World oil
prices have been consistently high since the end of 1999; this is
an unprecedented long period of time. This situation prompts an
analysis of two questions: What long-term effects will high oil
prices have? What will happen following the collapse of oil prices?
The price for the main oil grades, including Brent oil, has been
consistently exceeding $25 a barrel. This is causing the analysts
to speak seriously about the start of a lengthy “era of high oil
prices.”
Obviously,
there are clear geopolitical implications for the price levels of
the world’s primary source of energy. First, oil exporters (above
all, the Middle East countries, with Saudi Arabia and Iran being
the leaders) can seriously influence the global geopolitical
situation. Second, oil prices introduce new forms of international
confrontation which is rooted in the developed oil-importing
countries’ struggle for control over energy resources (the Iraqi
war is a graphic illustration). Third (this factor being
particularly important for Russia), high oil prices give a renewed
impetus of economic development for the transitional economies and
emerging markets. Although the threat of the ‘Dutch disease’ is
always present, these economies still have an opportunity to draw
nearer to the most developed economies in the natural course of
events. Finally, another factor affecting the redistribution of
economic influence in the world due to high oil prices is the
weakening of the economies of the world’s leading geopolitical
nations, since the bulk of them are net oil
importers.
Therefore,
some countries entertain high hopes on oil prices, while others
anticipate stagnation. How justified are these prospects in the
long term? Too many analysts are unduly concerned about the
situation; even U.S. Federal Reserve Chairman Alan Greenspan said
recently that world oil prices will remain high for a long
period.
Are these
predictions correct? How justified are the current super-high
prices, and how long can they stay at such levels? Are there
factors that could send prices plummeting in the foreseeable
future? What would this plunge look like and what implications are
there for Russia?
WHO CALLS
THE TUNE?
Despite my
deep respect for Mr. Greenspan, I must say that there are no
profound grounds for the statement that global oil prices will
remain high for an indefinitely long time. To understand how solid
the prospects are for consistently high prices, it is necessary to
analyze the world oil market structure somewhat deeper than many
analysts tend to do. As a rule, they proceed from standard
parameters related to real commodity flows, such as oil demand
dynamics, oil production by main oil producing countries, and
strategic and commercial oil stocks in the importer
countries.
But it is
erroneous to believe that current world oil prices depend on the
relationship between real demand and supply as on the classic
commodity market. This is no longer the case. Since the end of the
1980s, the prerogative of world price formation for oil and refined
products has been determined by three trading floors – the New York
and Singapore mercantile exchanges (NYMEX and SIMEX) and the
International Petroleum Exchange (IPE) in London. Physical trade
volumes on those three exchanges offering uninterrupted
round-the-clock trading, amount to less than one percent of the
total international oil trade volumes. Rather than trading on
commodities (a mere 1-2 percent of all deals), they trade on
derivatives – futures contracts for oil supplies. So, world oil
prices are determined today not by trade in commodities, but by
trade in financial instruments. Even though these prices take
account of the risks on the real oil market, they are mostly based
on projections and momentary fluctuations in the global economic
and political situation.
The
structure of supply and demand on the world oil market in 1999
through 2003 witnessed no real problems in oil supply, nor are they
expected in the future. Even during the “tough” years between 1994
and 2003, oil shortages never exceeded 2.6 million barrels a day,
or 0.1 percent of commercial oil stocks in the countries grouped in
the Organization for Economic Cooperation and Development (OECD)
(current shortages can be easily covered by oil in stock), while
during most years they ranged between one million and 1.5 million
barrels.
It is not
surprising under such circumstances that the actual availability of
oil on the world market is not a crucial factor in oil price
formation – most decisive is speculative trading by financial
investors. Oil market analysts generally believe that financial
derivatives traded on international oil exchanges have become a
safe and sound capital investment now that interest rates have
remained low in the Western financial systems, above all in the
U.S. Federal Reserve System.
Algeria’s
energy minister stated recently that oil prices could go down
substantially if the U.S. Federal Reserve increased its rate.
Speculation on the oil market could then become less attractive for
investors than on the traditional financial markets. Some
economists believe that a market bubble is emerging on the
international oil exchanges, similar to the one which occurred on
the American stock market in the late 1990s.
Speculators have effectively taken advantage of all trends and
even rumors that are more or less significant for the world market:
first there is the ‘Iraqi factor’ (even though in 2003 the market
failed to receive only 686,000 barrels of Iraqi oil a day and the
gap was rapidly filled by other producers); OPEC’s repeated refusal
to increase oil production quotas (even though cartel members have
never strictly observed agreements on quotas); strikes in Nigeria
and political instability in Venezuela.
