CRUDE OIL PRICES

2001: In like a lion, out like a lamb

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

Oil markets in 2001 behaved like the proverbial month of March, coming "in like a lion and going out like a lamb." The year began with a nasty energy crisis rapidly descending upon many parts of the globe. By year-end, this "crisis" had faded so fast that some suspected it was simply concocted. As 2002 begins, a lingering question is whether oil markets are now so saturated that the industry is exposed to a glut once again, or could the market be so closely in balance that either strong OPEC compliance or an increase in demand re-creates the alarming tightness of a year ago?

At the start of 2001, oil prices averaged around $3/bbl (WTI). Had the U.S. not released 30 MMbbl of SPR crude in the fall of 2000, the price would likely have been even higher. Over the course of the ensuing year, oil prices then fell by over 40%.

Was this extreme tightness and resulting high prices an aberration? Is the oil industry now going to return to the more "normal" prices that consumers enjoyed for so long? How bad was the drop in oil demand? When might demand recover? Can OPEC comply with its major cuts? Were they ever real? What roles will Russia and Iraq play? These are the key issues which will shape oil markets throughout 2002, as discussed here.

Crude oil: Non-commercial net longs (+) and shorts (-) on the NYMEX.

Weak Demand Dominates 2001 Oil Markets

Oil prices started coming under pressure last spring, as signs of a slowing economy and a concurrent slowdown in oil demand began to dominate oil news. Weekly reports of rising U.S. oil stocks added to the bearish tone of the oil markets. A growing group of oil observers were certain prices would soon collapse, although prices actually stayed surprisingly strong until the September 11 events.

These demand fears grew as the year progressed, despite several upward revisions to demand data, often significantly narrowing any gaps in year-over-year demand. Any time a weekly report on U.S. oil stocks showed any growth, oil speculators were spooked into increasing their short holdings of NYMEX crude contracts. Little attention was paid to the fact that record levels of U.S. finished-petroleum-product imports were leaving Europe’s petroleum stocks at their lowest levels in years.

Worries of a renewed global oil glut also grew. By the end of 2001, the International Energy Agency’s (IEA) supply / demand estimates for seven quarters ending September 30, 2001 showed a supply excess of 560 MMbbl of oil, although reported Organization for Economic Cooperation and Development (OECD) stock builds accounted for only 175 MMbbl – the "missing barrels" were back once more.

For a day or two following September 11, oil prices jumped by several dollars a barrel on worries of possible supply disruptions. But, as NYMEX crude trading re-opened, prices collapsed – soon, the $20 floor was breached.

Oil demand concerns were justified in the first few weeks following the terrorist attacks, particularly in the hard-hit jet fuel market. U.S. petroleum demand in September 2001 was down over 800,000 bpd, or 4.3% compared to a year ago. However, it made a surprising rebound over the rest of 2001. This was either ignored or dismissed as faulty data by most oil observers, who remained extremely gloomy on both oil demand and the U.S. economy.

Compounding these worries, winter weather through Christmas was abnormally mild. Even a burst of arctic weather in the last week of 2001 barely made a dent on heating demand. At the end of 2001, the U.S. winter measured by heating-degree days was 19% milder than normal and 26% warmer than a year earlier.

Despite all of this apparent bad news on demand, preliminary numbers for U.S. oil consumption in 2001 show that the year was equal to 2000’s all-time record high, Table 1. The table details estimated U.S. petroleum demand for 2001, compared with the two previous years. In total, U.S. petroleum demand changed relatively little over this period, while the economy initially soared and then weakened. All three years saw new, all-time demand records set for various key petroleum products, while other petroleum products suffered demand declines, even when the economy still boomed.

OPEC’S Production Cuts

OPEC announced four production cutbacks during 2001. A cut of 1.5 MMbpd was announced in mid-January. Second and third cuts of 1.0 MMbpd each came in March and July. While the market was highly skeptical of OPEC’s compliance, oil prices stayed in a tight $26 to $31 range until after the September 11 terrorist attacks, when prices plunged, hitting a low of $17.50 in mid-November. OPEC responded with its fourth announced cut of 1.5 MMbpd to begin in January 2002. After some intense arm-twisting, various key non-OPEC producers also agreed to cut their production by about 460,000 bpd.

The extent to which OPEC complied with its first three cuts is still widely debated. Oil speculators have aggressively bet that OPEC’s compliance has been weak, and many doubt the latest cuts will see better compliance.

