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09/14/2000

OPEC Update

Last October I ran two pieces on OPEC for "Wall Street History"
and then this past January I had two "Hott Spotts" articles
dealing with the future of energy prices. The latter two make for
particularly interesting reading given the recent turmoil in the oil
market.

In doing some research for this update, I came across a telling
recent quote from Italian Prime Minister Amato.

"We, the industrialized nations, must face the fact that we acted
irresponsibly toward the oil producers. We complain now, but
we forget what we did to them. These are developing nations
that derive their income from oil. Yet we did nothing when oil
prices slumped to $10 a barrel last year. We must realize the era
of globalization means we have to deal with the energy problem
collectively and not see it as a game of winners and losers."

There is no doubt that the current oil shock is a threat to global
prosperity. And the seeds were sown in the decade of the 90s,
more specifically, 1998, when prices collapsed to $10 for a barrel
of crude. The developing world was spoiled as low crude
fueled the economic recovery after the twin financial shocks of
1997 and 1998.

But we didn''t take into consideration the tremendous harm done
to the economies of the major exporters; OPEC* as well as non-
OPEC nations like Russia and Mexico. Many of these are
developing nations with restive populations. Saudi Arabia, for
example, despite the stories of tremendous wealth, is now
running a huge budget deficit and is way behind on its
infrastructure projects. There is incredible poverty in this nation
and it''s ripe for an Islamic Fundamentalist-fueled revolt.

But the industrialized world didn''t care that cheap oil was
hurting others. We reveled in the surplus of crude...and ignored
our own energy infrastructure. So the current market turmoil
should come as no surprise.

A few pertinent facts:

--The world now consumes approximately 76 million barrels of
oil per day.
--OPEC produces about 29 million barrels, or 40% of the world''s
energy needs.
--The U.S. consumes 19 million barrels, and imports over 50%
(it could be as high as 60%).
--Europe imports some 75% of its oil.
--$35 per barrel is the highest price in a decade.
--Three-fourths of the worldwide growth in oil consumption
during the past decade came from outside the U.S.
--OPEC has initiated three production increases in 2000 totaling
over 3 million barrels.

As long as the world economy continues to grow, any oil that
comes on stream will be sopped up. But, as one can see from the
protests in Europe, if the price of crude were to stay at current
levels, economies worldwide would be the victims.

But let''s focus on the U.S. Thanks to the historically low prices
of 1997-98, the U.S. energy industry had no incentive to search
for new crude or natural gas. Oil company profits tanked and
layoffs were the rule. Actually, despite the hue and cry today
about "excess profits," between 1977 and 1999, net income in
the oil industry was only 9.7% of net investment, as opposed to
11.5% for all of American industry.

Further, from 1994 through 1998, oil company profits averaged
7.2%, or about half of the figure for the whole S&P 500. You
can see why $10 oil wasn''t exactly an enticement to explore for
more.

And at the same time, cheap oil discouraged the U.S. from
adopting effective energy conservation measures. America
became a nation of "big." From big gas-guzzling cars to
mammoth homes which gobbled up energy like there was no
tomorrow.

Couple this with the soaring demands of Silicon Valley, and its
brethren in the technology sector, and you also have a situation
where the demand for electricity is soaring.

Which brings us to the topic of natural gas. Because of
environmental concerns, nuclear power and coal have lost their
attraction. Instead, natural gas is the solution when it comes to
the generation of electric power as well as the needs of heavy
industry. For instance, 90-95% of the power plants to be built
over the next decade will run on natural gas. In addition, 90% of
the new houses in the U.S. are outfitted to use gas these days.

In the past, equity investors really didn''t have an incentive to
fund new gas development because of the low prices. So it
should be no surprise that production capacity fell 7% since
1997, setting up the crisis in this sector. But over the next two
years, new production will be brought on line.

OPEC is well aware that the good times for them won''t last
forever. They have stated publicly that ideally they would like to
see the price of crude in a $22-$28 range. $25 is the target.

There is amazing unity within OPEC these days. And after
suffering through the tough times, the revenue is flowing into the
coffers. OPEC producers will earn at least $250 billion this year,
up from $160 billion in ''99 and $116 billion in ''98. [Source:
Petroleum Finance Co.]

But while OPEC says it wants to cooperate, they are also sitting
back thinking, "Why the heck should we help these guys?" As
Prime Minister Amato said in the lead quote above, "We can
complain now, but we forget what we did to them."