At the
same time, the market remained indifferent to much more significant
factors, such as Russia’s soaring oil production and exports
(growth by nearly 2.5 million barrels a day over five years), which
in 2003 easily (by more than 120 percent) offset the decline in
Iraq’s oil output. Nor was the world oil market overwhelmed by the
spiraling growth in oil production by the Middle East member
countries of OPEC in 2003. At this time, aggregate oil production
in Iran, Qatar, Kuwait, the Emirates and Saudi Arabia grew by over
2.4 million barrels a day up from 2002, i.e. a reported 14-percent
rise.
Naturally,
the world oil market is influenced by objective factors, as well,
and to a certain extent they instigate high prices. These include
the ever-growing demand for oil in Asia-Pacific nations, above all
in China, as well as oil field depletion which has intensified in
the major OECD oil-producing nations – the United States, Britain,
and Norway. It is obvious, however, that while the world oil market
depends too much on unpredictable speculative games at a time when
there is actually no oil shortage, the risks are very high that
world oil prices may plummet in the near future. If capital starts
flowing away from international oil exchanges, neither cuts in oil
production quotas by OPEC, nor a steady growth in Asia’s demand for
oil will help. Something similar already occurred in 1998 when
global oil prices hit rock bottom, not due to an excessive supply
of real oil (oversupply amounted to only 400,000 barrels a day),
but due to the crisis on the international financial markets, the
crisis of expectations, and, consequently, the price crisis on the
oil futures market.
If such a
scenario reoccurs, oil prices may drop not to a critical level in
terms of the profitability of commodities producers, but rather to
a level that reflects oil’s ‘real value,’ which helps cover the
average production and transportation costs, and has a reasonable
profit margin, as well. Prices can stay at such levels for a long
time. However, such a scenario would just make oil – which is now a
‘superprofitable’ commodity having ‘geopolitical significance’ – a
profitable commodity, but yielding no extra dividends.
HOW MUCH
IS OIL REALLY WORTH?
If we
estimate the real value of oil based on an analysis of production
costs, the average world prices for main oil grades – the so-called
‘port prices’ – will not be more than $8-$10 a barrel in the
foreseeable future. This holds true even if certain trends that
drive up prices are taken into account, such as the depletion of
key oil fields (mostly in the Middle East), higher oil production
costs in new regions (on the sea shelf) and the use of advanced
technologies. This means that even when taking into account freight
costs, the global oil market can be quite profitable even with
stable prices ranging from $15 to $18 a barrel for main oil
grades.
In such a
case, Russia will certainly find itself in an unfavorable position:
given that distances are very long between the oil production sites
and the ports, and that crude must be carried along pipelines
(other oil exporters are spared this problem), extra costs amount
to approximately $4-$5 a barrel. But even under these conditions,
oil exports will yield Russian oil companies ample profits. At the
same time, the state budget will be seriously impaired from such a
drop in prices. With the existing mineral production tax rates and
oil export tariffs, the state budget bears all the risks if the
price of Brent oil drops to $20-$22 a barrel. This situation will
also negatively affect the oil sector’s ability to reallocate
capital into other economic sectors. Under these conditions, only
internal savings and foreign investment can serve as sources for
Russia’s economic modernization and development, while the
government’s financial system will face yet another serious
test.
To a
certain measure, oil prices have grown due to the weakening of the
dollar: the dollar rate’s decline during the past few years has
prompted OPEC to consider raising the price range from $22-$28 to
$28-$36 a barrel. This may lead to certain adjustments in the
nominal price level, but the dollar’s weakening is not a factor
that can really send oil prices spiraling.
Will oil
producers’ resources be sufficient for another round of ‘price
wars?’ Can unpredictable global developments (for example, an
escalation of internal tensions in Saudi Arabia, in addition to the
Iraqi conflict) result in extra shortages of oil on the world
market? In theory, that is possible. But over the past few years
the world oil market has not grown more dependent on OPEC (even
though oil production has declined in the developed nations): in
2003 OPEC’s share in global oil production was lower than during
the past decade on average (39.7 percent and 41-42 percent
respectively).
New
players have entered the market, and there is much hope being
placed on Brazil and Kazakhstan (they already produce more than 2.6
million barrels of oil a day, or 3.5 percent of the world’s
output). At the start of this year, China’s authorities introduced
investment restrictions in a number of sectors in order to curb an
overheating of their economy. Thus, China’s oil demand growth may
slow down, which will have a serious impact on the market (in 2003
China accounted for more than 40 percent of growth in global demand
for oil).
Finally,
the fate of Libya remains uncertain. As the West has softened its
attitude to Libya, Muammar Qaddafi’s long cherished dream of
regaining his country’s 1970 oil production figures (more than 3.3
million barrels a day compared with less than 1.5 million today)
may come true. This would take two or three years to attain. The
Western world is likely to lure Libya into energetically increasing
its production and possibly even pulling out of
OPEC.
