1 INTRODUCTION

The oil prices have three dimensions -their level, their volatility and their trend over time.  Each involves different determinants and each has different implications for producers, consumers and investments in the industry.

The figure, in money of the day, clearly shows the two oil price spikes of the 1970s –the first in 1973 associated with the Arab oil embargo and the Yom Kippur War; the second in 1978-81 associated with the Iranian revolution and the Iran-Iraq war.  It also shows the subsequent price collapse of 1986.

The purpose of this paper is to consider what influences will determine the future of price levels, volatility and trend.  However, in order both to understand the complex forces at work and provide an agenda for analysis it is necessary to describe briefly how oil prices are determined.

2 THE DETERMINATION OF OIL PRICES

Three reasons explain the creation of capacity surplus to requirements, which after all represent financial investment failing to remunerate.  First, the price of oil has always significantly exceeded the cost of producing or replacing the barrel.  Thus the owner of the oil-in-place has always had an incentive to develop the capacity to produce to capture this economic rent. Second, the industry has always been subject to unexpected supply loss as a result of wars, accidents, nationalizations etc.  This required the rapid development of alternative capacity.  When the crisis ended and the original capacity returned to the market, the replacement capacity for a time becomes surplus to requirements.  Finally, upstream oil production is subject to long lead times.  In an industry that suffers from forecasters' cluster - i.e. everyone believes at the same time that the same thing will happen in the future – badly judged investment decisions are common.  This is a problem that also extends to other stages in the oil industry value chain such as refining and tankers.

In what is an oligopolistic industry –i.e. an industry dominated by a small number of large suppliers- with very low marginal costs of production, such excess capacity should lead to vicious price wars.  The participants should struggle to gain market share in order to maximize throughput thereby minimizing average fixed costs.  Before 1928, this was precisely what happened.  However, in 1928 the major oil companies – the so-called seven sisters plus the French company CFP - created what was essentially a cartel arrangement.  In the face of anti-trust concerns, this was replaced in the 1950s and 1960s by joint ownership of the major operating oil companies in the Persian Gulf.  By this mechanism they could legally exchange information to detect cheating and deter any such tendency by means of the lifting agreements that ruled the operating companies.  The nationalizations of the 1970s swept this arrangement away to be replaced by OPEC who as a collection of sovereign governments was not constrained by the niceties of anti-trust.

In all cases, the function of these arrangements was very simple.  It was to orchestrate the market to ensure that demand and supply roughly matched.  However, when successful, because of the short run unresponsiveness of oil demand, it meant that between a very wide range, any price would clear the market.  In today's numbers the range is probably between $8-10 and $25-30 per barrel.  The implication is that within that range, price making was indeterminate yet clearly there was an oil price. 

Before 1986, this was set because the market controllers –i.e. those orchestrating supply were also price makers.  At the risk of seeming simplistic, the oil price was set because a number of men in a room said a number.  If enough outside believed in the number then that was the price.  In the 1950s and 1960s the men inside and outside the room were the same because the oil companies were financially and operationally vertically integrated.  The number they "said" was relatively low because they were frightened of competition from nuclear and of a backlash from their home governments if they got too greedy. In the 1970s and after, OPEC became the men in the room and they said a much higher number.  The men outside were still the oil companies but they liked this higher numbers since they were still crude producers and were beginning to look for oil in much higher cost areas.  Only in 1986 did they cease to believe, hence the 1986 price collapse.

In 1986, OPEC gave up the price-making role although they kept the market control role to try and match supply with demand and contain any excess capacity.  Instead of setting an administered price they sold oil based upon the prices of a basket of crude –not the same as "the OPEC basket".  These crude prices (largely Brent, WTI and Dubai) were set by players in the markets.  These were the wet barrel traders interested in supplying and taking delivery of physical crude oil, and the paper barrel traders who had no interest in physical delivery.  The paper barrel traders were a mixture of the commodity speculators (professional and amateur –the so-called doctors and dentists) and the fund managers although wet barrel traders also played the paper markets.  Paper trading of oil only developed during the 1980s.  Previously there had been no price risk to encourage price hedging.

