In a decade, Russia, together with the adjacent former members of the Soviet Union, will probably be the only region outside the Middle East with a reasonably large exportable surplus of oil. I say ‘Probably’ for two reasons. First, some surprises may eventually turn up in the interior or offshore districts of Africa and South America, although a question must be raised as to whether they are the kind of surprises that we might be desperately in need of at that time. There is also this matter of exactly how that Russian surplus may develop.
Russia is now the second largest oil exporter after Saudi Arabia. One difference between the two countries is that production in Saudi Arabia may not have peaked as yet, while for all practical purposes a peak arrived in the Russian (i.e. the Soviet Union) output at a level close to thirteen million barrels per day (= 13 mb/d) about 1990. It could happen of course that production in the former Soviet Union (FSU) could spike above this level, however I don’t believe that any great significance should be applied to an event of this nature should it occur. A similarity however is that important observers in both countries have announced production goals that are almost certainly out of reach, and with this in mind, I have decided to reemphasize that estimates by the International Energy Agency (IEA) and United States Department of Energy (USDE) of a global supply of 120 mb/d of oil in 2030 are also virtually impossible to attain – assuming that the movers-and-shakers in these two countries have things like profit maximization and the overall welfare of their citizens in mind.
The oil minister of Saudi Arabia once said that his country could raise output to 15 mb/d, and keep it there indefinitely. The problem here is that at no point in the past 33 years have the decision makers in that country indicated that Saudi production would exceed 12 mb/d, although recently someone somewhere alluded to a production of 12.5 mb/d by the end of 2009. If it were technically and economically conceivable, it might certainly be true that Saudi Arabia would like to make a marginally larger contribution to averting an oil price explosion, because the present global oil price scene is close to wish fulfilment for many of the OPEC countries, and it is not in their interest to disturb this equilibrium – if it is an equilibrium – in order to make the dreams of amateur energy experts in their customer countries come true.
A year or so ago the leading oil economist in Russia published a note in the important review PetrominAsia in which he stated that oil production in his country could reach 30 mb/d. Unlike Mr Oil Minister, he did not provide an estimate of how long this bonanza could be maintained, although it hardly makes a difference. Output in the FSU is not going to come anywhere near 30 mb/d, just as a production in present day Russia of more than 10 mb/d could hardly be sustained for more than a few years. The large oil firms outside Russia are perfectly aware of this fact, and as a result they are not prepared to invest billions and billions in that country in order to pursue this mirage.
An interesting observation here might be that there are almost certainly a large number of highly profitable projects that could and will be made in Russia over the coming decade, and these will be greatly appreciated by managers and equity owners in the investing enterprises, but in terms of size these ventures should probably be described as modest, and will not even partially mitigate the all-inclusive requirements of the main oil importing countries. More important, although conveniently forgotten by most researchers, about the time I published my oil book (1980), the CIA was predicting that Russia was on its way to becoming an oil importer. The assumption then was that the Russian economy would eventually be patched up to an extent where it could attain a standard of living about on the level of Italy. This did not happen, but whether it happens or not at some point in the future, some question must be put as to whether energy rich Russia would find itself reduced to buying large quantities of expensive foreign oil.
Before continuing with the main topic, I would like to add a short comment to the previous discussion. Global oil consumption is about 85 mb/d, but practically the only spare production capacity is in OPEC countries, and altogether may amount to about 2 mb/d. Saudi Arabia has most of this, and a total production of almost 10 mb/d. These numbers suggest that at best there is only a small margin available in the oil exporting countries with which to counter a drastic supply disruption, which is probably why Daniel Yergin has said that the world is experiencing a slow-motion oil price shock. This is not a good thing, although it’s better than the alternative, which with a high probability would include an ugly macroeconomic and/or financial market adjustment.
A BEAUTIFUL MYTH
The oil story in every country has certain similarities. Finding oil, and then exposing it to the right kind of management and technology. The “right” management, of course, is eminently capable of locating the right employees and any finance that might be necessary. As Rhett Butler told Scarlet O’Hara in ‘Gone with the Wind’, there are few things in this old world of ours that money will not buy, and at present prices oil discovered in the most primitive countries imaginable can easily be brought to the surface, and without too much trouble can be dispatched to the far corners of the globe.
That brings us to a beautiful myth: Russia is desperately in need of outside assistance to enable it to realize its oil production potential. I first commented on this in my oil book, and my thinking went as follows: “That the Soviet oil industry is in trouble is well known, but various sectors of the Soviet economy are always in trouble. The point is that time and time again the Soviets have shown that when they concentrate their efforts, they have a remarkable capacity to break bottlenecks and get results. The quantity and quality of Soviet military hardware should make this abundantly clear”. Here I was thinking in particular of the quantity and quality of the hardware in what was then East Germany, and which definitely matched the assets at our disposal in the Western part of that country. On the basis of what we knew about their training, the same was almost certainly true of their infantry and armour personnel.
