CRUDE OIL PRICES

1999: Oil’s most volatile year

Matthew R. Simmons, President, Simmons and Company International, Houston

he 20th Century, often and aptly described as the Century of Oil, has ended. But its final year, 1999, turned out to be one for the record book. Oil has always suffered far more volatility than is healthy for, arguably, the world’s most precious and important commodity. Never in the past 100 years, though, has oil seen more volatility than the last year of the 20th Century.

The following presentation analyzes the factors that contributed to the oil price fall in 1998 and its rise in 1999, citing effects of paper-barrel (NYMEX) trading, crude-grade convergence and supply / demand. The question of what oil prices should be is debated, and an analysis of 1999’s supply / demand and present stock levels is presented. The "Missing-Barrel" controversy is discussed, and a view on where industry is headed in 2000 is offered. Concluding remarks give industry’s challenges for controlling its destiny in the first decade of the new century.

At the beginning of 1999, the highest quality oil grades were selling at around $12 a barrel, with the more prevalent heavier grades selling at far lower prices. Some heavy oil producers in parts of the U.S. were getting less than $5 for their product. On an inflation-adjusted basis, oil was as cheap as at any time this century, except for the days of the East Texas boom, when oil was selling at only a few cents per barrel. That period ushered in the Texas Railroad Commission’s enforcement era to protect the industry against such dangerous prices.

Unbelievably low prices early in 1999 created the backdrop for very bearish views on the long-term outlook for oil prices. Few industry observers saw any hope that these low prices might soon go away. On the contrary, there was widespread sentiment that these prices were a "new paradigm" brought on by abundant supply and technology changes that could push prices even lower.

This bearish sentiment deepened as 1999 unfolded. And the low prices began to have a devastating effect on almost every industry participant. The reasons for this bearishness were well known. They were reported almost daily throughout the world’s media and most petroleum journals.

Why The Price Got So Low

"The world is awash in oil." "All reported petroleum stocks are brimming or even too full." Another several hundred million barrels of oil were reportedly "hiding" somewhere, waiting for prices to rise. And these missing barrels would then have to be consumed before the market had any hope of recovery. New oilfield technology was making it possible to produce oil at ever-cheaper prices. If anything, improving technology might cause the price of oil to fall much lower. This was the bearish supply story being reported.

Growth in oil demand was thought to be meager at best, and Asia’s problems, which contributed heavily to the start of oil’s collapse, were not expected to be resolved for a long time. In fact, Asia’s problems seemed to be spreading to other parts of the world. And the hapless OPEC producers were demonstrating to the entire world how disorganized and "de-fanged" this overrated organization had become. Announced cutbacks never seemed to materialize. Too many producers were simply "cheating."

By the end of February, a far-worse scenario was gaining widespread credence: Saudi Arabia, it was believed, had decided to open its taps to drive the price of oil down to $5, and it might stay at these levels for at least five years.

The risk of oil dropping to $5 gained such currency that The Economist featured the probability as its cover story entitled "Drowning in oil," which hit the newsstand on March 1, 1999. Their timing was impeccable – oil prices had reached their all-time low as the magazine was published. To The Economist’s credit, they subsequently published a several-page report in their 12/18/99 publication entitled, "We Woz Wrong." In this story, they acknowledged that "It wasn’t long before this . . . theory . . . was proved wrong" – about four days, in fact.

The views summarized above were embraced by many as the "petroleum facts of life." But with the benefit of hindsight, oil market fundamentals were quite different – $10 oil was not normal; it was quietly and insidiously beginning to strangle the oil system. The price was far too low to create sufficient wellhead revenue for any oil producer to re-invest enough to even keep current production flat.

While oil prices were still above most producers’ lifting costs, this financial statistic was actually as irrelevant as saying a homeowner is in good financial shape as long as his cash flow is enough to pay for all the home’s utility costs. Although it was not apparent from analyzing their income statements, many of the industry’s best-known, publicly held E&P companies would, or should, have begun cutting their dividends and slashing E&P budgets to the bone, had oil prices stayed at $10 throughout 1999. If E&P budgets had been cut this heavily, the production bases of these companies would have quickly plummeted. The economic reality of the oil world was that no producer in the world was "well placed for a lengthy period of $10 oil."

These low prices were also devastating the economies of most major oil producing countries, which might enjoy low lifting costs but also needed oil revenues to pay the social costs of running each country.

