OUTLOOK 2003: United States
Cruide Oil Prices

Are oil & Murphy’s Law about to meet?

 Matthew R. Simmons, Chairman & CEO, Simmons & Company International, Houston

 Murphy’s Law – “If anything can go wrong, it will” – seems headed into the heart of our oil system. As 2003 gets underway, a confluence of events is tightening oil markets to an unprecedented level and threatens to culminate in a day of reckoning for oil as this combination of long-term energy problems finally converges. Most of these problems are not new; they have simply been ignored for too long. 

 The past decade was marked by a series of sporadic oil booms, inevitably followed by recurrent and devastating oil busts. The latter were each preceded by a violent collapse in oil prices, which then caused new rounds of down-sizing and postponement of long-term plans for added production. With each new collapse, the industry was forced to limit the capital it spent on new assets. The entire petroleum infrastructure continued to age, with minimum new investments; and industry’s ability to make long-term decisions was undermined completely. These repeated busts have made prospects for actively recruiting the next generation of oil and gas executives to replace a very gray  workforce quite remote. Capital for future energy projects is scarce – the risk factor is now deemed too high. 

 This ever-increasing volatility took a savage toll on the industry’s normal mode of operation. It created a cloud of pessimism, perhaps unmatched since the 1980s oil collapse. Throughout the decade, most oil observers worried that demand growth for oil was either slowing or had ended. They believed, with some passion, that any increase in oil prices above an $18 – $20 range would create an instant surge in non-OPEC supply. For a decade or more, a widespread belief that OPEC was sitting on 5 to 7 million (MM) bpd of shut-in supply grew to an almost accepted fact. The entire decade was marked by a general pessimism that oil supply was always about to create a new glut which would then cause prices to collapse. 

 During this same time, OPEC was widely dismissed as a toothless tiger, proving that cartels never work. Even worse, Saudi Arabia – a country extremely vulnerable to, and affected painfully by, low oil prices as it struggled to cope with high unemployment and an exploding population – was falsely accused of secretly scheming to bring oil prices to low levels to eradicate all long-term competitive supplies. In reality, no oil-producing country was more vulnerable to the risk of a price collapse. But as senior Saudi officials virtually begged for a mechanism to eliminate price volatility and create a stable but firm oil price, speculators and energy traders would accuse them of plotting to bring oil prices to $10 levels. 

 As it turned out, most of this deeply believed conventional oil wisdom was wrong. And 2003 might be the year when so many widely believed views are finally dispelled by the arrival of a series of serious oil and natural gas related supply problems. 

Oil and gas well exploration drilling, late 2001 and 2002.

  DEMAND INCREASES, SUPPLY CONSTRAINTS

 In a decade in which demand was supposedly flat, it actually grew far beyond any forecast made as the 1990s dawned. Global oil demand grew from 66.7 MMbpd in 1991 to 76.4 MMbpd in 2001; but global demand – excluding FSU demand which fell – grew by over 14 MMbpd. Had FSU demand not collapsed, global oil demand would now be well over 80 MMbpd, assuming such growth could be adequately supplied. Had northern hemisphere winters not been abnormally mild virtually every winter in the past 5 – 7 years, world global oil demand could easily have soared by another several MMbpd. Fate held oil demand much lower than it could have grown, but the net growth was still far more robust than anyone suspected as the 1990s began. 

 Meanwhile, oil prices averaged closer to $25 than $20 throughout the 1990s, other than three eras when they collapsed. And all three collapses were fueled by erroneous perceptions about oil gluts or by abnormal events, like the unwinding of MG, the failed German crude trading firm. 

 As the decade progressed, the widely predicted glut or surge in non-OPEC supply turned into a modest trickle. Other than a surprising and unpredicted supply surge from the FSU, the rest of non-OPEC supply grew by only 2.5 MMbpd between 1991 and 2001, which translates to an average growth of 0.7% per year. Over half of this trickle came from the North Sea, which is now clearly peaking. The FSU supply surge was a total surprise, and many skeptics question the sustainability of these gains without a massive overhaul/expansion of export logistics and the start of major Greenfield oil projects. At some point, a rapidly improving Russian economy will quickly rob Russia of much of its oil export capacity. 

