Rising Oil Prices: Less There than Meets the Eye

GLOBAL INTELLIGENCE UPDATE July 6, 1999

Rising Oil Prices: Less There than Meets the Eye http://www.stratfor.com/services/giu/070699.ASP

SUMMARY

Oil prices have gone up 80 percent in a couple of months. Twenty years ago, the world would have been riveted. Today, the world's equity and money markets remain indifferent and even soar in tandem. The doubling of the price of oil does not mean what it once did. Is the calm justified? To get at that question, we have to figure out why prices rose in the first place. We do not think that production cuts were the sole cause of the rise. Expectations of Asia's economic recovery and a growing feeling that Central Asia's oil may not make it to market were critical in driving prices up. Since we do not think that Asia's recovery will be all that dramatic and since Central Asian oil is a long-term issue, we do not think that prices will continue to surge, particularly since other mineral commodity prices have not kept pace with oil.

ANALYSIS

The world has seen a dramatic increase in the price of oil during the last few months. From a low point in February of under $10 a barrel, the price of North Sea Brent has risen to just over $18 a barrel at the close of trading in London. This is the highest price for oil since December 1997. That means that oil prices have risen by about 80 percent in about four months, with most of the gains in the last two months. This ought to be important and even startling news, yet it seems that both the media and the markets have taken the news in stride. American markets, which a generation ago lived in dread of high oil prices, hit new highs along with oil, rather than moving in the other direction. In many ways, that news is more interesting than the rising oil prices.

The collapse of oil prices, along with other commodity prices in the early 1980s was, in our view, the trigger behind the boom of the 1980s and the long-term surge in U.S. stock prices. We say "trigger" rather than "cause" because there were several important causes, ranging from demographics to the business cycle. Nevertheless, the decline in the cost of commodities decreased the cost of production and the cost of living in the industrialized countries, facilitating capital formation while easing pressure caused by consumer demand. The decline in commodity prices also exacted a toll, ushering in an intense third-world debt crisis. Low commodity prices, of which oil prices are the most important, propelled the American economy upward while cushioning the decline in Asia. These low prices also had the inevitable counter-action of severely harming commodity-exporting countries. From Venezuela to Saudi Arabia to Indonesia, the effect of low oil prices on national economies was becoming catastrophic by the beginning of 1999.

Suddenly, oil prices have nearly doubled. It is important to try to understand the causes leading up to this extraordinary event, in order to gage first its permanence, and second its consequences. The fact that the global economy has not yet reacted to rising oil prices can mean one of three things. First, the global markets may not be convinced that the rise is sustainable. Second, oil is not as important as it once was. Third, the markets have not fully absorbed the meaning of the shift. The reason matters a great deal.

The obvious cause of the rise in oil prices has to do with agreements reached by oil producers earlier this year. As oil prices collapsed last year, OPEC members, particularly major producers Saudi Arabia and Venezuela which had long worked at cross-purposes to each other, began to collaborate in getting oil producers not only to promise to cut production, but actually to enforce the cuts. This was difficult for two reasons. First, some of the most important producers in 1999, unlike in 1973, were not members of OPEC. Second, and more important, most oil-producing countries, particularly those that were heavily dependent on oil revenues for a large measure of their income, could not absorb the costs of cutting production. Quite the contrary, each agreement to cut oil production led to market openings for oil producers. In spite of promises, economic pressures caused producers to sell secretly into the market openings.

It was extremely difficult to create a cartel-like solution in a situation of oversupply, during a period when producers were unable to absorb the short-term loss of income needed to constrain supply and force up prices. Further complicating the problem was that the oil quotas, essential to constraining production, reflected outmoded realities by not taking into account the needs of OPEC members like Venezuela and completely ignoring the reality that key producers, like Mexico, were not in OPEC at all.

As a result, every agreement to cut production fell apart almost as quickly as it was reached. The standard explanation for the price surge during the last two months is that a successful agreement was finally put into place. Certainly, some things had changed since the end of last year. The most important change took place in Venezuela, where a new, radical government under Hugo Chavez was clearly more committed to working with Saudi Arabia to raise oil prices. The Saudis also had an internal financial crisis toward the end of the year that convinced them that it was time to be serious. So, an argument could be made that this time, the producers were simply more serious about things.

Perhaps. But some things had not changed. Many of the producers were in urgent need of cash. It is hard to imagine that all of them had the self-restraint and foresight to cut current income despite this need, not knowing whether someone else was going to be taking advantage of the situation. Systems of verification in place in spring 1999 were not really better than verification systems before. Whatever the intentions of the producers, it remains extremely difficult to believe that a cartel could get the traction it needed to raise a commodity price during a period of excess oil availability (stores and production) and financial dislocation. We believed that the cartel could halt the decline in the price of oil. Claims not withstanding, it strikes us as hard to believe that they could actually trigger an 80 percent rise.