So even as The Economist story was going to press, accusing Saudi Arabia of engineering a plot to bring oil to $5, the governments of Saudi Arabia, Mexico and Venezuela were working overtime to correct the awful impact of $10 oil. These three nations’ petroleum ministers were struggling to institute a cut in oil production so great that oil prices would be forced to rise. The reality of $10 oil was that it hurt Saudi Arabia just as much as it did the typical U.S. oil company.

Anatomy Of The Price Recovery

At the end of the first week in March, these planned cuts were announced and prices started rising. But the price recovery itself also highlighted how shallow so many experts’ views were as they commented about the future direction of oil prices. As oil prices climbed to $16, many observers argued that the price rise was at an end. Then, at $18, the price rise was "obviously petering out." As the price broke $20, conventional wisdom jumped on the theory that OPEC producers would now start to cheat, as the temptation to garner even more revenue at such "unsustainable" price levels would be too great for any of these countries to resist.

Effects of paper-barrel trading. When the price refused to fall, a new "why $20 oil is too high" theory was then embraced by the large number of oil bears who thought $10 oil was so normal only months before. Suddenly, many analysts began to note that "speculators in crude oil contracts" were long in record amounts, while the industry participants – who "know the most" – were short on the same oil contracts. Thus, they argued, the price had nothing to do with fundamentals. It was merely paper-barrel, speculative buying.

As this theory grew in prominence, I wondered why none of the same analysts seemed to care that the same "speculators" were holding record short positions on the same oil contracts when oil prices were plummeting to record lows, while the industry participants – "who knew the most" – were long. I also found it ironic that "paper-barrel pricing" was finally being discussed only when the price of oil seemed too high!

I first began writing about this phenomenon in February 1994, in this World Oil Outlook feature, when I speculated that NYMEX crude contracts were the probable cause of oil’s collapse to $13.50 as 1994 began. Moreover, one of my suggestions made in this same feature a year ago was that industry participants needed to better understand the power of paper-barrel pricing. But few analysts wanted to explore the behavior of the NYMEX oil contracts when oil was selling at such low prices. It apparently took a meteoric rise in oil prices to awaken the collective body of industry analysts to the power that speculators exert, in either direction, in setting the price of the world’s most powerful commodity.

Crude-grade convergence. As conventional wisdom still argued rather strenuously that oil over $20 could never be sustained, unprecedented phenomena began to occur. The historic spreads between the various crude grades of the world started to converge. Brent oil, which almost always sells at about $1.50 discount to West Texas Intermediate (WTI), began to trade close to parity with WTI, and finally began to exceed WTI prices. At various times during the fall of 1999, Brent, Bonnie, Urals and Malaysia’s Tapis grades were all selling at or above the daily price of WTI.

To any observant crude oil analyst, this should have been the clearest possible confirmation that supply and demand for oil were finally crossing one another. Individual refiners around the world were obviously bidding up the price for the barrels they needed, regardless of what WTI prices were at the time. But again, few analysts took notice of this price convergence, or they simply dismissed the phenomenon as a speculative squeeze on Brent paper contracts.

The skeptics grew more vocal as oil prices continued to rise. However loud the critics became, the oil price refused to go down. Instead, in mid-December, it briefly crossed $27 a barrel, almost equaling the high prices set as Desert Storm was about to begin nine years ago.

And as prices stayed high, the thesis that speculators of the paper barrel were the only thing propping up these prices also eroded, as speculative open interest in crude oil began to evaporate.

Thus evolved the latest argument that "current oil prices are artificially high." This focused on the "fact" that petroleum stocks were not falling nearly as fast as they should if, in fact, daily oil demand was really beginning to exceed daily oil supply.

Supply / demand, consumer pressure. Ironically, had any of the skeptics looked carefully at the reported petroleum stock numbers at the end of 1999, they would have seen that crude stocks and motor gasoline stocks had been falling consistently throughout the 3rd quarter of 1999. It was only the rest of the petroleum product stocks in excess of supply that were not being consumed which kept total stocks from falling as rapidly as global supply and demand numbers would have indicated.

But by the end of the 4th quarter, all signs were finally pointing to a sustained price of oil above the $20 threshold. First, petroleum stocks in both the U.S. and the OECD were falling with every new weekly, or monthly, report. Simultaneously, oil demand from Asia, which was not supposed to rise in the foreseeable future, was clearly turning around and beginning to grow once again. And, at the most inopportune time, Iraq chose to halt its exports for a few weeks.

