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The Oil Price How Long Can It Go on Rising?

Posted on: Sunday, 20 July 2008, 03:00 CDT

By Smith, Pamela Ann

IN AN EXCLUSIVE INTERVIEW WITH THE MIDDLE EAST, ROBERT MABRO, A WORLD-RENOWNED EXPERT ON OIL AND GAS, TALKS TO PAMELA ANN SMITH Robert Mabro is widely regarded as one of the world's foremost experts on oil and gas. He is the founder and current honorary president of the Oxford Institute for Energy Studies and emeritus fellow of St. Antony's College at Oxford University, England. Born and educated as an engineer in Alexandria, Egypt, he has received awards from leaders around the world, including a C6E from the Queen of England, others from the presidents of Venezuela and Mexico and, last November, the Distinction Prize from King Abdullah of Saudi Arabia for his lifelong contribution to energy research

In this wide-ranging interview with The Middle East, Mabro explains why he feels it is the banks and hedge funds, rather than Opec, that are driving the oil price to record highs, and why he believes, sooner or later, it will come down.

Daniel Yergin, one of the most influential oil experts in the US, said in May that he thinks with the current high price of crude oil, economic realities will start to kick in and lower demand in the US, one of the world's biggest consumers of oil.

Demand has already come down in the US, even before it hit $125 a barrel.

The US investment bank, Goldman Sachs, says that oil could hit $200 a barrel, on a surge.

Yes, 'a spike'.

But, Is this realistic? Doesn't this assume that there is no change in the world's demand for oil, even if it starts to lower because of the high price?

What Goldman Sachs says, is that supply tightened. Demand doesn't fall until the price goes up. So you have disequilibrium, an imbalance, which pushes the price up. They say it gives you a spike and then it's the spike that kills demand. Why not?

But, for me the question is, 'why $200?'.

Why?

Chakib Khelil, the Algerian minister and president of Opec, made a statement to the press saying that we could have a price of $200. But it is foolish to predict that. Perhaps it will happen but there's no point in saying it.

If what the market believes is the importance of Opec, when its President says it could reach $200, they see this as a message from Opec. Then when Goldman Sachs, which plays a leading role in the futures market, says it could hit $200 in a spike, and given that the same analyst in Goldman Sachs said a year ago that it would hit $100 a barrel when it was only $60, the bank's predictions have double authority. Their analyst was right once and people in the market, in the futures market, know that Goldman Sachs has weight. So you have the weight coming from Opec, and the weight coming from the financial sector behind the same prediction. This fuels the bullish mood.

To what extent do you think there are real supply constraints, or an imbalance between supply and demand?

There are supply constraints already. The people who try to explain the high price by the economic fundamentals of supply and demand say something very simple. They say supply is not in good health. We have great disappointments about the growth of oil production in the non-Opec countries. Mexico is down, Norway is down and also the US and the UK. Now, Russia, too, apparently, plus Egypt, Oman and Syria. The oil companies are also trying to produce more, but they are not doing very well. So the string of news coming out of the non-Opec region is pessimistic, disappointing.

And Opec does not seem to be increasing its capacity very much.

Do you mean capacity, or actual production?

The ability to produce the stuff.

We have problems in Venezuela, in Nigeria, in Iraq and in Iran. Production in Indonesia has been coming down, their production is declining. So we cannot expect much growth in supply.

On the other hand, Goldman Sachs claims demand is very robust. But it is not robust in the US. Demand in Europe is flat, Japan is flat. But we have the three others China, India and the Middle East.

Where It's going up, rapidly?

Yes. Fine, I accept both sides. But you have to put them together. If supply is tight and demand is robust, the price has to go up. But, can we predict that as the price goes up the Chinese will carry on growing at seven or eight per cent? I can't believe that.

India is always put together with China, but the scale is different. The rate of growth in India is high, but the absolute volumes are not very big. So I would not put India with China.

In the Middle East, of course, there's plenty of money, so you have an income effect. People have more money in their pockets, so they go on burning petrol. Why not?

But Saudi Arabia and the Gulf countries are also linked to the dollar, and their oil is subsidised...

No, it's not really subsidised. It's cheaper than elsewhere, but for it to be subsidised, the price of the gallon, or litre, of petroleum to the consumer has to be less than the price of it when it comes out of the ground. It has to be below cost.

