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August 16, 2005

Why Oil Prices Will Stay High
by KWR: Scott MacDonald

Oil prices are high and likely to climb higher through 2005 and probably into 2006. Despite ongoing comments about the market actually having enough supplies, the reality is that international oil markets are not driven by anything rational. Rather fear and loathing sit at the back of each upward oil trade. A confluence of increased demand and questionable limits to supply have resulted in a runaway oil market during the summer of 2005, with oil heading to over $65 a barrel. The idea of oil hitting $75 a barrel is no longer so far-fetched. All of this has implications for the global economy and world stock markets.

High Oil Prices - Why?

High oil prices are likely to be around for a while. On the supply side, the nagging points of concerns include the expectation that non-OPEC oil supply, mainly in the Gulf of Mexico and the North Sea are set to fall. According to the International Energy Agency (IEA) in August, non-OPEC oil supplies are forecast to fall 200,000 barrels a day. Part of the reason for this is that political factors and less attractive investment regimes are hurting the discovery and development of new oil sources in countries such as Mexico and Russia. This puts much more pressure on Middle Eastern oil producers, in particular Saudi Arabia. Yet, there is concern about the true level of Saudi Arabia's oil reserves. Considering that there is a debate over the quality of transparency and disclosure of Saudi reporting, this only adds another factor of market nervousness.

Adding to the stew over oil prices, is the nature of global refinery capacity utilization. During the early and mid-1980s, global refinery capacity utilization was around 75 percent; today it has risen to above 95 percent. U.S. refineries have especially seen heavy use, with capacity utilization reaching a little over 98 percent. Considering that the refinery sector was long a problematic area for oil companies to make money, the sector is largely defined by underinvestment and aging equipment. In addition, there has not been any new construction of refineries for environmental reasons since the 1980s. This set of conditions has meant that existing refineries are under stress, breaking down or stopping operations to make repairs. Since July 20, 2005 there have been 14 refinery breakdowns.

The U.S. refinery system is being pushed beyond its sustainable limits. As Richard Savage, global head of commodities research at Bank of America recently stated: "There are clearly issues in both production and refining capacity because plants have been running so hard that accidents keep happening."

Add to the above factors, damaging hurricane seasons in the Gulf of Mexico and the added weight of Chinese and growing Indian oil demand, not to mention the threat of geo-political factors, and a bet on higher oil prices does not seem unreasonable. At the same time, the global economy has not taken a major nosedive. In the past, oil prices spikes have resulted in economic downturns or recessions. Thus far, we have strong economic growth despite higher oil prices, largely due to lower energy use intensity. Indeed, the International Monetary Fund is projecting 3.6 percent growth for the U.S. in 2005 and again in 2006, with increased economic growth in both Japan and Euroland.

As a result, demand for oil is not likely to relent. That makes oil the key swing factor in the global economy over the next couple of years. Although we still have questions about oil breaching the $100 a barrel mark, the general nervousness in the market, the ability of hedge funds to push prices up, and the existence of many geo-political wildcards all translate into upward pressure.

The new world of higher oil prices has considerable implications for the structure of international relations. It has already added a degree of tension between the United States and China over the Chinese state-owned oil company CNOOC seeking to purchase U.S.-owned Unocal. It has generated new tensions between China and Japan over potential oil and gas reserves in the seas between them and over access to Russia's energy sources. Competition for oil and gas has also stimulated a return of big power interest in Africa and a new scramble for that continent's resources, allowed Venezuela's populist leader President Hugo Chavez to pursue an anti-U.S. foreign policy in the Americas which includes generous oil aid to Cuba, and provided an opportunity for China to develop closer ties with a number of Latin American countries.

