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TWENTY-FOUR
THE LONG-TERM
ENERGY SQUEEZE
w
w
hen hurricanes Katrina and Rita slammed into the soft underbelly
of America's vast Texas-Louisiana oil complex in the
summer of 2005, they tore a large hole in world supply. Prices
of gasoline, diesel fuel, and home heating oil soared.
It had been an accident waiting to happen. Oil prices had been edging
higher since 2002, as increases in global oil consumption progressively absorbed
most of the remainder of the world's buffer of excess capacity,
which had reached ten million barrels a day in 1986. In years past, that
buffer had been adequate to absorb shocks even on the scale of Katrina and
Rita without any worrisome impact on prices. By 2005, however, the world
oil balance had become so precarious that even an unexpected maintenance
shutdown in some East Coast refineries early in the year had been
enough to drive prices higher.
Despite periodic predictions that the world was running out of oil,
verified recoverable petroleum reserves belowground grew in line with
oil consumption between 1986 and 2006. This was due largely to the development
of technologies that increased the amount of oil that could be
recovered from existing reservoirs. But the world's oil producers were far
THE AGE OF TURBULENCE
less successful in actually building the capacity to extract that oil from its
deep caverns and to process it. Drilling and well completions fell behind
as countries with large available reserves, mainly members of the Organization
of Petroleum Exporting Countries (OPEC), failed to reinvest
enough in wells and crude-oil processing infrastructure to meet rising demand.*
Thus, while both world oil consumption and world oil reserves
between 1986 and 2006 rose by 1.6 percent per year on average, crude-
oil production capacity grew at a rate of only 0.8 percent.
Why didn't oil companies reinvest more of their sharply rising revenues?
All OPEC oil reserves are owned or controlled by state monopolies.
Their revenues are the principal source for financing the needs of rapidly
growing populations. Energy investments must compete with many other
priorities, including programs in some of the countries to diversify away
from oil and gas. Private-sector oil and gas companies, in contrast to the national
oil companies, have plowed a much larger share of cash flow into energy
investments in recent years. But with the oil reserves of developed
countries heavily depleted by more than a century of extraction, the payoff
in increased oil reserves in that far less fruitful environment has been a
small fraction of the return available to OPEC's national oil companies.
More important, private-sector international oil companies are increasingly
being blocked from access to OPEC's reserves.1" The era when these companies
had a virtual monopoly on technological expertise is long gone. They
no longer have as much to offer in exchange for access to the Middle East's
petroleum riches.
Half a century ago, the Seven Sisters—Standard Oil of New Jersey,
Royal Dutch Shell, Texaco, and other giants—presided over world oil. Today
the private international oil companies are a mere shadow of their past
glory. Of course, their profits have surged as the prices of their large oil in
*According to the International Energy Agency, world outlays on exploration and development
doubled between 2000 and 2005, but with costs rising in excess of 10 percent per year, the rise
in real terms was less than 4 percent a year. That was not enough to convert oil reserves into
adequate growth in crude-oil production capacity.
tForeign companies are wholly prohibited from investing in the oil and gas reserves of Saudi
Arabia, Kuwait, and Mexico. De facto prohibitions against foreign access are spreading to most
countries with national oil companies.
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THE LONG-TERM E N E RG Y S O U E E Z E
ventories and assets have mounted.* But their opportunities to invest profitably
in exploration and development are modest. And with access to the
OPEC reservoirs curtailed, the international companies have few alternatives
but to return much of their cash flows to shareholders through stock
buybacks and dividends.
With the exception of Saudi Aramco, none of the OPEC national oil
monopolies has professed a desire to contain oil-price increases by expanding
crude-oil capacity. On the contrary, they seem most concerned that excess
capacity will bring down prices and the huge revenues on which they
have come to depend for domestic political purposes. When I met with Ali
al-Naimi, the urbane Saudi oil minister, in May 2005, even he was clearly
uncomfortable with measures the United States was proposing to restrain
oil consumption and, by extension, OPEC oil revenues. Al-Naimi's country's
clout is based on its 260 billion-plus barrels of proved reserves, and its
considerable potential beyond that. He is acutely aware that if oil prices
rise too high, consumption could be permanently lowered as major world
consumers shift their emphasis to petroleum conservation. Most oil consumption
is determined by the oil-consuming propensities of motor vehicle
fleets, factories, and homes. While this infrastructure cannot be altered
overnight, it can and does change. The Saudis learned that lesson in the
1970s. The growth of consumption slowed radically in the years following
the oil-price shocks, and never fully recovered even as prices fell. What
happened then could happen again. Today the United States consumes a
fourth of world oil; if we lowered our growth path of consumption, and especially
if others followed suit, Saudi Arabia's world prominence would
surely diminish.
Ever since President Franklin D. Roosevelt met King Ibn Saud aboard
the USS Quincy in February 1945, the U.S.-Saudi relationship has been
close. It was an American oil company, Standard Oil of California (later
Chevron), that had discovered oil in the Saudi sands in March 1938, under
a concession granted in 1933. And it was a consortium of American oil
companies that formed the Arabian American Oil Company (Aramco) to
develop those resources. The ties were firm between what became by 1992
*Last-in, first-out accounting reduces but does not eliminate such spikes in profits.
439
THE AGE OF TURBULENCE
the world's largest oil producer and the United States (always the world's
largest consumer). The relationship even survived Saudi Arabia's nationalization
of Aramco in 1976.* As a Mobil Corporation director from 1977 to
1987, I was acutely aware of America's continuing connection to Saudi
Arabia. Prior to 1976, Mobil's dividends from its 10 percent share of Aramco
were a major component of Mobil's earnings, and access to Saudi
crude oil in subsequent years played a prominent part in the company's
operations. Saudi Aramco has been investing a significant part of its increased
oil revenues of the past five years in capacity expansion, though
still a far smaller proportion than the oil companies of the United States,
the United Kingdom, Canada, Norway, and even Russia.