Data confirming OPEC’s total production and its exports is "fuzzy" at best. While half a dozen organizations constantly report estimated OPEC production figures, the variances between each of these estimates is often startlingly large and even more disparate when the production estimates of each OPEC country are analyzed.

The most accurate OPEC data, although dated and incomplete, are OECD’s reports on its country-by-country OPEC imports. This data, which covers about 80% of OPEC’s total exports, rarely conforms with the far-higher production and export swings most published estimates show. The import variances by each month can also be very high or quite low, but often a low monthly import is subsequently followed by far-higher levels and vice versa. This makes it dangerous to read too much into a single month’s data.

The latest data to the OECD on OPEC exports for 12 months ending July 2001 fails to confirm that OPEC ever produced, or at least exported as much oil as most estimates have reported, nor does it confirm close compliance to the magnitude of announced OPEC cuts through July. The numbers do highlight that Iraq still remains the biggest swing exporter.

This lack of reliable OPEC data underscores the poor overall quality of oil data, particularly in light of how sensitive small changes in published oil data can be in impacting the price of oil.

The degree of OPEC compliance with the latest cuts will have a material impact on 2002 oil markets. If compliance is high, oil demand could weaken even further and still leave oil supplies in a tight state. Conversely, if oil demand picks up, these cuts could end up being too severe, setting the stage for OPEC production increases to keep the market from getting too tight.

Record Shorts For NYMEX Contracts

Speculators ("non-commercials") in NYMEX crude oil contracts stayed in a net short position for most of 2001. The accompanying figure illustrates the steady growth in net short crude holdings by non-commercials or speculators in crude contracts from the middle of 2000 through the end of 2001. At year-end, speculative shorts for crude oil were at an all-time high, running almost 7:1 over speculative longs. These speculators were only in net long positions for 14 weeks of 2001. Curiously, the few times that speculators’ holdings of NYMEX crude contracts changed from being net short to net long, the price of crude always rebounded by large margins.

This pattern proves once more that speculators’ behavior in the NYMEX crude markets is the best leading indicator of what oil prices do over a near-term period. And these record levels of speculative shorts demonstrate that many oil observers still believe that oil prices will stay low or even continue to fall.

Are Fundamentals Really Bad?

As 2002 begins, it is important to try to assess whether the bearish oil sentiment still overhanging the global oil markets is justified or now overblown? Key to answering this question is what happens to 2002 oil demand in the U.S. and the rest of the world. This answer will partially depend on how the global economies perform, although the impact of GDP changes is less profound to oil demand than most economists assume.

Weather and population demographics still have major impacts on demand. Thus, watching winter weather in both the U.S., Europe and Northern Asia in the critical months of January through March could have a far greater impact on global oil demand than economic performance around the world.

Future oil supply will also have a major impact on 2002 oil markets. The degree of OPEC compliance to its new cuts, how long these cuts stay in place, what Iraq does, whether Russian production gains are sustainable and whether Russia complies with its announced cuts, and how the rest of non-OPEC supplies respond to the lower oil price environment are the key supply factors to watch in 2002.

Equally important to 2002 oil markets is whether the widely perceived oil supply glut is real, or merely the by-product of imprecise data. Absent a major upward inventory revision in OECD petroleum stocks or quick build in reported OECD oil stocks, the estimates of supply excess in 2000/2001 are wrong. If so, it will mark yet another occasion when false perception of an oil glut created a serious and unwarranted price decline. It would also set the stage for the oil markets suddenly to become extremely tight if: 1) winter weather through the Northern Hemisphere is particularly cold; 2) the global economies begin to improve; or 3) a widely believed supply growth turns out to also be overstated.

Are Petroleum Stocks Too High?

Another key question which will shape 2002 oil market fundamentals is whether the recent buildup of global petroleum stocks, particularly in the U.S. where most of the observed build has occurred, signifies a renewed glut or merely a return to more normal, but still lean, petroleum supplies.

Around 1994 – 1995, U.S. petroleum stocks began dropping to record lows. The industry bragged about embracing "just in time" inventory management practices. These low inventories are now accepted as so commonplace that any buildup quickly gets described as a glut. In some cases, higher stocks still produce record-low inventories, when measured in days-of-supply due to higher demand. But, the oil markets rarely get this sophisticated. To many observers, any inventory buildup is evidence of a possible oversupply.

Table 2 details U.S. petroleum stocks at year-end 2001, compared to year-end stock levels for the 1996 – 2000 five-year average and the 1991 – 1995 average. Calculated on an average days-of-supply basis, U.S. crude stocks have declined from an average of 23 days over the 1991 – 1995 period, to just above 20 days at the end of 2001. Finished product stocks declined from an average supply of 43 days in 1991 through 1995 to under 35.5 days at the end of 2001. While total U.S. stocks are slightly higher than the abnormally low levels occasionally seen in the past five years, they are still as close to "just in time" inventory management as is prudent to practice.