 This reduced non-OPEC oil supply was not from a lack of E&P spending or reduced drilling. The past decade saw renewed drilling for new supplies at a pace not seen since the drilling collapse began in the early 1980s. Moreover, a series of breakthrough technologies made it possible to develop new oil reserves at water depths unheard of as recently as a decade ago; and they facilitated exploitation of fields once written off as either too small or too complex to be commercially productive. Heavy oil projects in Canada and Venezuela were positive surprises. Yet, daily supplies barely grew for most of the world’s producing countries. 

  DEPLETION EFFECTS, OIL PRICE VOLATILITY

 None of the above-mentioned breakthroughs, however, enabled most oil/gas producers to grow daily production fast enough to stay ahead of the steadily rising decline rate in virtually all world producing regions. Over the past five years, most active E&P companies have seen E&P expenditures soar while they struggled to achieve only modest growth in daily oil production. Depletion – a topic which this annual analysis has previously discussed – turned out to have as profound an impact on the growth in global oil supply, as was suggested on various occasions over the last decade. 

 The Big Five (ExxonMobil, BP, Shell, TotalFinaElf and ChevronTexaco) spent almost $110 billion on E&P costs between 1999 and 2001, yet their collective daily oil/gas production grew by a modest 500,000 boepd. In the first nine months of 2002, these five companies spent an additional $32.6 billion on upstream capital expenditures, yet daily production still barely grew. These are extraordinary sums merely to keep production flat. Had oil prices stayed where so many energy experts thought they should, these companies would have experienced major cash squeezes.

 There is no question that 2002 will go down in the industry’s history as a year when the oil markets came in like a lamb and ended the year roaring like a mad, wounded lion. A bigger question is why oil prices were so volatile, not only in 2002, but over the course of the past decade. Even more important is the question of where oil prices might head during 2003, with a handful of observers worrying that prices might be headed far higher, while many others are sure oil prices will soon drop back to $20 or below. Is the industry now doomed to an ever-increasing band of price volatility? If so, will this create a risk premium so high that the oil industry fails to attract the necessary capital to sustain even stable production?

 A close examination of 2002 oil prices shows that it took a massive amount of speculative shorts on the WTI and NYMEX contracts to keep prices under $25. To drop oil prices below $20, speculators had to short the oil contract up to eight times the amount of speculators’ long holdings of crude contracts. Every time speculators began covering these shorts, let alone turning their holdings into speculative longs, crude prices immediately bounced back to a $26 – $30 range, which they had averaged for most of the prior two years. 

  OIL STOCK DROP CAUSES

 A little observed event began unraveling US oil stocks. In late Spring 2002, Iraq’s steady Oil for Food exports began to fall. They stayed very low until the week prior to OPEC’s fall meetings. Then, suddenly, Iraq resumed exporting at high levels, although almost every high week was followed by a week of unusually low exports. No one has figured out why Iraq’s exports became so random, but this odd behavior had a significant impact on tightening the vise of steadily shrinking stocks throughout almost all of the Organization for Economic Cooperation and Development (OECD). 

 When oil prices returned to the $26 – 29 range in the summer of 2002, many analysts assumed this high price was solely the result of an Iraqi war premium. Few took time to notice that the January/ February 2003 contracts to buy WTI crude, the time when war with Iraq was most likely to occur, remained in a low $20 price range. As 2002 progressed, the notion of a war premium began to be widely discredited. But this conviction that the only reason oil prices were misbehaving was due to this supposed war premium led many oil observers to ignore the record declines in US oil stocks. 

 US stocks were already at the low end of a five-year range as the 3rd quarter ended. But then, an unusual combination of two back-to-back Gulf of Mexico hurricanes effectively served as a weather gate across tanker lanes into the Gulf. This disrupted the steady flow of 4.5 – 5.5 MMbpd bound for US refineries. This gate first closed on September 25 when Hurricane Isadore formed. Just as Isadore was petering out, Hurricane Lilli developed and slowly churned over the same narrow tanker lane south of Cuba and north of the Yucatan. 

