US Treasury bond yield curves demonstrate the major movement of liquid money after the SE Asian economic collapse last fall and the recent redistribution and rebalancing of the markets. Asian demand is the long-term key to oil price recovery. [7,065 bytes]

Victor Schmidt

Perspective: From Asian collapse to US bond markets

Thailand's baht collapsed eight months ago. The country's currency difficulties became the first of many across Asia, and Asia's woes continue to create repercussions around the world. Oil demand from Asia is still in the doldrums, although oil prices are beginning to firm based on the expectation of another round of production cuts from OPEC and non-OPEC nations.

These cuts may or may not happen; the last round was only partially successful. The only sure way out of the current low price environment is an increase in demand. That means reviving the economies and consumption of Southeast Asia.

Money always flows to the region of highest return with the lowest acceptable risk. A financial collapse is the worst of all worlds - unlimited risk and negative returns. Thus, it was only natural that from August 1998 to March 1999 that the world's store of liquid money fled to safety in the bond markets.

The US bond market inverted (shorter maturities yielding more than longer maturities) and stayed that way. Most of the money bet on the 3-5 year notes, an expectation of the time needed for full recovery. The 30 year maturities dropped but did not invert, confirming the relatively short term nature of the problem. In March 1999, the curves returned to a normal pattern, longer maturities returning higher yields. This is the end of the initial crisis and the beginning of the rebuilding of both global financial markets and the demand for oil:

  • The investment community now sees better investment opportunities outside of the safety zone of the bond markets.
  • It can now see the effect of the IMF and World Bank interventions.
  • It also sees the end of disarray of SE Asian governments as they try to salvage former economic structures and build new, more durable structures.
  • Investment has redistributed itself to regions with more knowable risks, clear reporting standards, transparent accounting, and efficient and discernable profit centers.

Finding differentiation in commodity pricing

The petroleum industry has a major problem - no one will pay a premium for products. That is the way it is with commodities. If there is no detectable difference between competing products, the consumer will aim for the lowest price. Gasoline is gasoline in the consumer mind. There is no added value to the consumer without a noticeable difference between products.

Never mind that it is a complex product with special additives and properties to protect the engine. Differentiation has ceased to exist in the consumer's mind. Branded products work equally as well as unbranded. To capture more of the consumer's money the industry has to demonstrate that its products add premium value to daily life - a challenging task.

... the basic structure

Oil is no longer a strategic material, but is produced around the world like any other raw material: water, wood, or sand. As a raw input, it forms part of the basic cost of every manufactured or value-added product. There is always an incentive to seek the lowest input cost to maximize profit on the other end. Raw material producers can only increase their profits when demand rises.

The largest oil producers are caught in this commodity trap. Their economies are dependent on crude oil sales and increasing demand. To preserve their economies into the new century they must move to higher value-added products.

As new leadership comes into power over the next few years, watch for this shift. Kuwait has made the move into gasoline marketing, as Saudi Arabia did earlier with Texaco in the Star joint venture, and as Venezuela's Pdvsa has done with Citgo. The more producers can control the value chain, the more profit they can extract at each juncture. It is a form of vertical integration.

Offshore oil and gas exploration and pro duction are very expensive processes. The OPEC producers would like to limit competition and squeeze out any production with high lifting costs. That means that offshore operations are one of their primary targets. The only way to develop the resources under the seas is to be very efficient, preserve the technology advantage, and find large reserves.

... high value, low cost

The western mass-market economic process is a reinforcing cycle that constantly seeks to achieve the highest value for the greatest number at the lowest possible cost. The wonder is its ability to adjust to the changing conditions of the marketplace. The mass market also constantly seeks ways to meet and enhance consumer's lives. The consumer, not government, directs it. For an enhanced life, a consumer will part with hard-earned money. This allows the market to continue the cycle and improve products. Products that achieve wide use then become a part of society's basic infrastructure. They become commodities.

Used by everyone, available everywhere, the product or service then lends itself to economies of scale. What was a limited high-value item now becomes a product differ entiated more and more on price alone.

The industry that creates the product then contracts to the minimum number of companies necessary to service the society. Only if the market expands is there room for more players. New entrants can then take advantage of niches or natural and political divisions.

A positive sign in Latin America

Latin Americans adhere to market economic thinking according to a recent public opinion poll by Corp. Latinobarometro. Some 69% of respondents agreed that foreign investment should be encouraged and 65% agreed that a market economy is best for the country. Fifty-eight percent agreed that prices should be determined by free competition and 51% agreed that production should be left to the private sector. Fourteen countries were represented in the 15,000 Latin respondents.

Copyright 1999 Oil & Gas Journal. All Rights Reserved.

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