Rises of that magnitude are normally triggered by politico-military crises, particularly those that affect significant oil producers, such as those in the Persian Gulf. Since there has been no crisis that would justify a price rise (and we include Kosovo in this), that is not the likely explanation. Since we regard the cartel explanation is only part of the story, we need to consider what other forces are pushing up the price of oil. There seem to be two, one on the demand side, the other on the supply side.

On the demand side, there is a growing expectation that the worst is over for Asia and that with Asian recovery underway, the surge in demand for oil that had been expected for 1998 will finally materialize. On the supply side, there is the recognition that long-term fears of Central Asian oil flooding the world markets may have been premature. With political instability throughout the region, oil exports materializing in the next few years has turned from a certainty into only a possibility. With that, current oil reserves become more valuable. In our view, OPEC's ability to construct a framework for controlling oil production was a factor in propelling prices upward, but did not stand alone. Expectations about Asian recoveries and Central Asian oil further affected the markets. Therefore, we need to examine whether the market is being realistic.

Asia is certainly doing better. After all, it could hardly be doing worse. However, in our view, we are experiencing two phenomena. First, we are seeing a cyclical upturn in a secular down turn. Nothing moves in a straight line and an upturn in Asia's general depression was inevitable, just as there were several upturns in the U.S. depression of the 1930s. However, key Asian nations like Japan and China have failed to solve their deep structural problems during the past year. Those structural problems severely limit their capital formation capabilities, in that each upturn creates money that is used for alleviating short-term debt problems, without creating long-term capital.

The second phenomenon we are seeing in Asia is a differentiation between countries. It is no longer reasonable to think of Asia as a single entity when discussing economics. It was once reasonable, at least in the sense that almost all Asian nations were heading in the same direction upward. Today, they do not even share a general direction. Some seem to be truly recovering, like South Korea. Others are moving sideways. Some are still slumping. But most important is that, in our opinion, the two engines of Asia, Japan and China, despite recent stock market rallies and promising economic numbers, will not move forward without massive internal restructuring which is not under way. They are still trapped in the structural problems that caused the problem in the first place and because they are the powerhouses of Asia, the general trend will follow them in spite of divergences by individual countries. In our view, that trend remains downward. Thus, Asian demand will increase, but it is not clear that it will increase dramatically or that it will increase permanently.

There is no question but that instability in Central Asia and the Caucasus is bullish for oil prices. Not only is production over the next decade is at risk, but the transport mechanisms pipelines that pass through some of the most fractious areas of the earth are exposed to political shifts in an area known for upheaval. Hopes for the stability of the region are certainly on the decline and with it optimism about the ultimate return on billions in investment. But increased concern does not mean certainty. The oil may flow and, either way, the impact on world oil prices, positive or negative, won't be felt for years. Thus, while the situation in the region might account for some upward pressure, it is difficult to imagine that very much of the 80 percent price rise in a few months can be attributed to it.

Part of the explanation is cyclical. There is no doubt that oil, at below $10 a barrel, was oversold. In real terms, adjusted for inflation, it was at the lowest level since the 1930s. That was unreasonable. OPEC, Asia and Central Asia notwithstanding, those prices were clearly too low. But the important question is whether the rising prices represent a fundamental shift in the economic geometry of the globe. It is interesting to us that the increase in prices has been confined to the oil patch, at least as a matter of magnitude. That indicates to us that the long-term collapse in commodity prices a dominant factor in the global economy for a generation is not yet over.

Oil prices have risen less because of OPEC's behavior, in our opinion, than because of expectations in the short run about Asia's recovery and a long-run concern about Central Asia's oil ever coming to market. In our view, since Asia's recovery, taken as a whole, is more apparent than real, the great expectations held by the market will be disappointed. The American stock markets have simply ignored the rise in oil prices. So have Asian and European markets. Whatever drives them, the markets are saying that the rise in oil prices is either unsustainable or can be absorbed by the advanced industrial countries. In our view, the stock markets are acting appropriately. A dramatic return to the 1970s is not likely. Oil is still cheap and, we believe, will remain cheap. If other mineral commodities started to seriously surge, we might have to reevaluate our views.

In the meantime, it seems to us that oil traders are once again betting on an Asian recovery to generate demand for oil. After having their expectations shattered in 1997, these perennial optimists are betting once again that Asian demand will overcome the fractious appetites of the oil producers, who may again break ranks to take advantage of market openings and solve pressing financial problems. Our view is that, except for a few bright spots, Asia has not even come close to turning the corner. That said, we do not see this oil price rise as the harbinger of the bad old days.