 This unusual weather put a significant crimp in the normal tanker flow from Venezuela, West Africa, the North Sea and the Middle East. The interruption lasted 10 – 15 days. This rare hurricane combination created what was undoubtedly the world’s longest-lasting tanker traffic jam. 

 By the second week in October, VLCC (very large crude carrier) and ULCC (ultra-large crude carrier) tanker rates soared to levels only seen occasionally in the previous 25 years. This convinced most oil observers that a record amount of OPEC oil was being put on the high seas in response to high oil prices since the hurricanes pushed oil prices back over $30. 

 Unfortunately, many energy pundits were so sure the supply surge would soon bring prices back to levels they knew would occur that they failed to notice the low number of tankers actually loading in the Middle East, or the lack of any oil imports surge in any part of the OECD other than Japan. Since this supposed OPEC glut never arrived in any OECD port, it was probably one more occasion when rumors were mistaken for facts. In reality, the double hurricanes impeded oil at sea instead of triggering record OPEC exports. 

 Meanwhile, in Japan, a freak series of unreported nuclear cracks caused a significant shutdown of Japan’s nuclear power plants. Japan’s only alternate fuel response was to increase both its LNG and crude oil imports by 10 – 20%, constricting an already tight Asian market to a state that sent key Asian crude grades to premiums over WTI, a virtually unprecedented event. 

  NEGATIVE EFFECTS OF VENEZUELA, IRAQ, PRESTIGE TANKER

 At the root of the Murphy’s Law theory is how often one error seems to quickly lead to a second and then a third. Suddenly, a critical mass of small errors can quickly create a full-blown crisis. Such was the state of the global oil markets as December began. 

 On December 2, 2002, Venezuela, the most reliable of all OPEC suppliers to the US, underwent an unprecedented shut down of its entire oil system in a desperate effort to oust President Chavez from leading Venezuela into what the opposition – i.e., leaders of the oil shutdown –  deemed to be a dangerous and possibly dictatorial state. Whether these strikers were right in this view will only be decided by historians, but what they managed to accomplish was astonishing. Within days, Venezuela’s steady production of 3 – 3.1 MMbpd dwindled to less than 500,000 bpd and, by month’s end, daily production was less than 10% normal production at the start of December. 

 From the most accurate reports, just over 2 MMbbl of crude or finished product was exported from Venezuela during the last three weeks of December. At the month’s start, a greater amount would have been exported each day. 

 For the first two weeks of this oil supply crisis, the media seemed oblivious to the lack of supplies, and the subsequent impact on oil prices. But, gradually various key participants began to appreciate how risky this shutdown was to an already tight global market. Persistent rumors of record levels of oil at sea were fast vanishing, and all assumptions of OPEC having 5 – 7 MMbpd of shut-in supply were beginning to look equally shaky. 

 In the meantime, the likelihood of war with Iraq grew with each passing week. Predicting how war in Iraq, or any added turmoil in the Middle East, will impact the already tight global oil markets is impossible. What is clear, though, is how spurious the notion is that quick resolution of the Iraqi problem will bring a flood of new oil. Given the beleaguered state of Iraq’s oil system, massive spending will be needed to merely sustain its existing daily 2.3 – 2.5 MMbopd. It will take close to a decade and $30 – $50 billion to get Iraq to levels of 5 – 6 MMbpd, if this is even a remote possibility. Yet, too many oil experts constantly warn that this Iraq oil flood will be felt as soon as a war ends. 

 Another event that may have a lasting impact on global oil markets is the tragic sinking of the Prestige, an unfortunate name for the ill-fated, old single-hull tanker carrying a particularly unpleasant grade of fuel oil from Russia to Singapore. When the vessel first broke apart and sank into waters 2.5 miles deep in early October, most observers hoped the icy waters would help contain and prevent the oil onboard from further leaking. Within weeks, this theory was shattered by submarine pictures showing heavy oil oozing out like a tube of toothpaste. This will be recorded as the world’s most serious spill and will, unfortunately, have a lasting impact on the Galician coast. It is likely to put more urgency into the European Union’s unwillingness to let single-hull, older tankers use its ports, or perhaps even get within 200 miles of the coast line. 

