SCRAPING THE BARREL

Increased demand is an obvious reason for the alarming oil price rises, but several other forces are also playing their part, writes Michael Casey.

WHAT KIND of company persuades its customers to consume less of its products; spends great swathes of its money on items unrelated to its core business; doesn't manufacture the products it sells; and at a major triennial convention, does not display any of its products on any of the hundreds of exhibition stands?

Answer: a petroleum company, of which there are three kinds. The first are the super gigantic multinationals like ExxonMobil, Chevron, Shell and BP. The second are the nationally-owned companies (NOCs) such as Qatar Petroleum, Petroecuador and Aramco. The third category includes the independent oil companies (IOCs) such as Broken Hill, Enserch Exploration, Union Pacific and so on.

All say they want their customers to consume less oil and gas; all claim to spend a lot on the environment; none of them manufactures the products as such (they extract and refine them); and, despite hundreds of exhibition stands with various items on display, there was not one drop of oil or cylinder of gas to be seen at the recent World Petroleum Congress.

The oil and gas business is unique in many other ways as well, some of which will become apparent later on.

This was the 19th congress at which these companies had come together to talk, present their case to various governments - and indeed to the world. Not all of it was hype and there was certainly a feeling of genuine scientific inquiry in the meetings held by geologists, engineers and independent academics. They often disagreed among themselves - a sure sign of truth-seeking.

The administrative chiefs of the oil companies tended on the whole to sing from the same hymn sheet - always a little worrying for those who believe in the benefits of competitive forces. There was a substantial degree of consensus about the following: the recent alarming oil price rises were not caused by financial speculation - the financial wünderkind were simply "following" the fundamental forces of supply and demand. One Kuwaiti woman questioned this from the floor and was given a long and severe lecture from the podium.

No speaker suggested that financial speculation could be exacerbating the price rise through the familiar mechanism of "over-shooting". For some reason, the oil chiefs wanted to focus solely on the fundamentals of supply and demand. They argued that the main reason for the surge in demand for energy was the rapid economic growth in countries like China and India.

The problem is made worse by the existence of oil subsidies in these and other developing countries.

On a per capita basis, the demand for oil in OECD countries is actually falling slightly, though from a high level. The average consumption of oil per head per year in the OECD area is 17 barrels, compared with two barrels in China.

The fear is that developing nations will become as energy-profligate as developed nations.

Why should oil-producing companies worry about growing demand for their product? Don't they get to sell more at higher prices? Yes, but there is a snake in that fool's paradise. It is the fear of "demand-destruction" - if the price goes too high, people will slash their consumption and turn to alternative sources.

At present, the world consumes 81.5 million barrels of oil every day. Proven reserves of oil are estimated at 1,238 billion barrels.

At this rate, those reserves should be able to keep the world going for about 40 years. The equivalent figure for gas is about 70 years and our old friend coal, which is making a comeback, is good for approximately 150 years. Geologists and engineers claim there are good chances of significant discoveries in the Arctic, Russia (mainly natural gas) and Brazil. At the congress, they said that refining technology could be improved so that we can get up to 15 per cent more refined product out of the same volume of crude.

There wasn't much discussion of "peak" oil, which is, apparently, a fuzzy concept. There might be a "plateau" for a few years at a fairly comfortable level of 95 million barrels a day. Moreover, a lot of natural gas should be coming on stream. And, as well as transporting it by pipeline, it can now be liquefied and shipped by tanker.

So where is the problem? If reserves are comfortable, why are prices rising at such an alarming rate? It was summarised succinctly, but elliptically, by the chief executive of BP. "The problem is not speculative or geological, but political."

Another insider was even more coy, saying that most of the problems were "above ground". We got a bit closer to the truth when another oil chief referred to "rising resource nationalism".

What all these euphemisms mean is that big companies just can't go into sovereign countries any more, grab the oil and gas, and leave. In the past, there were plenty of examples of large oil giants damaging the environment of countries like Nigeria - and leaving a whiff of neo-colonialism in the already-polluted air. More recently, we had a case in this country where six men were jailed for several months.

At present, the countries that won't play ball with the oil giants include Venezuela (under Hugo Chavez), Nigeria and Iran. Even the Russians are backing out of some of their earlier deals with the oil giants.