These players determined the price based upon belief.  Their function in the words of John Maynard Keynes writing about the financial markets of the 1930s was to "anticipate what the average opinion (.. of oil traders..) of the average opinion might be".  However, in general they operated within a "band of belief" which represented their view of "normal oil prices".  Between 1987-1998 this was some $16-18 per barrel for Brent.  Events would push the price outside of those bands but once the event ended or dissipated, prices would revert within the band.  Belief of course can be volatile which explains the dramatic increase in price volatility since 1986 seen in figure 2.

3 THE FUTURE

This explanation of how oil prices are determined gives an agenda if future prices –level, volatility and trend, are to be considered.  Clearly supply and demand of crude oil is a matter of concern.  So too is the way in which the price of the marker crudes that fix sales prices are determined which concerns the attitudes and beliefs of traders together with the efficiency of the markets in which they operate.  Finally, it is necessary to consider the behaviour of the market controller –i.e. OPEC in terms of its cohesion and it objectives.  All these factors are subject to economic, technical and political forces that can range from the implementation of the Kyoto accords to technical developments in salt dome drilling to the performance of the New York stock exchange and much much more besides.

However, it is even more complex than this since the time frame for the future is crucial.  Price determination contains a large number of potential feedback loops.  At its simplest while price is determined by demand and supply.  Supply and demand are also determined by price.  Current levels of price influence price expectations that in turn affect decisions that determine supply and demand.  However, the leads and lags are uncertain.  In the short run, real supply and demand matter much less than perceptions and beliefs.  However, in the longer run, fundamentals matter more although the long run itself consists of a series of short runs.

The paper will proceed by considering the various drivers in the short and long run. 

3.1 OIL DEMAND

Absent sudden economic collapse or prolonged severe weather, in the short run, oil demand is relatively stable.  This arises because of the nature of the three-stage decision to burn oil.  In the first stage the consumer must decide whether or not to buy the oil-burning appliance.  Consumers do not want oil products for themselves.  They actually want light heat and work.  To get these, useable energy must be converted into useful energy in an energy-burning appliance.  This can range from a car engine to a light bulb.  The second stage is to decide what sort of energy using appliance to buy.  The choices will relate sometimes to fuel depending upon the technological options and always to the efficiency with which the appliance converts useable to useful energy. The final stage concerns the decision over the capacity utilization of the appliance.  Here language is important.  Reducing capacity utilization to achieve more or less the same outcome can be called "conservation".  However, oil can really be saved by dramatic reductions in capacity utilization.  However, sitting in the cold and dark is "deprivation" not "conservation".  In the short run, once the first two stages are complete, the stock of oil using appliances is given. It can take quite some time to change the stock of these appliances.  Absent "deprivation" which is assumed to be undesirable, there is very little scope to change the amount of oil used.  Hence the relative stability of oil demand in the short run.

The significance of this relates to consumer governments predilection for imposing sales taxes on oil products.  For example, in Western Europe, in 1999, nearly 75 percent of the end user price of the product barrel was sales taxes.  The explanation is simply that oil products are a tax revenue collector's dream.  They have a very large tax base because of their widespread use.  The can bear very high tax rates because demand is unresponsive to price.  Finally, they are very cheap taxes to collect and difficult to avoid or evade. The politicians can then wrap up all this greed for revenue in green credentials.  There are growing signs that the EMEs are beginning to tread the same path as they desperately seek ways of raising revenue in a context where more sophisticated methods such as income or profits taxes faces serious barriers.  If they do continue to raise end user prices, this could have a dramatic impact on demand projections.

3.2 OIL SUPPLY

This argues that depletion of oil is not an issue.  Nor does it make any sense to talk about a fixed quantity of oil.  While price exceeds production costs, producers will invest to develop the resources and convert them into producing capacity.  If costs rise or prices fall or both and investment is no longer profitable, investment stops and the industry dies.  In the words of M.A.Adelman –"what is left is unknown, unknowable and completely uninteresting".  Signs of depletion would be rising costs and or rising prices.  As can be seen from figures 3 and 4 there are no signs of a rising trend of prices.  Furthermore, since the oil price collapse of 1986, the costs of producing oil have been falling dramatically.  A whole set of new technologies ranging from 3-4D seismic, new drilling techniques such as horizontal and small bore, sub-sea completion methods and many others have all combined to force costs ever lower.  In the battle between depletion and human ingenuity so far it has been a rout for depletion.