Suddenly, some of the most vocal oil bears of 1998 and 1999 began to warn that prices could exceed $30 unless OPEC producers "came to their senses" and began "opening their taps." A chorus of oil experts began to wring their hands about the danger of high oil prices, urging "moderation" on the part of OPEC. "Remember the consumer!" became a mid-December battle cry from the same forces that argued $10 oil was normal, or even a long-term trend, less than a year earlier. In a highly publicized speech in mid-December, the head of the International Energy Agency (IEA) in effect, chastised Saudi Arabia’s Prince Abdullah, the Norwegian Prime Minister and the government of Venezuela for urging price stability only after Brent crude prices had appreciated an astonishing 150%.

Prices retreated slightly as 1999 came to an end, before soaring once more as 2000 got under way. But what a roller-coaster ride the year had turned out to be! As the millennium began, with oil prices above the levels last seen at the end of 1996, oil stocks in the U.S. were also at record lows. And as was the case in 1996, oil prices were regarded by almost everyone as being "too high."

What Should Oil Prices Be?

In hindsight, it is easy to chronicle the strange tale of oil prices dropping to $10 and then rebounding by over two-and-a-half times. And it is tempting to poke fun at so many seemingly knowledgeable oil analysts who were so sure that oil would stay at $10 forever, unless it fell to $5! But, a more important topic is what oil prices should have been to ensure that the industry remained financially viable and capable of not only maintaining current production levels but also providing sufficient growth in daily oil supply to satisfy rising demand.

There still remains a wide gap in opinion as to what oil prices should ideally be. But it is clear to me that $10 oil would have quickly destroyed the oil industry worldwide. And it is just as clear that a sharp increase in oil prices from current levels could adversely impact the financial well being of the world’s economies.

Is $25 oil dangerous? Time will tell, but there were no signs that this price would have killed the economies of the globe when we last saw them at the end of 1996. Nor is there any solid evidence that these prices are now damaging crucial facets of today’s economy.

There is no question that cheap oil benefits airlines and gasoline consumers. But perhaps both benefited too much when oil prices were so low as 1999 began. At some point, there has to be a happy medium for what sustains the producing industry and what is best for the consumer.

What Happened To Supply And Demand In 1999?

It is enlightening to look back on what really happened to supply and demand in 1999, based on the most recent numbers. Worldwide oil demand ended up exceeding 75 MMbpd for the first time ever. By the 4th quarter, oil demand was apparently close to 77 MMbpd. We should recall that, as the 1990s began, most long-term demand forecasts did not envision world oil demand exceeding 75 MMbpd until 2010 at the earliest. And at the beginning of 1990, the U.S. Department of Energy’s long-term forecast assumed worldwide oil demand in 2010 would reach only 70 MMbpd!

Simultaneously, non-OPEC supply, which many assumed would soar throughout the latter 1990s, flattened out. For the third consecutive year, non-OPEC supply remained around the 44.5 MMbpd range. And this would have been far lower had the price of oil not recovered so swiftly. Only three years ago, the IEA published a lengthy book, entitled Global offshore oil prospects to 2000, which forecast that non-OPEC supplies would near 50 MMbpd by the time we began 2000! To miss the mark by almost 5 MMbpd in such a short period of time is perhaps as egregious as the mistake made by those who thought demand would probably never exceed 70 MMbpd.

The major cause of the difference between actual supply numbers and what was forecast by all the overly optimistic supply analysts was not a steep drop in drilling activity. This only began late in 1998, and its major impact has yet to be felt. The discrepancy arose from the steady rise in the decline rates for many of the world’s producing basins. Most of the new fields coming on stream merely enabled regional production to remain flat.

Current Petroleum Stocks

Perhaps the most significant aspect of 1999 supply / demand estimates was the widening gap between demand and total supply. Given OPEC’s resoundingly strong commitment to keep its production cuts in place, global stocks began to plunge through the 4th quarter of 1999.

The most recent estimates of year-end petroleum stocks in the U.S. show total stocks almost as low as year-end 1996. When measured on a days-forward demand cover, current stocks are almost 1.5 days lower than 1996, and the lowest ever since the Energy Information Agency (EIA) began collecting data in 1973, see Table 1.

