MANAGEMENT & ECONOMICS: Supply constraints and high prices; oil business still long-wave phenomena

To be fully useful and create maximum value for any economy, oil must be manufactured into other products. It must be separated into its component parts and processed into other chemical building blocks for fuels, power generation, and feedstocks for other manufacturing processes.

To increase suits in response to increasing demand, the full value chain must expand. The shepherd must grow more sheep, process more wool, and spin more thread. Then the weavers must build more looms to produce more cloth, and more tailors must cut and sew, if you can find trained people. Short-term, such output is a problem. Over the long term, value chain capacity will expand. This is the simple story of oil markets.

Generational cycle

Oil markets are long-wave phenomena; they operate on a 25-30 year cycle. The last price spike began in 1973 with an oil embargo and culminated with a price peak in 1981 (see accompanying figure). This was an artificial supply-constrained market induced when OPEC first exercised prod- uction-volume power on the world oil market.

This time is different. The industry is experiencing a true demand-driven price cycle. There is nothing to stop the price rise except a reduction in the world's economic activity. OPEC holds 40% of the oil market and is firmly in control. The cartel has some extra capacity, but have no real incentive to use it.

OPEC has learned some hard lessons, but they still want continued high energy prices. They also want to increase production by investing in new wells and facilities for the future.

Major oil's dilemma

Major oil companies are unable to affect current produced volumes or prices. At 17% of the market, they would have to increase production 10-15% to meet the current demand signal. That 1.2-1.5 million b/d of extra oil production would lower the price into the $20-25/bbl range and allow the world economy to continue to expand at a strong rate.

This is not possible. Most are operating at capacity to take advantage of present high prices and banking the resulting cash. It is in their economic interest to do so. Oil companies took a drubbing from stock analysts over the past few years because of the analysts' inability and unwillingness to think in long-wave terms. Analysts' clients all demanded continually improving stock values. If improving values did not materialize, the analysts would recommend placing the money in other industries that had the expectation of growth, most recently dot-coms.

These wider-market competitive pressures forced the major oil companies to show short-term added value on their balance sheets by layoffs and mergers. The major oil companies have to please the markets by showing profitability and a rate-of-return (ROR) above the money market rate.

The need to please stock markets with good ROR numbers forced both balance sheet focus and minimal upstream investment. This was demonstrated by a recent Wall Street Journal statement by Fadel Gheit, a senior analyst at Fahnestock & Co.: "The industry realizes drilling more hole is not going to attract more investors."

Next year

Demand has overwhelmed available supply in modest terms, and the price will rise until either supply increases or demand retreats. Supply cannot be increased in the short-term, so demand will likely fall to bring the prices down. This is not a conspiracy; it is basic economics.

This sets up a shift in investment direction back into basic industries. The dot-com sizzle is burning off, leaving the markets looking for equity growth and profitability, and finding none. Remember that the dot-coms operate on electricity, which is generated by burning fossil fuels. Oil and gas are basic inputs into all economies, even "new" ones!

Industries are already seeing global economic activity slacken. This softening will accelerate through the coming high fuel-cost winter as consumers moderate spending. The presidential election in the US will not change the outcome, and next spring, the next US president probably will face a mild recession. This economic slow-down will reset the economic engines across the world and buy time for oil development to create new supplies. New processing capacity will take much longer.

This dose of reality is a good thing - for the petroleum business. It is an opening for the industry to prove to the markets and convince the global economy that it can meet three continuing and growing needs:

• Basic materials - crude oil and natural gas
• Refined products - gasoline, heating oil, and feedstocks
• Natural gas for electricity, space heating, fertilizers, pharmaceuticals etc.

New investment round

It is time for the energy industry to change the tenor and tone of the political game. This "evil" industry, as depicted by the political and environmental communities, is a societal "good" that finds and creates necessary resources to underpin modern economies. The industry must have new capacity and therefore must state its case clearly to the investment community: the expanding world need for fossil-fuel-based energy must be met.

BP's new image campaign is a step in the right direction. Other oil companies must join the conversation with clear arguments and silence the bashing by third parties. Only then will the needed investment flow to industry, and new infrastructure work will begin.

Supply has met demand. The industry must act to meet the growing present demand and growth in future demand. Investors must see the development of new fields and new refineries to process the growing flow of crude oil into needed products. The probable recession in 2001, whether mild or strong, will see investment shift to basic industries that have a clear growth path. Movement along that path will have to be powered by oil and gas.