Hardly anyone mentioned Iraq, or the fact that the US could be using high oil prices to pay their war debt as a more politically expedient method than raising the taxes of American citizens. Every time we put fuel in our cars, we are probably paying for the war in Iraq - a disturbing thought. The fact is, oil output from Iraq fell to one-third of what it was before the invasion and one-fifth of what it could now be. Fortunately, some Iraqi oil wells are currently being brought back into more regular production and there is talk of the discovery of a new field in the western desert of Iraq.

There is also the issue of OPEC countries wishing to keep the oil in the ground. They reject this and claim they are happy to pump more oil - at the existing high prices of course and certainly not so much that prices would fall. They do have massive reserves - especially Saudi Arabia. But if they want to leave most of it in the ground for their children, as is widely rumoured, what can the oil companies do about it except make them an offer they can't refuse? And all that will do is serve to push costs up.

Then, continuing our global tour, we come to Russia, which, as far as natural gas is concerned, has the whip hand and is not going to give it away. The newly-appointed president Dmitry Medvedev wants Gazprom to be the world's biggest company by 2017, and his colleague Vladimir Putin expects oil output to rise by almost 14 per cent by 2015.

As Dan McLaughlin outlines in the next article, Putin has committed his government to cutting taxes for oil firms and introducing incentives for exploration. And in Medvedev, he has an ally who knows the needs of the oil and gas industry - before becoming president, he was chairman of Gazprom.

Shoot over to the US and there is very limited exploration going on, largely due to the fact that permits can be blocked by locals and by NGOs. In summary, oil production and international politics are intertwined in a dangerous and damaging way.

Leaving aside conspiracy theories involving the US, Saudi Arabia, Iran and Israel, what has really happened is that the big oil companies now have to negotiate with countries and regions outside the aforementioned established few to get at the oil and gas. And these new countries are not prepared to be pushed around. So, even though reserves are adequate globally, oil companies are going to have to give better terms to the countries in question.

In the meantime, while we wait for deals to be agreed and rigs are put in place, it's likely that prices will stay on the high side. Even when the oil and gas is being extracted, it is likely to remain quite expensive, because the oil companies will have had to offer fairly attractive terms to the new - business savvy - host countries.

Then there are the rising costs of extraction. There is a reasonable degree of consensus that costs in the oil industry generally are rising by about 20 per cent annually. (For specific reasons to do with forward contracts, Shell is below that figure.)

So, even if supply and demand do come into better balance and even if the over-shooting caused by speculators abates, we are still talking about high cost oil and gas in the future. So to turn to the governments: what can your country do for you at the pumps?

Well, get in line. It's not just truck drivers and fishermen that are knocking on government doors for help over oil.

In one of the great twists of fate, the big oil giants, once archetypal private-sector entities, are now pleading for help - and for subsidies. More than anything else, they want certainty. This is because the investments they must make in exploration and refining oil are enormous, even for oil companies with plenty of cash and resources.

The days when small countries like Ireland virtually gave away exploration rights are long gone. Suppose the government of the host country changes, and seeks to nationalise its own oil or gas. Where would that leave the company that made the huge investment? Suppose the finds are not economical or the lead times and pay-back periods too long?

These are high-stake risks, similar to those faced by early prospectors. Speaking to oil company chief executives these days, it's hard to avoid the impression that some are frozen in the headlights. These are not the risk-taking prospectors of old, but cautious accountants more used to trimming costs than going for broke. One of the most serious aspects is that the big oil firms are actually doing very little exploration: most of that is undertaken by the NOCs and IOCs.

One chief executive revealed to us that his company outsourced almost everything - even corporate strategy. Whether governments can give any help or reduce the risks in any significant way is a moot point.

It seems that the countries with the reserves don't have the technology - and the companies that have the technology don't have access to the reserves. So, is there a danger that drilling for oil will be seriously scaled back? One could envisage a geo-political situation in which this could happen, but the odds of this are slight. Even if the oil giants pull in their horns, the NOCs and IOCs will undoubtedly fill the gap. One major problem for the big oil giants is the greying factor. Senior staff are ageing and the industry is finding it difficult to attract young professionals. Young people don't find the industry sexy. Even the physical image of huge refineries and rows of large, ugly tanks is off-putting. Most people see it as an "old" industry and not really part of the new "information" economy, which is largely based on services.

Is it possible that the people speculating on oil prices are the young "quants" who, in a former age, might have gone into the petroleum sector? In most developed economies, the financial services sector is the fastest growing one.

