Market's control of oil prices uncertain

April 24, 2005|By Paul Roberts | Paul Roberts,SPECIAL TO THE SUN

Although $50-per-barrel oil is getting to feel normal, many U.S. policy-makers and other oil "optimists" still talk about high prices as a temporary spike lasting at most a couple of years. Oil prices, they tell us, are being driven mainly by those gouging Machiavellians at OPEC and are therefore relatively short term.

According to the optimists, the same high prices that are filling OPEC's coffers today will encourage other, non-OPEC oil producers, such as Russia or Kazakhstan, to drill more oil wells to cash in on the hot prices. And soon -- perhaps as soon as three years -- all this new oil will hit the market, pumping up supply, tipping prices down and taking OPEC's power with it.

It's a comforting bit of classical economic theory, especially to Bush administration officials; polls suggest that gasoline prices are hurting voter confidence in the president's handling of the economy. And, historically, the supply-and-demand dynamic has brought prices down to earth. The spike in prices created by the Arab oil embargo in the 1970s touched off a round of new drilling in Alaska, the North Sea and elsewhere, flooding the market.

But the idea that the free market will once again step in to tame OPEC isn't as convincing any more, and any country, company or consumer whose near-term plans depend on a drop in oil prices will probably be in for a surprise.

In the first place, for all of OPEC's well-documented greed, today's prices are being driven mainly by something less made-for-TV: a decline in "spare production capacity." This is the term for all the extra oil wells and pipelines and tankers that the big oil producers, mainly the Saudis and the Kuwaitis, have kept on hand in case of emergencies. Spare capacity is what producers, like OPEC, have left after they meet world demand of about 80 million barrels a day.

In times past, the Organization of Petroleum Exporting Countries had as much as 5 million barrels a day of spare capacity, which it was able to bring on line whenever some event disrupted oil production. Three years ago, when a political crisis in Caracas shut off Venezuela's 2.5 million barrels of daily exports, OPEC used its spare capacity to fill in the shortfall.

And the buffer wasn't simply physical, but also psychological: Just the knowledge that the Saudis had all that extra oil on hand was enough to keep the market from getting too edgy and prices from going too high.

In the past three years, however, much of that cushion has eroded. The burgeoning economies of China and India are burning more oil than predicted. At the same time, supply hasn't been as robust as hoped. In particular, the expected flood of Iraqi oil -- as much as 3.5 million barrels a day, by some optimistic estimates -- has yet to materialize because of political and economic turmoil. By some estimates, the global oil industry now has 1 million barrels or less of daily extra capacity, most of it in OPEC countries.

There appears to be very little slack to handle short-term crises, and the market knows it. Because supplies are so tight and because the slightest disruption can only tighten markets further, the world oil market is collectively wagering that oil prices will only rise. And given the inherent instability of some of the world's biggest oil producers -- among them Russia, Nigeria, Venezuela and most of the Middle East -- that bet seems safer all the time.

Oil optimists, including Federal Reserve Chairman Alan Greenspan and Treasury Secretary John W. Snow, insist that the lack of spare capacity is temporary. Their argument: High prices will inevitably encourage non-OPEC producers to ramp up new oil projects. As this new oil comes on the market, OPEC will have to increase its production to preserve its share of the oil market. And given the billions of dollars oil companies and countries are raking in with today's high prices, drilling new wells and building new distribution facilities won't break the bank.

Although it's true that oil companies and petro-states are sitting on a pile of uninvested cash, boosting supply is more than a matter of pouring that cash into oil fields ripe for the pumping.

Many exporting countries -- Nigeria and Venezuela, for example -- are so poorly governed and so corrupt that, even with the flood of new oil revenue, they can't afford to beef up production capacity. Even Saudi Arabia is straining to handle the social costs of a burgeoning population and can't invest in its oil sector as freely as it once could.

Moreover, many oil producers, such as Saudi Arabia and Kuwait, may well be tired of serving as the world's emergency oil reserve. Building and maintaining spare production capacity costs these producers tens of billions of dollars, yet mainly benefits oil importers like the United States, because spare capacity helps keep prices low. OPEC has little incentive to put any slack back in the system, at least until competition from non-OPEC oil producers makes it absolutely necessary.

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