European petroleum stocks are even lower. The latest reported total stocks in Europe (November 2001) were at their lowest end-November levels in eight years. Motor gasoline inventories were at their lowest since 1992.

The Real Supply Concerns

Several important longer-term supply issues might finally come to the forefront during 2002, including the question of how much supply is actually being planned from new field developments now under construction, and how steep the declines might become for the world’s current supply oil base as the race between new supplies and "depletion" likely accelerates.

Since the world has almost no data on decline rates for most key oil fields around the world, nor much published data even on field-by-field production rates in most parts of the world, estimating decline curves is a difficult, if not impossible, task. But, it is now becoming the most important aspect of predicting future oil supplies. Until the world develops better data on field-by-field decline rates, almost all long-term supply estimates are simply guesses.

It should be quite clear that adding vast amounts of new supply is becoming more costly and taking more time, even when prices are high. Table 3 documents the International Energy Agency’s supply estimates for global non-OPEC oil production in 1999, 2000 and its most recent estimate for 2001. In total, it shows that non-OPEC supplies rose by only 1.8 MMbpd over this two-year period, despite prices being at their highest levels in two decades. More important, Russia’s surprising and unpredicted supply improvement contributed almost half of this gain. Had the Russian "production miracle" not occurred, the balance of non-OPEC supply growth would barely have kept pace with slowing demand growth, despite high prices and rising drilling.

There are also various questions about accuracy of the 2001 supply numbers for some regions of the world, including two countries with the best data, namely, the U.S. and the UK. Each country’s supply estimates could be overstated by as much as 100,000 to 200,000 bpd.

There are many important new sources of supply being developed, including almost 30 new deepwater projects scheduled to come onstream between now and 2005. But many of these projects are likely to peak fast and experience rapid decline rates. Only a handful of deepwater fields will experience production rates in excess of 100,000 bpd. None is expected to have peak production in excess of 250,000 bpd. By the time many of these deepwater projects are on production, some of today’s deepwater fields will already be in steep decline.

There is mounting evidence that the UK sector of the North Sea has now peaked, with Norway’s production peak to also occur soon. Decline rates of the existing production base in both sectors are now sufficiently high to offset all the new smaller fields coming onstream. Whether this phenomenon is limited to the North Sea or is now occurring in many other key basins will be an important event to monitor carefully in the coming year.

While Russia was the biggest positive supply surprise in 2000 and 2001, after almost a decade of supply declines, how sustainable this supply improvement is – as opposed to a one-time event – will be important to understand. As critical is whether Russia’s internal oil demand also begins a real recovery as its economy improves.

The most important long-term supply question is the status of the world’s population of giant oil fields – 26 giant oilfields still produce over 25% of the world’s daily supply. The average age of these exceptionally large fields is almost 50 years. Seventeen of these giant fields are in OPEC countries where virtually no field-by-field production data has been released in over two decades, making it impossible for any outside observers to track when each field begins to suffer production declines. At some unidentified point in time, each one of these oil fields will begin to decline; many have probably already started this process. The decline rates of these giant fields should be seen as one of the world’s biggest oil supply uncertainties.

Conclusions

2001 was an abnormal year in the world’s oil markets. Gloomy demand estimates drove crude oil prices to low levels that are dangerous to the well-being of the economies of almost all OPEC countries, and lower than many non-OPEC areas of the world need to sustain current drilling levels. The oil markets are now highly sensitive to how oil speculators estimate their fundamentals. Regardless of how valid bearish beliefs might become, once real data is known, the sheer perception of bad oil fundamentals can quickly become bearish reality in terms of oil prices.

Whether 2002 becomes a continuation of this highly volatile oil world, and whether the bearish oil views that dominated oil markets throughout 2001 become permanent features of the future oil markets will be key events to watch as 2002 progresses.

Only a slight improvement in oil demand, or a modest negative change in oil supply could quickly recreate the extremely tight markets that dominated world news as 2001 began. The year did go out "like a lamb" but perhaps we witnessed a "false spring."

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. He is past president of the Harvard Business School Alumni Association, and he is a trustee of the Museum of Fine Arts in Houston, and the Farnsworth Art Museum in Rockland, Maine and Commonfund Capital Inc. He serves on the boards of several industry and civic groups. 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.