However, this should not encourage complacency.  Of key importance are the prospects for the investment needed to maintain or indeed increase capacity.  Without this there certainly could be short-term supply constraints resulting in price spikes.  The issue is the willingness to invest in capacity.  Figure 5 shows clearly that when excess capacity disappears, the system is vulnerable to price shocks.

The system is currently vulnerable as can be seen from figure 5.  The prospects for investment and hence future capacity development depend upon three factors –company cash flow, which determines capital availability, profit after tax, and finally opportunities to get access to acreage.

After-tax profits also have beneficial drivers.  First, there is the dramatic reduction in finding and developments costs already referred to.  Second, there are changes in the fiscal system that governs the take of the governments.  Over the years, these systems are becoming more progressive.  While of course this skims windfall profits, it also protects the company from the downside risks of lower prices.  The pain from lower prices is now taken more by the governments as the fiscal system becomes more progressive.  Hence even in a low price world, there is no reason why continued investment should not be forthcoming.

As for acreage opportunities, not since the 1950s have such opportunities been on offer.  This is in part due to technological developments that allow for much deeper offshore operations together with developments in the seismic assessment and drilling of salt dome formations.  The political changes of the 1980s and 1990s have also opened up huge areas for exploration and development.  While this has most obviously been in the former Soviet Union, there are ever growing areas being added to the list.  Most recently this has included the OPEC countries.

Of particular relevance is the situation with respect to the Gulf four –Iran, Iraq, Kuwait and Saudi Arabia.  Together these four account for 55 percent of world proven reserves and until recently have been off-limits for the international oil companies.  However, there is potential to change this.  Iran, Kuwait and Saudi Arabia have all started the process of opening to oil company investment although for the present in Saudi Arabia, the oil upstream is excluded.  The motives have differed.  Kuwait and Iran need the technology and the international links. Saudi Arabia needs the international links but also needs investment to create linkages within the economy to absorb growing problems of unemployment and a benchmark against which to judge the performance of their national oil company.  Iran also needs access to capital.  In all cases progress is slow since in each country there are significant barriers of an essentially political nature.  Again these differ.  In Iran it is part of the political infighting between the reformists and the conservatives.  In Kuwait it is tied into the issue of who rules –the family or the national assembly.  In Saudi Arabia it is concerned with opposition from the national oil company and some family infighting.

Between them they have created something of a logjam.  If one country is able to breakthrough the others are likely to follow.  The case of Iraq is somewhat different since access is denied by UN sanctions.  However, these restrictions could loosen.  There is growing pressure (rightly) to remove sanctions on humanitarian grounds.  Indeed there have been proposals in the UN from the UK to allow foreign company investment in return for some sort of weapons inspection regime.  Also it is worth remembering the old comment in 1972 that "only Nixon could go to China" i.e. his anti-communist credentials meant he could do so without fear of criticism.  In similar vein the same argument might be applied to the new Bush administration and sanctions against Iraq, especially an administration concerned over oil supplies and energy issues.  The opening of Iraq could also break the logjam in the other three countries if they saw it as threatening their ability to secure capital and technology.

Putting all this together suggests that over the next five to ten years at least, capacity to produce crude oil will be sufficient and there is likely to be a restoration of surplus capacity. 

3.3 OPEC COHESION

Another key variable in the equation to influence prices concerns OPEC cohesion.  OPEC, as the market controller, must be able to manage supply and keep excess capacity off the market.  This is a necessary requirement to maintain the very large element of rent in oil prices.  OPEC faces two broad problems –micro-managing the market in the face of severe information problems and cheating.

The information problems are of two types.  First, information upon supply, demand and inventories is extremely poor.  To be sure there are a great many bodies in the business of estimating the numbers, but these are subject to constant revision and periodically the issue of "missing barrels" emerges when the apparent changes in demand and supply fail to be reflected in the inventory data.  Hence trying to balance a market with such poor data is extremely difficult and there is a constant danger of under or over-shooting. 

