More Long-Term Pressure on Oil Prices

A pair of items in today's Financial Times could signal a longer run of high oil prices, even if Europe were to slip into recession and economic growth elsewhere slow. The first article (registration required) reported that Saudi Arabia has raised its target oil price to $100 per barrel, up from the $75 level that King Abdullah had previously endorsed as "fair." Meanwhile, Venezuela has announced that it would withdraw from a World Bank body for arbitrating contractual disputes, preferring them to be resolved within its own judicial system. That can't be welcome news for companies that had been considering new investments in the country's oil and gas sector. Taken together, these stories suggest both less future supply and a greater likelihood that OPEC would respond to any significant weakness in oil prices by restricting output.

With markets currently tense over the prospect that Iran might make good on its threat to close the Strait of Hormuz, the prospect of Saudi Arabia boosting output if necessary to keep prices from going much beyond $100/bbl must seem welcome, at least in the short term. But as the FT explains, the choice of that figure, rather than a lower one, reflects the fiscal realities of a broad group of Middle East producers. The Saudis, Iran, Iraq, and the UAE all require oil prices north of $80/bbl in order to balance national budgetary requirements. Considering that the cost of producing much of this oil is likely still in either the single digits or low double-digits, that is an extraordinary commentary on just how much these countries depend on oil revenues to fund the social expenditures that maintain their respective domestic status quos. So while Saudi oil minister al-Naimi may have intended his comment to convey a comforting price ceiling, it probably said as much about his government's view of where the floor should be. With UK Brent crude currently trading at roughly the same $111/bbl level that set a full-year price record last year, I'm not sure how many of us would find that reassuring.

The decision by Venezuela's dictator to exit the World Bank arbitration mechanism shouldn't have come as a surprise, with an estimated $40 billion in international claims outstanding for his past actions in nationalizing assets and arbitrarily altering contractual terms in a variety of industries. The recent ruling by the International Chamber of Commerce in favor of an ExxonMobil claim might just have been the final trigger. Yet despite the obvious expediency of such an exit, it seems grossly counterproductive in the context of a producing country that depends increasingly on foreign investment to stem a long-term decline in output. Since President Chavez punished his nation's oil industry by firing its most capable managers and engineers following a strike in 2002-3, Venezuelan oil production has fallen by at least 15%, and it only avoided a larger drop due to the contribution of the big Orinoco production and upgrading projects built by foreign firms such as ExxonMobil, Chevron, ConocoPhillips and Total--some of which are now seeking compensation for expropriation of assets and other grievances.

Requiring disputes to be resolved within a court system that has been stacked with Chavez loyalists hardly seems like the recipe for reducing political risk and reassuring companies that have already seen past investments turn sour. While companies that have too much at stake to leave will try to make the best of this, others would be well-advised to steer clear. However this turns out for the industry, the likely outcome for Venezuela is lower production in the future and even greater support for hawkish price policies within OPEC, to prop up the oil revenues upon which Chavez's redistribution policies depend.

Of course none of this guarantees high oil prices in perpetuity. After all, OPEC was unable to prevent prices collapsing to below $40/bbl in late 2008, though it did restrain output enough to get them back to around $80 within a year. However, both stories should remind us that in a world in which oil prices are set to suit producers better than consumers, our primary focus should be on actions and policies that enhance our energy security. That means substituting plentiful natural gas for oil and its products where we can, promoting conservation and efficiency, pursuing cost-effective renewables, and ensuring that we have access to as much oil from domestic and trusted international sources as possible. Rejecting the Keystone XL Pipeline, instead of committing to find a way to make it work while addressing reasonable concerns about it, would be nothing less than a gift to OPEC.

Disclosure: My portfolio includes investment in Chevron, which is mentioned above and owns projects and facilities that could be affected by these events.

Barrel Rattling

The chance that Venezuelan President Chavez will follow through on his threat to cut off oil exports to the US, in retaliation for a freeze on Venezuelan financial assets secured by ExxonMobil, seems minimal. As today's Wall Street Journal notes, he probably gains more through the impact of the threat on oil markets than he could from its actual execution. Still, Mr. Chavez has earned his reputation for being mercurial and unpredictable. With high energy prices already contributing to the weakness of the US economy, how much damage could such an oil cut-off inflict?