The most current OECD stock reports are through the end of October, as detailed in Table 2. These show total stocks down almost 100 MMbbl from 1998 levels. It is also noteworthy that total stocks by each category never varied as much as one would have expected, given the collapse in oil prices from the end of 1996 to the end of 1998. On a forward-day basis, there was never the massive overhang that one would have expected from the gloomy news being reported throughout the oil crash.

OECD stocks should continue to drop through both year-end 1999 and through the 1st quarter of 2000, unless OPEC decides to turn on its taps. But soon, the industry will test minimum operating levels in various key petroleum grades. There is some evidence that the U.S. is now about as low on stocks as it can get without serious tightness or occasional shortages.

What Happened To The Missing Barrels?

If OECD petroleum stocks continue to drop, this obviously tightens the markets and probably raises prices even higher. But could all this be relieved by the "Missing Barrels" which plagued the industry through 1998 and 1999? These Missing Barrels arose from the gap between the IEA’s (and many other prominent oil forecasters’) supply and demand estimates compared with the observed build in petroleum stocks.

At the end of 1998, the IEA’s Missing Barrels totaled over 400 MMbbl of oil that they argued were "stashed" somewhere outside the recorded petroleum stocks of the OECD.

When the IEA’s February 1999 Oil Monthly report was published, with oil prices at an all-time low, the Missing Barrels had almost doubled – growing by another 300 MMbbl. This report warned that until the Missing Barrels were absorbed, the longer "things may stay the same for the price environment."

When the IEA’s August 1999 Oil Monthly report was published, its special feature was entitled "Yesterday, today and tomorrow." Once more, the issue of the Missing Barrels was prominently raised. "Were there really missing barrels? And if so, who had them? Months have elapsed with no hard evidence that would reduce the unusually large miscellaneous to balance. We (the IEA) are left with the increasingly discomforting thesis that there are real ‘missing barrels’ lurking somewhere in the non-OECD countries and/or in independent storage tanks which are not counted in OECD stock data."

For almost 18 months, the IEA doggedly stuck to its belief that there was a massive overhang of hidden oil that would ultimately swamp the oil markets. As a result, their monthly commentary routinely warned that prices would stay low until these barrels were absorbed.

The first break in this saga occurred in the November 1999 IEA Oil Monthly report. After 18 months of ignoring dissenting views on the validity of the Missing Barrel thesis, the IEA finally acknowledged that "There had been significant disagreement among various analysts about the size of the overhang of global production and differing judgements about the extent of OPEC overproduction in late 1997 and early 1998."

The IEA’s December report contained a section entitled "An un-fond farewell to the Missing Barrels" which stated, "Most of the evidence is now in. The weight of that evidence is that the missing barrels did exist and they have now returned to the market . . . to meet current demand . . . The rest of the barrels are likely to show up by the end of this quarter . . . It may be possible at last to bid farewell to the missing barrels issue."

Several months ago, the IEA warned that these Missing Barrels had "high velocity" and would, at some point, come rushing back into the market. But, to think they all "came home" in such a short period of time strains credibility.

Hopefully, we are at the end of this sad saga. However, I still strenuously disagree with the IEA’s new theory that suddenly the vast excess supply created in the 1st half of 1998 – which led to the severe collapse of oil prices – ever existed in the first place, let alone suddenly came rushing back into the physical markets to satisfy a supply squeeze. In my opinion, not only would it have been physically impossible to hide so much oil for so long, it was also implausible that anyone would be bold enough to hoard so much oil when the price forecast was so gloomy (or even have the $10 billion of funding needed to hoard it for so long).

The whole episode was not one of the better examples of the IEA’s attempts to provide transparency to world petroleum markets. Hopefully, such data breakdowns will never occur again. But serious, industry-wide damage was done as a result of the massive price collapse, and some of the blame needs to be directed to the Missing Barrel issue.

Where Is The Industry Headed In 2000?

The oil industry is now beginning its second century of prominence. But what a difference in position oil has on the world scene as 2000 begins, when compared with 1900! Back then, oil was still primarily a source of illumination, competing with whale oil. Even 20 years into the last century, world demand for oil was only about 2 MMbpd.

Now, oil is the most dominant energy commodity on earth. The IEA now forecasts 2000 worldwide oil demand to reach 77.1 MMbpd. Before long, demand will exceed 80 MMbpd. Oil-based fuel is still the only commercially feasible way to power cars or planes. Substitute transportation fuels are realistically close to a decade away. And remember, almost 40% of the world’s population is only just beginning to drive cars or fly in planes.