OPEC's reluctance to expand capacity has dramatically affected the
petroleum market. The buffer between supply and demand has narrowed
to the point where it is unable to absorb, without price consequences, shutdowns
of even a small part of the world's production. Growing threats of
violence to oil fields, pipelines, storage facilities, and refineries, especially in
the Middle East and Nigeria, threaten this fragile balance. The February
2006 terrorist attack on Abqaiq, Saudi Arabia's vast seven-million-barrel-aday
crude-oil processing facility, failed, but not by much. By some accounts
the attackers penetrated the first line of defense. Had they succeeded, the
resultant oil price surge would have severely unsettled world financial markets
and, depending on the extent of the oil facility shutdown, could have
brought much of world economic expansion to a halt, or worse. More recently,
fears escalated that if Iran felt itself to be sufficiently threatened or
provoked, it might block the Persian Gulf's Strait of Hormuz, the shipping
artery for a fifth of the world's crude oil.
Fortunately, the action of the market has created a new kind of buffer.
Developed-world oil producers, consumers, and, more recently, investors
brought aboveground inventories of oil to record levels. For most of the
history of oil, only those who could physically store large quantities of oil
had the ability to trade. Inventories were held largely for precautionary
purposes, particularly against unanticipated cutbacks in production any
*Saudi Arabia gained a 60 percent control of Aramco in 1974 before it was fully nationalized.
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THE LONG-TERM E N E RG Y S O U E E Z E
where in the world. But important advances in finance have opened the
way for a far greater number of players to take part in the oil markets and
hence in oil price determination. Thus, when in 2004 it became apparent
that the world's petroleum industry was not investing enough to expand
crude-oil production capacity to meet rising demand, auguring still-higher
prices, hedge funds and other investors seeking long-term investments in
oil began bidding up its price. This went on until they had induced owners
of inventories to sell some of them. Investors accumulated substantial net
long positions in crude-oil futures, largely in the over-the-counter market.
When all offsetting claims are considered, the sellers of those contracts
promising future delivery to investors were of necessity owners of the billions
of barrels of private inventories of oil held throughout the world.
Sales of oil to investors through futures contracts left many oil companies
unhedged and exposed to surges in demand. They quickly sought to
replace the newly encumbered inventories. Their increased inventory demand
was superimposed on rising consumption demands, pressing oil production
and prices still higher. The consequence has been an accumulation
of inventories that reflects both the traditional precautionary holdings of
industry and the additional quantities held in "escrow" by industry to fulfill
obligations to investors under the terms of futures contracts. In other words,
some of the oil in the world's storage tanks and pipelines is spoken for by
investors. The extent of the rapid buildup in participation by financial institutions
in claims on real barrels of oil is reflected in the nearly sixfold rise
from December 2004 to June 2006 in the notional value of commodity
derivatives, mainly oil, reported to the Bank for International Settlements.
The investors and speculators who are the new participants in the
world's more than $2-trillion-a-year oil market are contributing to and hastening
an adjustment process that has become urgent with the virtual elimination
of an adequate world supply buffer. Demand from the investment
community caused oil prices to rise sooner than they would have otherwise,
spurring investors to assist in the accumulation of record oil inventories,
adding to the thin buffer between oil supply and demand. That is, the
addition of investors to the oil market did not increase the supply of oil in
the world, but their activities speeded the necessary price adjustment that
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THE AGE OF TURBULENCE
moved some crude oil from OPEC reserves to the aboveground inventories
of the developed world. This promoted greater oil security, which, I presume,
will reduce price pressures over the long run.
This speeded-up adjustment process and the soaring gasoline prices that
accompanied it sparked a lot of controversy, of course. As crude oil reached
an all-time high of $75 a barrel, some critics asserted that speculators and
the oil industry were engaged in a vast price-gouging scheme. Recent
American history is replete with oil price spikes, leading to accusations of
oil company conspiracies, triggering congressional investigations. When the
investigation fails to uncover collusion, the report is quietly shelved. Conspiracies
are exciting, and the price shifts certainly have been significant,
not to mention painful for some consumers. But the reality is much more
mundane: we were again seeing market forces effectively at work.
Consider: had prices not risen owing to the anticipatory buying by investors,
oil consumption would have increased at a faster pace, bringing
forward the time when demand would smack into the supply ceiling. At
that point, world consumers would rapidly run through their inventories,
and prices would rocket sharply higher, with severe consequences for world
economic stability. Instead, in response to higher prices induced by investor
demand, producers have increased production measurably, and some consumption
has been discouraged. Even though crude-oil production capacity
remains inadequate, it too rose in response to higher prices. The bottom
line is that without the buildup of inventories owing to speculation, the
world would surely have eventually experienced a far more precipitate and
severe oil shock than actually occurred.
If we still had the ten million barrels a day of spare capacity that existed
two decades ago, neither surges in demand nor temporary shutdowns
of output from violence, hurricanes, or unscheduled maintenance would
have much, if any, impact on price. None of the tight balance between supply
and demand is due to any shortage of oil in the ground. The problem is
that aside from Saudi Aramco, those who would like to invest (private-
sector international oil companies) cannot find profitable investments, and
those who can invest (national oil companies) choose not to.
Many members of OPEC have announced short-term production expansion
plans in response to higher oil prices. But how firm such plans are
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