As of November, US crude oil imports from Venezuela in 2007 were averaging 1.1 million barrels per day, or about 11% of all our oil imports, with most of it coming into the US Gulf Coast, followed by the East Coast and an occasional cargo to the West Coast. By contrast, that volume amounts to roughly half of Venezuela's total oil exports, corresponding to roughly 20% of the country's GDP at current exchange rates. While the global crude oil market would surely readjust to compensate for a Venezuelan oil embargo against the US, the financial consequences of the temporary chaos following such a move could be proportionally worse for the perpetrator than the victim.

At the same time, we shouldn't underestimate the fallout in domestic energy markets, and for the economy as a whole. Even in a globalized market for crude oil, it would take a while to work around such a significant shift. US refiners would have to scramble to purchase cargoes of oil from more distant suppliers, driving up the cost of shipping and bidding up the price of the nearest substitute grades of oil. Coming at a time when the output from West Africa has been reduced by problems in Nigeria, it could take a couple of months to arrange suitable alternatives. In the interim, commercial crude oil inventories, which have recently recovered to more comfortable levels, would fall dramatically, unless bolstered by releases from the Strategic Petroleum Reserve.

Nor would refiners be the only ones affected. Although oil futures seem to be pricing in some small probability of such an outcome, the actual event would drive prices up by a lot more than a dollar or two. A $10 per barrel spike, about the least I can imagine for such a disruption, would quickly translate into another $0.25/gallon or so at the retail level, pushing us close to a record high for gasoline. That would pinch the average household's budget to the tune of another $20/month, further squeezing a variety of merchants or adding to credit-card debt.

Mitigating against that eventuality is the reality of what such a cut-off would mean for Venezuela. Citgo, the US refining and marketing subsidiary of PdVSA, the Venezuelan state oil company, controls about 5% of US refining capacity. Its facilities would presumably be hit as hard as any others by an embargo. Meanwhile, just as US refiners would drive up the price of non-Venezuelan oil in their search for substitutes, PdVSA would have to discount its oil twice, to keep it flowing. That's because the cost of shipping it to Europe or Asia would be much higher than for the short voyage from Maracaibo to Houston, and because few refineries elsewhere are configured to extract maximum value from the heavy sour crudes that make up much of Venezuela's output.

While I'm skeptical that President Chavez's remarks about suspending exports to the US mean much outside the context of his ongoing dispute with ExxonMobil over the nationalization of their assets in his country, stranger things have happened. Given the general antipathy of his government for ours, I continue to believe that we would be wise to plan for this outcome occurring sooner or later, and wean ourselves from a supplier so bent on creating the perception of unreliability. A gradual divorce would hurt both countries a lot less than a sudden breach.

Another Castro, With Oil?

Roger Cohen’s column in yesterday’s New York Times called attention to Venezuela’s impending constitutional referendum, which is expected to cement Hugo Chavez’s aspirations as President-for-Life, giving him effective control of the few levers of government that he had not yet consolidated. The following is excerpted from a posting I wrote in August 2006, examining some of the implications for Venezuela and the US:

As Fidel Castro fades from view and Venezuelan President Chavez accretes ever more power to himself, the speculation about Sr. Chavez’s ability to assume the mantle of Castro's revolutionary leadership grows. That would be worrying enough, geopolitically, if Venezuela weren't also our fourth largest oil supplier. Oil is the only thing that makes Chavez's "Bolivarian Revolution" economically feasible, though it's worth recalling that Chavez's own actions had previously put Venezuela's future oil revenues into a death spiral, by breaking the 3-month strike of the national oil company, PdVSA, and firing 18,000 managers and workers. By a quirk of fate or good luck, this was just about when oil began its long march to $75/barrel, with the US invasion of Iraq. So even though Venezuela's oil production has never entirely recovered from the strike, its oil revenue has risen dramatically.

According to the Oxford Institute for Energy Studies, Venezuela's oil export revenues in 2000 were $27 billion, but their net from that was only about $11.3 billion, after accounting for tax and royalty rates that were intended to make the country's challenging oil reserves more attractive to international investors. At current (2006) prices, gross revenue on today's lower volumes should be roughly $50 billion, but their net take has probably tripled, after factoring in the recent changes in terms. That's quite a track record, but where does it go from here? While oil may yet hit $100, that won't necessarily add another $25/barrel to the price of the heavy oil Venezuela specializes in. We are into diminishing returns, here. Venezuela has only a few more levers to pull on oil revenues:

• Completing the recent partial nationalizations. However, if companies like Chevron actually do know more about running these complex facilities than PdVSA's downsized staff, production would fall again.