Another dimension to the information problem is that many of the paper traders (and indeed others) are extremely ignorant of the industry and are liable to misread market signals.  A very good example was the ever higher prices experienced between January and November 2000. Paper traders drove this rise in price.  They saw historically low inventories as a sign of crude shortage.  While there were some localized potential shortages in the US these were due to problems with refining and transport infrastructure.  There were more plausible explanations for the "low" stocks.  First, as part of the drive to cut costs, the industry had been moving towards "just-in-time" inventory management.  Second, only primary stocks held in the OECD are measured.  Rumours of shortage encourage stocks to move from primary into secondary (wholesalers and retailers) and into tertiary holdings (final consumers).  Hence primary stocks fall but overall stocks remain unchanged.  Finally, the futures markets were in strong backwardation (prompt prices were higher than future prices).  Anyone wishing to lock in wet barrels for future use would be far better buying paper at a lower price than buying physical oil at a higher price and on top paying for expensive storage.  The "low" stocks of 2000 had little to do with crude shortage.  Not only did the paper traders misunderstand this, so too did the US Administration.  The result was Secretary of State for Energy Richardson trying to bully the oil producers to produce more.  They did so but with little effect on stocks for the reasons outlined above.  The result was prices continue to rise until it was suddenly realized in December that there was actually a large over supply of crude above ground.  The result was a $10 fall in oil prices in December.  Trying to micro-manage the market with such information problems is extremely difficult and likely to lead to growing price volatility.

The second problem facing OPEC is cheating.  While this has been a long-standing problem for OPEC, during 2000 it was not a problem.  Indeed many OPEC members were struggling to produce to quota.  However, the high prices of 2000 have led to a significant upturn in investment in new capacity and the cheating problem will return with the growth in excess capacity.  This invariably leads to squabbling and reduces OPEC's cohesion.  There is a widespread assumption that such squabbling takes OPEC to the brink but when they peer over the abyss, the consequences of their action leads them to mend fences and rally to the defence of price.  While there is historical precedence for this view, it cannot be viewed as an automatic consequence.  The last time disaster threatened was in January and February 1999.  However, the subsequent OPEC agreement in March 1999 that rescued the situation was only possible because of two political accidents coinciding.  The first was the accession to de facto power of Crown Prince Abdallah in Saudi Arabia whose policy objective of détente with Iran overrode oil policy considerations.  The second was the inauguration of Hugo Chavez as President in Venezuela, which made Venezuelan promises to abide by quota a reality rather than the laughing stock it had been for the previous five years.  Such coincidental accidents cannot be relied upon to rescue the situation in the future unless it is assumed that at heart God is an oilman.

Absent agreement, the default situation becomes the volume game. Something that was widely discussed in the Persian Gulf during the 1998-99 crisis.  This is when the large reserve low cost producers actually seek to maintain low prices for a considerable period.  The logic is that this is supposed to increase demand for oil and at the same time put higher cost producers out of business.  Thus the loss in unit revenue is eventually offset by higher volume.  Effectively rent is sacrificed to quantity.  The weakness with the strategy is the extent to which the producers can survive politically the period of lower revenue without suffering major political upheaval.

Issues of OPEC cohesion in the short to medium term carry great implications for price volatility while in the longer term it is the level of prices that is likely to be affected.

3.4 MARKETS

The final piece of the analysis to understand future oil prices is the nature of the market itself. 

An important unresolved issue is what the traders' bands of belief might now be.  Since the oil price collapse of 1998-99 it is not clear if the old $16-18 band is still valid or, if it is not, what range has replaced it.  The absence of any band is an invitation to ever-greater price volatility since there is no "norm" to pull the price away from extremes.

There is periodic talk that oil is too important in strategic terms to be left to the market and somehow governments must intervene.  This leads to periodic attempts at producer-consumer dialogue of the sort seen last November in Riyadh.  However, in general such exercises tend to become two monologues with interests so divergent as to make solution impossible.  Furthermore, trying to regulate speculative markets is impossible in a world where the virtual reality of the Internet allows unlimited and uncontrollable trade.  Undoubtedly there will be attempt to control and manipulate the market, not least from OPEC, but ultimately they will fail and the market will continue to generate oil price volatility and rent will be eroded.

4 CONCLUSIONS

There are huge uncertainties surrounding the future of oil prices in terms of their level, their volatility and their longer-term trend.  These arise because of the wide variety of technical, economic and political influences that drive prices.  The only thing to be said with confidence is that the future price path will be volatile.  That is not controversial.  However, this paper also concludes that the trend of oil prices will be downward back to the sorts of average levels seen in figure 3.  This view is more controversial.  However, those who argue otherwise must either do so based on the depletion argument, which has been pretty well discredited.  Or they must argue on the grounds that oil is different from other commodities.  This latter argument could still be made but for this author has yet to be done so convincingly.