It cannot
be ruled out that political pressure will be exerted on Venezuela
and Nigeria to force them to withdraw from OPEC. OPEC itself is not
free from internal contradictions – oil production quotas it fixes
have never actually been observed, while the financial position of
its leading member countries (Saudi Arabia, in particular) has
substantially worsened over the past years. It is very doubtful
that those countries can afford to engage in heated price wars that
drive prices down.
How
realistic is the forecast that prices may plummet in the coming
years? Proceeding from the above factors, this is unlikely to
happen, but such a scenario is still quite realistic. It is also
possible, of course, to provide reasons in favor of other
scenarios, but those must be taken with a grain of salt, as well.
In other words, we are entering a risk zone here.
THE WORLD AFTER
OIL
Is it possible for oil
to retain its leading position among global energy sources in the
long term? It looks like its days (or rather years) are numbered.
Naturally, global oil reserves are sufficient for oil to remain a
significant energy resource for another 30-40 years. However, no
one doubts that oil resources are exhaustible in principle. Earlier
theories claimed that resources would be rapidly depleted
(according to those theories, the world should have used up its oil
resources by the start of this century), but they have not been
confirmed. The global community still has some time for a global
restructuring of the world political and economic system, making it
possible to mitigate the effects of an ‘energy revolution.’ Still,
oil has been gradually losing its global position to other types of
fuel in heat and electric power production, while remaining the
unchallenged leader only as a motor fuel.
Meanwhile, an ‘energy
revolution’ will likely continue. Too many factors compel the
developed nations to look for systemic solutions that would reduce
their economies’ dependence on organic fuel: growing oil prices,
depletion of their own organic fuel reserves, and foiled attempts
to gain control over areas that are rich in energy resources (i.e.
Iraq). This factor has already induced the developed nations to
search for a ‘new energy sources agenda’ to be implemented after
2030. A sort of ‘global energy revolution’ is about to occur, which
will permit the developed nations to do without organic fuel as a
main source of energy, while promoting large-scale use of
alternative energy sources.
It is clear that
various natural renewable energy sources (solar, wind, water, and
geothermal energy) cannot serve as a real alternative to oil, nor
as a driving force of the ‘global energy revolution’ since their
potential is quite limited. Hydrogen energy is seen as the main
alternative to organic energy and its development is coming to the
foreground. Hydrogen energy is promising for a number of reasons:
hydrogen resources are virtually limitless; technologies for using
it as a source of energy have reached a highly advanced level
(applied research is required to broaden the range of application
of hydrogen-based fuel cells); hydrogen energy is highly efficient
and productive. Fuel cells are a universal source of energy. They
can be used in power generation, as motor fuel, as well as in our
homes. Actually, they are a ready substitute for oil.
Governments and private
businesses in the developed nations have already begun
energetically investing in the development of hydrogen energy (in
2003 the U.S. administration allocated $1 billion for the purpose,
and Japan has started large-scale production of motorcars powered
by fuel cells). With a sufficient scope of applied research
providing for the use of fuel cells in everyday life, and with
special incentives to promote investment in the broader application
of fuel cells, hydrogen energy may become widespread by 2030. After
2030, hydrogen as a source of energy will be able to replace
traditional organic sources of energy in 30 to 40 percent of
applications. According to the International Energy Agency’s
estimates (World Energy Investment Outlook, 2003), by that time per
unit capital costs of fuel cell-based energy capacities will
decrease to a level that would let them compete with traditional
power-generating capacities.
In principle, this
‘revolutionary’ scenario in the sphere of energy could put the
Western nations beyond the reach of the rest of the world in terms
of economic and technological development, not to mention
geopolitical influence.
Are there reasons for
Russians to panic? No. If the country’s leadership is really
concerned about diversifying the structure of its national economy
in favor of high-technology manufacturing sectors, Russia will be
able to do away with its critical dependence on the oil sector,
promote its economic development and find its niche in the global
high-technology production related to the field of ‘new energy’
somewhere between 2020 and 2030. The oil sector (with account of
depletion of the main oil fields) will increasingly transform into
a normal sector of the economy with annual production rates between
250-300 million tons of oil a year, and its main target will be
meeting domestic demand.
But will the economic
policy pursued by the Russian authorities allow the country to
prepare for this course of events? So far, the authorities have not
shown any other intention than presenting the results of
restructuring accomplished in the 1990s, and the effects of the
most favorable situation in the world oil market as their own
achievements. Further structural reform in the country’s economy
has yet again been delayed for the sake of ephemeral political
stability. The government, which has proclaimed the ambitious goal
of ‘doubling the GDP,’ does not have a national program for a real
economic breakthrough. Meanwhile, the oil clock is
ticking.
