growing populations to have economic hope". D. Murali on the report.

THE latest `shock-n-awe' report doing the rounds is Goldman Sachs's perspective on oil. "A super spike period may be upon us," it declares, predicting oil prices inching towards $105 a barrel. We're still only `in the early stages' of such a period, aver the authors, key among whom are Arjun N. Murti and Brian Singer. While, for consumers, the forecast is as grim as the diagnosis of a terminal malady in its early stages, the report's view is `attractive' for a `new industry perspective', so the sector remains a `buy', but for a key risk — "a sharp slowdown in economic growth in China and other emerging Asian economies," such as India.

What we have on hand is no video game from Nintendo going by the Super Spike name, but "a multi-year trading band of oil prices high enough to meaningfully reduce energy consumption and recreate a spare capacity cushion, after which alone will lower energy prices return."

That is jargon enough to go over most heads, as if to save them from the worry about a gloomy future that has high price on one side of the see-saw, and low consumption on the other. Capacity builds up on the supply side, pulling the high price down to match demand, so there is the hope of prices falling, sometime in the future, though such an assurance is no cushion for the immediate worry. An indication of the seriousness can be gauged by the drastic revision in the Goldman Sachs (GS) price forecast — from the earlier range of $50-$80 (based on past super-spike period of 1979-1985) to $50-$105 — all because of `resilient demand'.

The authors of the report are surprised by "the strength in oil demand and economic growth, especially in the US and China," after a year of $40-50 per barrel, and so look back at what happened in the late 1970s and the early 1980s to draw insights. What do they find? That, in the US, the money spent on gasoline was "a much higher percentage of the US economy and consumer spending than it is today." Thus, though fuel prices have been rising, the impact has not been felt in the form of reduced demand.

A dangerous finding, because, even the $105 projection is `conservative' for two reasons. One, it assumes "a level of gasoline spending relative to the economy and consumer spending that is still below the heights reached in 1980-1981," and, two, it does not factor in the `if' of "a supply disruption in a major oil exporting country." On the latter, GS opines that the potential political revolution may be kept at bay as long as the financial position of `key oil exporting countries' is kept well-oiled by `persistent high prices'.

The caution, therefore, is: "Pressure on these governments still very much exists and would be exacerbated by an unexpected sharp fall in oil prices." However, Murti and Singer have a prescription to avert `future political crises': Oil exporting countries must reinvest cash inflows into building "a diversified economic base that can allow the majority of their growing populations to have economic hope".

Drivers of oil prices

The report lists three fundamental factors driving oil prices. One, the costs of E&P (exploration and production) have been rising; reasons are "increased geologic maturity in many of the traditional areas of oil supply" and cost inflation of input services and materials.

Two, higher premium for light-sweet crude oils compared to heavy-sour grades, because of "high (and rising) OPEC production volumes, limited complex refining capacity, and increasingly strict sulphur specifications in the US and Europe."

And, three, world economies are able to take high nominal oil prices in the stride because of "significant increases in energy efficiency since the 1970s".

To add to these, and turning a sour tale into something sourer, there is "geopolitical turmoil in key oil exporting countries coupled with populist rhetoric," preventing "foreign oil companies from developing host country resources in a timely manner." Don't blame the sustained price hike on speculation and hedging, advises GS, because such activity has had "a negligible role in global oil markets beyond day-to-day trading noise".

Accountants may find an interesting discussion in the report about cost structure. A revealing graph looks at how `futures contracts starting 60 months forward' are in sync with by E&P unit cost structures in recent years, based on "the differential between realised company revenues per barrel of oil equivalent (BOE) and the West Texas Intermediate (WTI) oil price benchmark."

Pushing costs further up are "steel price increases and drilling rig rate hikes, likely to be felt to a much greater degree in 2005 and 2006 than was the case in 2003 or 2004."

A forewarning

The day's story on Bloomberg reports the results of a survey among 62 analysts and strategists; more than half of them feel oil prices will decline, even as there is a hike in production by OPEC members boosting inventories in the US. Yet, short-term inventories are less relevant, believes GS: "We believe movements in short-term inventories are not as relevant in a secularly tight environment as would be the case during an era of significant overcapacity."

To explain, there are two revealing charts, one on OPEC's `immediately deliverable spare capacity' which is now `essentially gone'; and the other, `global oil demand as a percentage of refining capacity' now `running full out'. Murti and Singer elaborate: "During much of the 1980s and 1990s, there was significant overcapacity throughout the energy supply chain. Given the ability to easily `turn on the taps', either in terms of crude oil supply or refining capacity to meet surge demand, it is logical that movements in short-term inventories played the dominant role in driving energy commodity prices."

Not so now, in the `era of secular tightness', because "addition of meaningful new quantities of supply is measured in 5-10 year increments as opposed to a few months or quarters."

Demand destruction

Well, that's `the essence of a super spike', elucidates the report. Demand has to fall "because spare capacity throughout the energy supply chain is limited" and "supply additions take a very long time to complete." Only then can we have "the kind of spare cushion that existed through much of the 1980s and 1990s." In what may appear sinister, there is a Table that computes $3.5 to $4.3 per gallon as the price at which the US consumer may restrict the demand by 2007-08, not only for oil but also gas-guzzling SUVs.

We may need to do a similar exercise here too, though it is quite likely we would only talk about reducing our demand for oil. In one of the two references to India in the report, Murti and Singer speculate that rising oil demand here, and in China, is "equivalent to the industrial consumption that used to occur in the US in the 1970s." The other reference complains about the complication introduced in pricing here, tending to be "far more regulated" and therefore "potentially muting the impact of higher spot WTI oil prices", as is happening now. "We are respectful of the fact that it is more difficult to gauge the true health of the Chinese economy," concede the analysts elsewhere, and also add that an unknown quantity is when and if China will revalue its currency upward.

Supply construction?

Yes, that should be the antidote, rather than kill demand. But GS doubts if `major new quantities of supply' can come in before 5-10 years. This despite assumptions of `perfect conditions', such as there being `areas of opportunity' for mass investment. Not only are supply conditions far from perfect, there's a problem with `Middle East demographics' too.

To distract from adding to oil supply, the region lacks `a diversified economic base', even as it boasts of "governments that are not representative of or responsive to underlying populations".

The clue, therefore, lies in making large investments. That can grow supply; but not enough to "recreate a spare capacity cushion," points out the report. What's the difference? The former can happen `in the years ahead' but the latter `is unlikely without demand destruction', because as long as the rate of growth is consistent with the rate of growth in oil demand, you don't achieve any change in spare capacity, do you?

Are we running out of oil? A logical question, but GS reassures, saying it doesn't believe so. "We are not subscribers to the theory that global oil supply has hit some magical inflection point that will result in permanent supply declines at some point in the near future," write Murti and Singer. "It appears to us that there exists a large `known' quantity of both conventional and unconventional oil resources to develop."

Sounds like a prophecy, but there's a bigger hitch: "A large portion of these resources are effectively off limits to western investment due to either outright prohibitions or major restrictions on investments placed by host governments in the Middle East, Russia, and Venezuela." And that calls for changes in `the political landscape', with host countries paying attention to investments in oil on a large scale. A case of running out of options, it appears, rather than of oil. Or, are they just crying wolf?

(dmurali@thehindu.co.in)

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