The New Flow of Funds

Venezuela 's Chavez enjoys theater. Seeking to bait the United States, he has steadily announced that Washington plans on invading Venezuela. He is also making use of higher oil prices to consolidate his position internally as well as providing help for other leftist leaders and organizations throughout Latin America. In 2002, Venezuela's foreign exchange reserves stood a little over $8 billion; as of mid-2005 they stand around $20 billion. Having eroded the control of the central bank over the country's foreign exchange reserves, Chavez can benefit from the rise in reserves by increasing social spending and offering to buy back debt to help Ecuador and Argentina. The former is also likely to help Chavez win re-election in 2006 for another six years.

Hugo Chavez is not alone in benefiting from the oil boom. The Gulf States, including Saudi Arabia, Kuwait, Bahrain, Qatar, and United Arab Emirates are currently pumping oil at the highest rate in 25 years to keep pace with growing demand. Throughout the region this trend is evident in faster growth rates, improved fiscal positions and rising foreign exchange reserves. According to the Washington-based Institute of International Finance: "Gulf State countries will buy about $360 billion in foreign assets from bonds to property in 2005 and 2006 - 50 percent more than their total purchases of the past 5 years." A lot of this money is heading into U.S. and European markets, but also into the rest of the Middle East.

The Geo-Political Factor as a Trump Card

Although the antics of Chavez make colorful copy, the major geo-political concerns are largely centered on the Middle East. This is because three of the world's four largest oil reserves are located in the Middle East - Saudi Arabia, Iran and Iraq. Each of these have problems. Iraq remains locked in a civil war, with its oil industry a target of sabotage. Its level of production is well below its potential.

At the same time, neighboring Iran has just elected a hardline government under President Mahmoud Ahmandinejad. One of the cornerstones of the new government is the pursuit of nuclear power. Despite negotiations to prevent the emergence of a nuclear Iran, Teheran is determined to join the ranks of the nuclear powers. This is especially the case now that North Korea, India and Pakistan already have nuclear weapons. Iran's policy, therefore, is set to put it on a collision course with the international community, which could encompass United Nations sanctions.

Saudi Arabia , the world's leading oil country, also faces major political challenges going forward. The Middle Eastern country is a closed society, confronted by difficult problems of extremist Islamic fundamentalism and increasing demands for economic and political reform. And then there is the issue of political succession.

On August 3, 2005, the Saudi religious and tribal leaders gathered in Riyadh to pledge allegiance to new King Abdullah bin Abdel-Aziz al Saud, following the death of his half-brother King Fahd. Considering the smoothness of the succession, it appears that the Saudi royal family is well entrenched in power. The network of family relations, firm control over the state security apparatus and ability to tap the country's oil wealth give the appearance of control and stability.

The reality of the Saudi situation is that it is a restless society, with a young, relatively well-educated and generally underemployed population. Caught between influences from the West via satellite TV and a strict Wahhabist Islamic code, Saudi society has become more volatile, and the future path less certain.

Looming over the political landscape remains the political succession. Saudi Arabia's new King Abdullah has been the real ruler of the country since 1995 when King Faud suffered a debilitating stroke. While this means continuity in policies, Abdullah is already 82 years of age. This means that political succession sits out on the horizon, probably sometime in the next 10 years. The problem of an aging leadership elite is compounded by the fact that the next three leaders in line of succession are likely to be Crown Prince Sultan, a spry 81 years, Interior Minister Prince Layef, 71 and Riyadh Governor Prince Salman, 70. As Stratfor observed: "Even if succession takes place in this sequence, transitions will take place much more frequently than before, rendering the system progressively less and less stable."

Conclusion

Oil markets are likely to remain volatile going forward, with more pressure for prices increases than declines. The global economy has thus far been able to absorb the price increases due to past improvements of technology, which augmented energy efficiency. However, sitting somewhere out on the horizon is a point where oil prices are too high and disruptive to economic activity.

Dr. Scott B. MacDonald,
KWR International, Inc.

Scott MacDonald is a Senior Consultant at KWR International. To obtain your free subscription to the KWR International Advisor, please click here to register for the KWR Advisor mailing list. Please forward all feedback, comments and submission and reproduction requests to: KWR.Advisor@kwrintl.com.

The views expressed within do not necessarily relect those of KWR International, Inc.

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