 The Prestige sinking also strengthens the hand of the Turkish government to rigidly impose new restrictions on exporting Russian oil through the Bosporus. Such restrictions, while needed, then put a further squeeze on Russia’s ability to steadily export its oil to the West. 

US crude oil inventory decline during 2002, and January 2003 level. Source: JP Morgan Securities, Inc., Weekly Oil Data Report, January 8, 2003.

  SERIOUS QUESTIONS FOR 2003

 From my perspective, the number of problems coming home to roost in 2003 seems to resemble a gathering of the entire worldwide Murphy Clan. This seems destined to be the year when many of the myths that clouded the future of oil are finally dispelled. Perhaps by the end of 2003, the cloud of constant pessimistic views might dissipate, and the mantra that demand will never grow, that supplies are always about to surge, that OPEC is falling apart and that oil prices will soon sink, will fade into distant memory. 

 If these erroneous worries finally vanish, they urgently need to be replaced with a host of genuinely serious questions impacting the future of the oil industry that should have received serious analysis and debate but, instead, were dismissed as silly by all who were so sure oil prices would fall. 

 Exactly how much real shut-in capacity any of the OPEC producers really have in terms of either near-term surge or long-term sustainable supply growth is among one of the most serious energy issues to address. Embedded in this issue is another important question: every OPEC producer has only a handful of key fields that make up the vast majority of each country’s production. All of these giant fields are old – many are extremely old. Some of the giants have undoubtedly begun a steady decline, as have the world-class giant fields outside OPEC.

 Yet no one has any reliable data on the rate of declines in these critically needed fields, nor does anyone have a reliable notion of what future, field-by-field OPEC production declines might become. For too long, most oil observers have naively assumed that Middle East oil will last forever and that it will always be cheap. The days of cheap Middle East oil might now be ending as effectively as the era of $2 – 3 oil ended just 30 years ago. 

 How long the Venezuelan shutdown lasts and then how quickly the country can return to some level of normal production will also play a critical role in dictating the fate of 2003 oil markets. Whether Venezuela suffers the same fate as Iran did when it tried to bring its production back after shutting down its oil system 24 years ago, will also bear close watch. Iran, which produced close to 6 MMbpd before its shutdown in 1979, never got back above 3.6 MMpbd – and this took a decade to accomplish. 

 Why the oil and gas producers have not responded to the surge in oil and gas prices will be another key puzzle to resolve. If lack of a major drilling up-tick is caused by a lack of ready-to-drill sites, it might take far longer than anyone now worries about to address how the oil industry recreates a sufficient cushion of oil stocks. 

 How the world begins to rebuild an aging offshore drilling fleet while also replacing an even older tanker fleet is a further question few analysts have bothered to address. 

 The ultimate, serious question that 2003 might finally answer is when just in time oil stocks breach the industry’s minimum operating levels. Over the last decade, the industry’s observed commercial stocks have fallen by 5 – 10 days in both crude oil and most finished products. This has left it extremely vulnerable to unplanned accidents or events such as the unprecedented shutdown of Venezuela’s oil system. Whether this just-in-time inventory move turns out to be an example of industry’s overall efficiency, or a simple coincidence of too many times when demand exceeded supply with the deficit met by stock liquidation, might be the biggest oil story of 2003. 

 Amid all these uncertainties, the one thing that seems clear is that 2003 will not be a normal year for the oil markets and that Murphy’s Law is still alive, and as well as it was when the term was first invented in 1949.  

THE AUTHOR
	Matthew R. Simmons, Chairman & CEO of Simmons & Company International graduated cum laude from the University of Utah and received an MBA with distinction from Harvard Business School in 1967. He served on the faculty of Harvard Business School as a research associate for two years and was a doctoral candidate. After five years of consulting, he founded Simmons & Company International in 1974. The firm has played a leading role in assisting energy client companies in executing a wide range of financial transactions. He is a trustee of The Museum of Fine Arts, Houston, and The Farnsworth Art Museum in Rockland, Maine. He serves on the boards of several industry and civic groups. He is past chairman of the National Ocean Industry Association, and he serves on the board of the Associates of Harvard Business School and is a past president of the Harvard Business School Alumni Association. Mr. Simmons’ papers and presentations are regularly published in a variety of publications and oil/gas industry journals including World Oil.