There is not a subsidy that is paid out. There is an opportunity cost, an opportunity lost, if you like. The government could have sold that barrel of crude oil for, say, $120 but is selling it domestically for $50. This is not a subsidy in the sense of money coming out of the budget to pay the difference, even though the budget is not getting as much as it could. It's a subsidy only in a very loose sense.

On the supply side, there Is a huge controversy about what Saudi Arabia's reserves really are. There is talk of a peak, very soon, In oil supplies worldwide and that after that, we will have to learn to live with much less oil.

It's all irrelevant. It's nonsense.

When we talk about reserves, we are talking about oil in the ground. The concepts about reserves are metaphysical concepts. They have never been accurate, and they never will be.

So, the distinction between proven and probable reserves is meaningless?

No, it's not meaningless. But it is one phony number compared to another phony number. I'll give you an example. I tell my students, do the following exercise. 'Go to the BP Statistical Review of World Energy and see what the reserves of the non-Opec countries were 20 years ago. Then, compare them with the reserves of the same countries in the latest issue/ Then, they have to make a longer calculation: 'see how much these non-Opec countries have produced in these past 20 years.' Now, if the first estimate is correct, they, the non-Opec countries, would not have a drop of oil left. That's the first point.

The second point is, 'Why should I care? Why should anybody on earth care whether Saudi Arabia has 260bn barrels of crude oil reserves, or 100bn?' It doesn't matter, not at all. Because what you can produce today, whether it's 260bn or 100bn, the answer is the same. You cannot produce on the basis of 300bn, or 260bn in reserves. But if you produce at the same rate vis-a-vis reserves that the North Sea has, Saudi Arabia would be now be producing more than the whole world's consumption. Of course, its oil would then run out quickly.

So, it's irrelevant unless you are thinking 40 or 50 years ahead. But I will certainly be dead by then...

And all sorts of things could happen by then?

Yes. There is a hysteria about what the reserves are. But there is an even worse hysteria produced by a guy called Simmons. I have met him, he is a fun guy, but he is dangerous.

You mean Matthew Simmons, the author of Twilight In the Desert: The Coming Saudi OH Shock and the world Economy? The book that is a bestseller In the States?

He has said that the Ghawar field in Saudi Arabia, which is something like 110 miles long and 17 miles wide....

It's huge. It's the biggest one in Saudi Arabia, isn't it?

Yes, and it is well behaved, too. Simmons has said, "It cannot produce anymore. It is declining, and there is water in it." Well, every field has water. If there isn't water in it, the oil doesn't come out! oil is not like a swimming pool, it is in rock, in porous rock. There is water and gas, so when you make the hole, you bring the pressure down, and the water pushes up, so all oil has water in it, and you have to take it out. He claims it's a lot more, and makes a comparison with a field in Oman which is declining. But this is like comparing a calf with an elephant. A small thing with something big. He has written nonsense on Ghawar.

Then he said Saudi Arabia has no surplus capacity. In other words, that they don't have the capacity to produce more than they are producing today. Why? I was in Saudi Arabia, and I haven't seen this. Whose leg is he pulling? You can't see any evidence for this. We have lists of the fields that Saudi Arabia has shut down. This is public knowledge. 'Surplus capacity' means that you can produce more, but you keep it in the ground, you shut down certain fields so that you can re-open them when you need it.

So if Saudi Arabia>> the world's number one exporter, has surplus capacity, why is the oil price so high?

Well, you have different theories about this. There is one theory which is led by Paul Horsnell of Barclays Capital. He worked with me at the Institute for 10 years. I respect his views, but I cannot accept them 100%. He argues very forcefully and consistently that it is a supply/demand problem. That the market sees that there is tightness of supply, and that demand is still going on and decides that this is not a tenable situation in the long run. So his theory is that the market is testing the limits. It is like a child who wants to explore the boundaries to see how far he can go before his parents start screaming at him. So what we are observing is a period where the market is testing the boundary, trying to establish what the boundary is, what the price should be. Since no one is intervening, the market can carry on wondering and pushing the boundary. I see a lot of merit in that theory. But, this is not the whole of the story. There are several dimensions in the oil market, because you have to remember that what is happening is that the reference price of oil comes from the futures market, from Nymex (New York Mercantile Exchange) in New York and from ICE (Intercontinental Exchange) futures in London. Nymex is the WTI (West Texas Intermediate, a pricing benchmark for crude oil) price, ICE the price for Brent crude (a pricing benchmark for oil from the North Sea that is also widely used for other crude oils traded in the West). People say no, it is the spot price as well. But the spot price and the futures price move together, because nobody is going to bid the spot price without looking at the futures price and vice- versa. So, they are co-determinant.