OPEC is scared to death that if they continue to increase
production, eventually the price will collapse. And they don''t
just blame high prices on the supply / demand picture. OPEC
says, look at the bottlenecks in the refinery process and transport
restrictions. And they point out that there has been a certain
amount of speculation in the oil markets. But their best point has
to do with the issue of taxes. Taxes make up some 60% of the
cost of a gallon or liter of petrol within the 29 industrialized
nations that comprise the Organization for Economic
Cooperation and Development. [The average is about 70% in
Europe and 24% in the U.S.] Lower your taxes and you
wouldn''t see the domestic unrest that you currently have in
Europe, for example.

So what now? European governments are being forced to
address the tax issue. You can be sure that if governments give
in, they will find the revenue elsewhere. Each nation will treat
the crisis differently, with Britain''s Tony Blair vowing not to
give in to the protestors demands.

In the U.S., you can expect President Clinton to tap into our
strategic petroleum reserve of some 570 million barrels. It sets
an ugly precedent, especially because this is an election year.
But it wouldn''t be the first time that politics stood in the way of
good policy.

Simply put, we dug this hole and now we''re frantically trying to
dig ourselves out. Which is a good analogy since one of two
things is going to happen in terms of driving oil prices back to
earth (say, $25). Either $35 or higher oil will tip the global
economy into recession, or, the existing incentive to go out and
explore and develop new fields will lead to a situation where
supply will once again overwhelm demand and the price will
tumble.

The one wildcard in all of the scenarios is political instability.
And when you look at a list of the world''s leading oil producers
you can see that this is always going to be a distinct possibility.
The next time crude tumbles, for example, you know some
radical elements in nations such as Iran and Saudi Arabia will not
be very happy. The West has done them no favors in the past.

*OPEC: Algeria, Indonesia, Iran, Iraq (under sanctions),
Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, UAE, and
Venezuela.

Note: Just an interesting sidelight. According to energy maven
Daniel Yergin, revenue for natural gas producers in North
America is expected to increase about $25 billion in 2000. That
$25 billion is more than the total revenue of Cisco, Amazon,
Nextel and eBay combined.

Sources:

Various, including Paul Raeburn / Business Week, William
Drozdick / Washington Post, Neela Banerjee / New York Times,
Robert Mosbacher.

Brian Trumbore


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-09/14/2000-      
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Hot Spots

09/14/2000

OPEC Update

Last October I ran two pieces on OPEC for "Wall Street History"
and then this past January I had two "Hott Spotts" articles
dealing with the future of energy prices. The latter two make for
particularly interesting reading given the recent turmoil in the oil
market.

In doing some research for this update, I came across a telling
recent quote from Italian Prime Minister Amato.

"We, the industrialized nations, must face the fact that we acted
irresponsibly toward the oil producers. We complain now, but
we forget what we did to them. These are developing nations
that derive their income from oil. Yet we did nothing when oil
prices slumped to $10 a barrel last year. We must realize the era
of globalization means we have to deal with the energy problem
collectively and not see it as a game of winners and losers."

There is no doubt that the current oil shock is a threat to global
prosperity. And the seeds were sown in the decade of the 90s,
more specifically, 1998, when prices collapsed to $10 for a barrel
of crude. The developing world was spoiled as low crude
fueled the economic recovery after the twin financial shocks of
1997 and 1998.

But we didn''t take into consideration the tremendous harm done
to the economies of the major exporters; OPEC* as well as non-
OPEC nations like Russia and Mexico. Many of these are
developing nations with restive populations. Saudi Arabia, for
example, despite the stories of tremendous wealth, is now
running a huge budget deficit and is way behind on its
infrastructure projects. There is incredible poverty in this nation
and it''s ripe for an Islamic Fundamentalist-fueled revolt.

But the industrialized world didn''t care that cheap oil was
hurting others. We reveled in the surplus of crude...and ignored
our own energy infrastructure. So the current market turmoil
should come as no surprise.

A few pertinent facts:

--The world now consumes approximately 76 million barrels of
oil per day.
--OPEC produces about 29 million barrels, or 40% of the world''s
energy needs.
--The U.S. consumes 19 million barrels, and imports over 50%
(it could be as high as 60%).
--Europe imports some 75% of its oil.
--$35 per barrel is the highest price in a decade.
--Three-fourths of the worldwide growth in oil consumption
during the past decade came from outside the U.S.
--OPEC has initiated three production increases in 2000 totaling
over 3 million barrels.

As long as the world economy continues to grow, any oil that
comes on stream will be sopped up. But, as one can see from the
protests in Europe, if the price of crude were to stay at current
levels, economies worldwide would be the victims.