Thus, there is no reason to assume that oil demand is about to flatten, let alone shrink, absent massive economic downturns around the globe.

The only feasible substitute for oil in the next few years is natural gas. But there is a greater likelihood that most natural gas supplies throughout the world will be directed toward creating electricity as a substitute for coal. Consequently, the outlook for continued growth in oil demand has never been brighter. The only downside is the question of availability and price.

The issue of availability, in my opinion, is not reserve based. The world fortunately still has abundant proven and probable oil reserves. Rather, the supply quota is based on industry’s ability to drill enough wells, in the right places, to get oil out of the ground in a timely manner. And the need for more wells will be compounded by an ever-rising rate of decline, or depletion, from many – or even all – of the world’s producing regions.

Deepwater oil must provide a major source of incremental oil supply. But getting this supply developed will be a function of deepwater-rig availability; and the current balance between supply of these very expensive, complex drilling machines is fragile – particularly given the need for them to drill both exploratory and development wells.

Only four years ago, deepwater rigs were expected to cost as much as $200 million and take about two years to build. Today, it would appear that most deepwater rigs actually cost close to $350 or even $400 million, with a three-year lead time before a deepwater bit can be turning to the right.

The industry’s manpower needs and limits will also soon test its ability to keep increasing oil supplies in step with steady increases in demand. These manpower issues would have challenged the industry before the massive downsizings that occurred when oil prices collapsed. Now the manpower problem has become a far more acute issue.

With the benefit of hindsight, the decade of the 1990s should have been a "warmup" for what expansion the industry needs to undertake over the next few years, for daily oil supply to keep up with expanding daily demand. But due to a series of unintentional mistakes that plagued the 1990s, demand was badly underestimated, while easy-to-accomplish, non-OPEC supply estimates were just as badly overestimated. Then Paper Barrel pricing created two painful oil price collapses. The first, which happened in 1993/94, was bad enough. But the Missing Barrel collapse of 1998/99 could have sowed the seeds of a series of unplanned consequences that will strain the industry well into the first decade of the Second Oil Century.

Conclusions

A year ago, I entitled this same article, "1998: A year of infamy" and encouraged the oil industry leadership to convene an energy summit to redesign how petroleum data is collected, interpreted and reported, along with beginning a serious discussion of how oil prices are set. I feel even more strongly now about the need for such dialogue to begin. It is time for the industry analysts to stop "pigeonholing" various industry views into oil "bull" or "bear" categories. It is also time for industry executives and analysts to stop trying to predict the future price of oil in the first place.

If the same price forecasters spent more time seriously studying the data underlying demand for oil and the relentless pressures embedded in creating growth in daily supply, could the knowledge gained from this exercise be more educational than trying to guess oil prices? The industry needs a major re-evaluation of the "depletion issue." Analysts need to start preparing some accurate, forward-looking, decline-curve projections before it is to too late to correct any mistakes.

The next decade will be as challenging a time for the industry as it has ever faced. Circumstances will be exacerbated by all the energy mistakes made through the last decade of the 20th Century. Hopefully, in the future, we can avoid any further miscues, as the challenges we face are strenuous enough.

The author

Matthew R. Simmons is president and co-founder of Simmons & Company International, Houston. He graduated cum laude from the University of Utah in 1965 with a BS in accounting, 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 from 1967 to 1969, and was a doctoral candidate at the school. After leaving Harvard, he spent five years providing consulting and investment banking advice to a variety of clients. In 1974, he founded his present company as a specialized investment banking firm exclusively serving the worldwide oil service industry. He was chairman of the National Ocean Industries Association in 1996–’97, and he is a member of the National Petroleum Council and the Interstate Oil and Gas Compact Commission, serving on the Energy Resources Committee. He is past president of the Harvard Business School Alumni Association and a member of the school’s Visiting Committee; and he is a trustee of the Museum of Fine Arts and the Alley Theatre in Houston, and the Farnsworth Art Museum in Rockland, Maine. He serves on the boards of United Meridian Corp., Pilko & Associates and PanEnergy Corp. Mr. Simmons is well-known for his presentations at many industry meetings and seminars. His publications appear frequently in World Oil and other oil/gas industry journals.

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