However, these are corporate and political issues that partly reflect the state of the industry and the reason it struggles to quell the rising prices and risks to their business that are inherent within that. They are well discussed between all the firms.

However, the phantom elephants in the room whenever oil executives meet are science and innovation. Suppose over the next few years some innovative young engineer or physicist develops a really good energy alternative, or perhaps a means of leveraging the known alternatives - what would happen the mega oil companies?

Maybe they have contingency plans, but they certainly don't talk about them. Not openly and between one another at the World Petroleum Congress, anyway.

Presumably they would try to buy out the genius inventor at an early stage. However, there is no doubt that if oil prices continue to rise sharply, the push to find cheaper alternatives will be accelerated to an extraordinary degree. This "demand-destruction" is what the companies fear.

The process is commonly known as economic adjustment, and it has worked well throughout history. When spices became scarce and the Eastern countries cartelised the spice trade, Columbus set out on his voyage. He didn't find many spices, but eventually other means were discovered to keep food fresh for longer periods of time. Price signals are extremely powerful.

After the first oil shock in the mid-1970s, no one thought the US would or could produce smaller cars, but they did. The world is already working on five or six alternative forms of energy. And the push towards energy conservation is increasing daily.

The oil companies are right to fear "demand-destruction". And though it seems rather masochistic to say it in today's developed societies, it could be in the world's interest if prices went through the roof, despite the pain. If you have confidence in the innovation and inventiveness of humans you will believe that cheaper, sustainable alternatives would undoubtedly be found, sooner rather than later.

The present difficulties are worrying, but not on a par with the first oil crisis of the mid-1970s, when the price of crude oil quadrupled virtually overnight due to the actions of OPEC, which had more monopoly power than it does today.

That crisis plunged the world economy into recession and caused geo-political problems which remain with us today.

One could argue that the seeds of the Gulf War and the subsequent invasion of Iraq were sown back then. Unfortunately, oil and geo-politics are inextricably linked and there are several conspiracy theories doing the rounds involving America and Iran. It's a time for cool heads and reasoned debate. It is also time for transparency from the US.

In the mid-1970s, OPEC countries amassed huge sums of cash, and banks recycled most of it by lending to developing countries without doing any sovereign risk analysis.

This led to the massive financial crisis of the early 1980s. The banks are already in serious difficulty and it is to be hoped that if and when the latest oil revenues find their way into their coffers, they will handle the funds sensibly. But there is a risk that they will not.

There does not seem to be a pressing problem regarding energy reserves, and gas finds are regularly made, especially in Russia and Iran. Technology is increasing the yields of refineries.

The problem on the demand side is that China and India are growing fast and increasing their consumption of energy, especially as it is subsidised in those countries.

The problems on the supply side are partly due to speculative over-shooting, geo-political factors (including the Iraq war), a weakening of the power of the giant companies vis-a-vis national governments and, possibly, a desire on the part of OPEC to keep most of their reserves in the ground for their children.

An additional issue may well be the record of bad treatment meted out by the oil giants to various host countries in the past. Putin refers to some of the deals done by oil companies with Russian authorities when the country was financially unstable as "colonial".

The lack of skilled young people in the oil industry does not augur well, nor does the fact that the big companies are the most reluctant to engage in risky exploration.

The problem is not a long-term one, since the reserves are there; it's a medium-term one which is both cyclical and structural. It is not clear what governments can do, but some kind of international summit is called for. An international body, engaged full-time in energy R&D might be a possibility. Certainly, the search for viable renewables should be considerably speeded up.

If this happens, and is seen to be successful, the oil companies may have to start pumping more oil quickly because leaving it in the ground won't be of any use if renewable alternatives come fully on stream.

They may of course buy up the renewable companies and achieve diversification by that route. There is likely to be major restructuring in the energy industry in the years ahead. One could also not rule out an increase in government-run energy companies on the grounds that the private sector is afraid to make such risky and high-cost investment decisions.

Ireland is still far too reliant on imported energy and, although we've made a good start on wind energy, it's disappointing that we haven't made more progress in relation to wave and tidal power.

Our first major warning about energy came in the mid-1970s. Even though the present recession in Ireland is largely of our own making, there can be little doubt that world energy prices will worsen the situation for the next couple of years and may even postpone our hoped-for recovery.

Dr Michael Casey is a former senior official with the Central Bank and a former member of the board of the International Monetary Fund