But let''s focus on the U.S. Thanks to the historically low prices
of 1997-98, the U.S. energy industry had no incentive to search
for new crude or natural gas. Oil company profits tanked and
layoffs were the rule. Actually, despite the hue and cry today
about "excess profits," between 1977 and 1999, net income in
the oil industry was only 9.7% of net investment, as opposed to
11.5% for all of American industry.

Further, from 1994 through 1998, oil company profits averaged
7.2%, or about half of the figure for the whole S&P 500. You
can see why $10 oil wasn''t exactly an enticement to explore for
more.

And at the same time, cheap oil discouraged the U.S. from
adopting effective energy conservation measures. America
became a nation of "big." From big gas-guzzling cars to
mammoth homes which gobbled up energy like there was no
tomorrow.

Couple this with the soaring demands of Silicon Valley, and its
brethren in the technology sector, and you also have a situation
where the demand for electricity is soaring.

Which brings us to the topic of natural gas. Because of
environmental concerns, nuclear power and coal have lost their
attraction. Instead, natural gas is the solution when it comes to
the generation of electric power as well as the needs of heavy
industry. For instance, 90-95% of the power plants to be built
over the next decade will run on natural gas. In addition, 90% of
the new houses in the U.S. are outfitted to use gas these days.

In the past, equity investors really didn''t have an incentive to
fund new gas development because of the low prices. So it
should be no surprise that production capacity fell 7% since
1997, setting up the crisis in this sector. But over the next two
years, new production will be brought on line.

OPEC is well aware that the good times for them won''t last
forever. They have stated publicly that ideally they would like to
see the price of crude in a $22-$28 range. $25 is the target.

There is amazing unity within OPEC these days. And after
suffering through the tough times, the revenue is flowing into the
coffers. OPEC producers will earn at least $250 billion this year,
up from $160 billion in ''99 and $116 billion in ''98. [Source:
Petroleum Finance Co.]

But while OPEC says it wants to cooperate, they are also sitting
back thinking, "Why the heck should we help these guys?" As
Prime Minister Amato said in the lead quote above, "We can
complain now, but we forget what we did to them."

OPEC is scared to death that if they continue to increase
production, eventually the price will collapse. And they don''t
just blame high prices on the supply / demand picture. OPEC
says, look at the bottlenecks in the refinery process and transport
restrictions. And they point out that there has been a certain
amount of speculation in the oil markets. But their best point has
to do with the issue of taxes. Taxes make up some 60% of the
cost of a gallon or liter of petrol within the 29 industrialized
nations that comprise the Organization for Economic
Cooperation and Development. [The average is about 70% in
Europe and 24% in the U.S.] Lower your taxes and you
wouldn''t see the domestic unrest that you currently have in
Europe, for example.

So what now? European governments are being forced to
address the tax issue. You can be sure that if governments give
in, they will find the revenue elsewhere. Each nation will treat
the crisis differently, with Britain''s Tony Blair vowing not to
give in to the protestors demands.

In the U.S., you can expect President Clinton to tap into our
strategic petroleum reserve of some 570 million barrels. It sets
an ugly precedent, especially because this is an election year.
But it wouldn''t be the first time that politics stood in the way of
good policy.

Simply put, we dug this hole and now we''re frantically trying to
dig ourselves out. Which is a good analogy since one of two
things is going to happen in terms of driving oil prices back to
earth (say, $25). Either $35 or higher oil will tip the global
economy into recession, or, the existing incentive to go out and
explore and develop new fields will lead to a situation where
supply will once again overwhelm demand and the price will
tumble.

The one wildcard in all of the scenarios is political instability.
And when you look at a list of the world''s leading oil producers
you can see that this is always going to be a distinct possibility.
The next time crude tumbles, for example, you know some
radical elements in nations such as Iran and Saudi Arabia will not
be very happy. The West has done them no favors in the past.

*OPEC: Algeria, Indonesia, Iran, Iraq (under sanctions),
Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, UAE, and
Venezuela.

Note: Just an interesting sidelight. According to energy maven
Daniel Yergin, revenue for natural gas producers in North
America is expected to increase about $25 billion in 2000. That
$25 billion is more than the total revenue of Cisco, Amazon,
Nextel and eBay combined.

Sources:

Various, including Paul Raeburn / Business Week, William
Drozdick / Washington Post, Neela Banerjee / New York Times,
Robert Mosbacher.

Brian Trumbore