We have to understand that. And the reference price comes from this. Countries which have oil to export and who want to sell it in the Western hemisphere put this reference price in their formula, i.e. if they are selling to the USA. The same for Europe and Africa. It's only Asia where it is done differently.

So, the reference price...

So, to understand how the oil price is determined, you have to have some views about how the financial markets work. My argument is that the futures market for oil is only partly an oil market, because it is also a financial market. People buy and sell a financial instrument, which is called a futures contract.

Your argument Is?

My argument is that there is also a financial dimension in the operation of the oil futures market. It is not only a question of supply and demand. Now what does that mean? It means that when I go there and I want to buy or sell oil in the futures market, if I am a hedge fund, or whatever, I look at the sentiment, or other opportunities, in other financial markets. IfI find that the equity markets are not so attractive, and if I see that the bond market is not attractive, and that the foreign exchange market is not attractive, because we don't know where the dollar is going, I might ask, 'What are the financial markets that are rooted in the real world?'

Equities are not rooted in the real world. There's no real supply and demand for equities, for bonds, for foreign exchange. But there is for wheat, for gold, for metals, and for oil. So, I would tend to move to these markets, or to move out of them. Or vice versa.

Suppose I think that the oil price will not go up. But I expect the bond price to go higher. And I don't have an infinite amount of money, so I move my funds from oil to bonds. So the oil price comes down, even though I expected it to go up.

Then take the mirror image. If I am investing in oil because everything else is unattractive, and I think that oil should come down because there is a fear of recession, the oil price actually goes up, because money comes in to it.

In other words, it's a question of expectations, what people think? But people think that the oil price should come down if growth slows, don't they?

They don't think that, but they should think that. In normal circumstances, the price would come down because there is fear of recession. And everybody in the press is writing about this. There is bad news on the front pages, that the economies are coming down. So demand for oil has to come down, except for this miracle, this miraculous China. But, you know, this is not the Olympics, this is economics.

The oil price should come down, but It doesn't. So what Is the counterforce, what It preventing that?

Horsnell would say the counterforce is that there is tightness.

Scarcity?

Yes.

Following US President George Bush's visit to Saudi Arabia in May, there were conflicting reports about whether the Saudis agreed to increase their oil output. What do you think?

It was a Friday. Saudi Arabia made a statement that it would increase output by 300,000 barrels a day to compensate for shortfalls among other Opec countries. But what happened? The oil price went up instead of down. That same day, Goldman Sachs had produced a report saying that the average price later this year would be $147. So, who is leading the market? Saudi Arabia or a big US investment bank?

If the oil price continues to go up, will Saudi Arabia produce more oil?

Saudi Arabia produces as little, or as much, as its customers want, subject to its own production constraints. If customers go to, let's say, Algeria, Algeria may say no. Saudi Arabia has much more oil, much more. They will say yes. The production quota set by Opec is not relevant, except if the market is tight. What determines the level of production is demand.

There is one exception. If the oil price collapses and prices are going very, very low, then Saudi Arabia will produce less than the market wants. This happened in 1998. But the rest of the time, they produce for the market.

So, is Horsnell right? That too little supply is the main problem?

Some other people would say that oil, along with wheat and some metals, remains more attractive than other investments in the financial markets. And we know that the people who lead these markets are financial institutions, the banks and the hedge funds. They are the leaders. So the paradox is that, consciously or unconsciously, the determination of the oil price has gone away from the producers to the financial sector. It went away from the oil people to the non-oil people.

So is there anything that could stop the oil price from rising in the coming year?

Yes, of course. A bubble has formed. We know one thing about bubbles, and that is that they burst. When, I don't know. It could be tomorrow, it could be in four years' time.

Are the oil reserves of the world about to run out or does it just depend on how you analyse it?

In the Middle East, of course, there's plenty of money, so you have an income effect. People have more money in their pockets, so they go on burning petrol. Why not?

My argument is that the futures market for oil is only partly an oil market, because it is also a financial market. People buy and sell a financial instrument, which is called a futures contract

Copyright International Communications Jul 2008

(c) 2008 Middle East. Provided by ProQuest Information and Learning. All rights Reserved.

Source: Middle East

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