Thursday, August 26, 2004

Future Oil Prices
Continuing on from yesterday's theme on oil prices and last week's comments on market backwardation, I see that the Economist (subscription required) has joined the growing consensus that oil prices are likely to remain high for some time. Their best argument comes in the form of a chart comparing the recent history of the "prompt" NYMEX WTI contract (for delivery in the next month) with that of the contracts for delivery 24 months later. It shows clearly that, despite big moves in the prompt prices, the price for two years out held steady in the mid-$20 range until the beginning of this year. Subsequently, something has convinced the market that we aren't on the verge of another slide toward "normal" prices.

The Economist article lists many reasons why high oil prices might not be temporary--including a few dubious items such as Asian speculation in oil futures as a play against the dollar. (I'm a simple type who believes that when traders want to bet against a currency, they have much better ways to do it than fooling around with a commodity that is influenced by practically everything on the planet.) If they are right, it is important for more than the obvious reasons; the level of oil prices three to five years from now is also a key signal about the sustainability of the industry.

Barring a global recession or a major slowdown in Asia, lower prices later this decade would indicate that conventional oil production can continue to expand to meet growing global demand, perhaps with a bit of help from oil sands and gas-to-liquids, but without reliance on more exotic alternatives. Prices would only fall back into the normal range if the events of the past few years have not pushed us into an entirely new regime of scarcity and constraint, or broken the industry's ability to respond to shifts in demand.

So when the longer-term futures prices join the spot-price party and backwardation shrinks, I think we should pay attention. While the futures markets don't predict the future, they provide useful insights into current thinking on it. At the moment, the market expects that prices will stay high beyond the typical response cycle the industry has exhibited in the past. That suggests the international oil majors should not only be redoubling their efforts to invest in the relatively few truly material resource opportunities out there (e.g. Russia and the Middle East), but they should also seriously reconsider some aspects of the last decade's main strategy of ruthless cost-cutting. Perhaps those "marginal" fields they've been busily divesting are not quite so marginal, and further consolidation--which reduces the industry's aggregate capital budget--might not be in the majors' or anyone else's best interest.

Today's Wall Street Journal raises this issue of oil industry underinvestment on their front page. Wouldn't it be ironic if the thing that finally drove the world away from oil and towards alternatives weren't climate change or OPEC, but the unwillingness of the oil industry to invest enough money in its core business to keep up with demand? That would have been unthinkable to the generation of oil executives who built the companies that are today's market leaders.

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