• Expanding production via more international investment, presumably with a different group of companies, since the political risk models of the folks who've already been semi-nationalized must be flashing all sorts of warnings. Unfortunately, those same companies are the ones that best understand the intricacies of Venezuela's Orinoco Belt geology and the necessary upgrading technology. There's also a significant time lag involved in bringing new upgraders on-line.


• Cutting off oil exports to the US. They'd have to hope that the resulting rise in world oil prices would more than offset the much higher freight costs to Venezuela's alternate markets in Asia or Europe, and that this could be done without triggering a direct response from us. This looks like a fool's bet.

So, unless the adherents of the Peak Oil theory are correct and global production will never again outpace demand growth, Mr. Chavez could just be looking at the high-water mark of his oil revenues, at the same time that he has committed himself to foreign activities and transactions that will tie up an increasing share of them, on top of an ambitious domestic social agenda. There's no better antidote to good luck than hubris, and an extra $20 billion or so of oil money only goes so far in a region with an aggregate GDP of $2-4 trillion.

The Chavez Way (Re-run)

I see that President Chavez has moved another step closer to reshaping Venezuela into a Cuba with oil, by gaining preliminary approval for his constitutional "reforms", which include the removal of term limits on his rule. As preoccupied as we are with events in the Middle East and Afghanistan, we can't afford to ignore this self-declared foe of America's interests. I looked at some of the implications of his policies in this posting from last April:

The Chavez Way
It might be tempting to view the creeping nationalization of Venezuela's oil industry as an appropriate re-assertion of indigenous ownership of natural resources, taking them back from a greedy international oil industry dominated by rich European and American companies. President Chavez's energy minister, Sr. Ramirez, explains these actions (NY Times archives) by saying, "...this country and this government do not allow themselves to be blackmailed. We don't want companies that do not adjust themselves to our laws in our country." Unfortunately, this is a classically inverted piece of propaganda, in which the blackmailers claim to have been blackmailed, and the thieves complain they are the victims of theft. Herr Goebbels would recognize the emulation, conscious or not.

I don't need to recite my earlier comments about the degree to which Sr. Chavez's present power and growing political influence are largely the result of sophisticated oil processing hardware built and paid for by the same multi-national companies that have become his scapegoats. You can read those elsewhere, if you like. Instead, I think it's more important to contemplate the implications of the latest round of oil asset seizures for the global energy market.

Venezuela may not be Saudi Arabia, but in energy terms it is in the same league, in terms of its direct impact on the US energy situation. We rely on Venezuela for 11% of our oil imports, along with additional supplies of gasoline and distillate. The country has between a quarter and half of the western hemisphere's oil reserves, depending on how you count Canadian oil sands, and excluding Venezuela's undeveloped ultra-heavy Orinoco deposits. At the same time, a wholly-owned subsidiary of the Venezuelan state oil company supplies 10% of the US gasoline market. How many Americans realize that 14,000 Citgo stations provide are the local face of an increasingly hostile foreign government?

The re-direction of Venezuela's oil wealth has immediate consequences, raising the stakes in an already frothy, risk-driven oil market. It also has two less-direct, longer-term outgrowths. First, although I remain skeptical about the prospect of an imminent peak in global oil production, the peak in non-OPEC production is in sight, as mature basins in North America and the North Sea run down. The world will increasingly need to draw on the oil resources of OPEC countries, and access to that oil on commercial terms is key. Venezuela's actions remind other producers of the temptation, especially at times of high prices, of enjoying 100% of the proceeds of investments made in their countries by Exxon, Shell, et al, rather than having to share them. We have been down this path before, and its benefits are largely short term, as countries such as Libya and Kuwait have begun to realize. A return to the large-scale nationalizations we saw in the 1970s would guarantee the premature arrival of Peak Oil.

The other geo-political concern is not specific to energy. Surging oil income gives a disproportionate heft to the distorted economics of President Chavez's Bolivarian Revolution and make it more attractive and influential throughout Latin America. What he portrays as a fairer system is nothing more than the re-distribution of billions of dollars in resource rent. However, that may not be immediately obvious to the millions in poverty for whom his philosophy appears superficially more attractive than the international system of globalized trade, as we saw in Bolivia's recent elections. While much of our attention is focused on dealing with radical Islamic adversaries, we cannot ignore the dangers of an emerging petro-fascism to our south. Mr. Chavez has ways to hurt us of which Al Qaeda can only dream.