Two Russian gentlemen who are not buying any of this are Vladimir Kvint, who was/is a frequent contributor to one of the best business publications in the world, Forbes, and Vladimir Milov, president of the Institute of Energy Policy in Moscow. Writing in l990, Mr Kvint informed us that “If the capital and expertise of companies like Exxon, Shell and BP could be turned loose on the region (East Siberia), there is no telling how high production could go.” Maybe he couldn’t tell, nor could I at that time, since the Soviet empire was imploding, but I am very definitely capable of carrying out that assignment today. It won’t go much higher than when he was vigorously trying to peddle this bizarre misunderstanding to his admirers in the financial districts of London and New York.
The second Vladimir wants no less than a repudiation of the “desire” to limit foreign investments in Russia’s energy sector. To his way of thinking “we need strategic foreign investors in Russia to ensure development of our new oil and gas fields.” The truth happens to be that just as these investors are not wanted by the Russian government, they are not needed. President Putin has openly and explicitly called for a limitation of foreign investment in what he calls “strategic sectors” of the economy, because he understands that foreign investors do not necessarily have the best interests of ordinary Russians at heart; and if he doesn’t understand this, a majority of his countrymen may choose to inform him or his successor in very crude language some day. As bad luck would have it, the television audiences in Sweden and America are a bit vague on this topic, but it may happen that future events will bring them to their senses.
At the same time that he doesn’t want foreigners tooling about in Siberia and elsewhere in his country, Mr Putin has expressed an interest in equity positions in foreign enterprises in Western Europe. To obtain this, he apparently is prepared to use the oil weapon – i.e. to say, reduce the availability of oil to large importers of Russian oil. There are probably some illusions of grandeur which led him to take this position, because in a rational world he would discern that there is a tremendous amount of work that needs to be done within the boundaries of his own realm, and it is unlikely that this would be expedited by giving some of his best Russian managerial talent the opportunity to purchase their electronics and underwear at the more exclusive outlets in London or Paris.
Since Russia is the largest country in the world, it is easy to perpetuate the delusion that enormous amounts of exploitable oil and gas will be located in the not too distant future, particularly in Eastern Siberia or the Barents Sea. Observe: “enormous” as compared to merely large! This is the kind of eccentric idea that Professors Peter Odell and Paul Stevens have attempted to foist on the unwary for years, despite the fact that they know – or should know – that in the executive suites of the oil majors mentioned by Kvint, contrary beliefs have been in circulation for a number of years. If we look at North America, for instance, we see that the best technology in the world never uncovered any super giant deposits of conventional oil in Canada, which is a country about as large as Eastern Siberia; nor has it been able to reverse the U.S. peak, although almost all of the oil produced in that country in the last century has been extracted from only a miniscule portion of the total surface area of the lower ’48 and Alaska.
Milov also wants “Moscow” to repudiate what he calls the “gas supply blackmail” now being practiced by his government. He could have called it the “oil supply blackmail”, given the direction in which a new large Russian oil pipeline will ostensibly run: a 1.6 mb/d installation from the Irkutsk region to somewhere on the Pacific coast opposite Japan. However let me emphasize that while that scholar may call it “blackmail”, in the MBA lectures at Harvard and Stanford it’s called business, and what it amounts to is making it clear to potential customers that if they can’t match the offers of other buyers, they will have to obtain their requirements elsewhere.
According to the chief of the Russian pipeline ‘Transneft’, Russia should cut supplies to “overfed” Europe, because according to him “economics manuals” clearly indicate that “excessive supplies depress prices”. Low oil prices apparently have no place in his latest 5-year plan. The part about supply and demand is correct, but unfortunately he and his colleagues should have examined the Russian equivalent of Econ 101 in the late l990s. According to the kind of reasoning in that and similar volumes, he might have been able to deduce the theoretically correct conclusion that his country was producing too much oil. Not only would a higher price have provided Russia with a larger export income, but it would have sent a valuable signal to oil users that there was probably less of that commodity in the surface of the earth than they were being led to believe.
With all due respect, I think that it might be an excellent idea if our political masters and their advisors attempt to understand exactly what Russia and adjacent states will or will not be able to offer when or if oil demand suddenly lunges ahead of oil supply, and the gap might have to be closed by some traumatic price escalations. What I do not suggest though is that extra attention should be given a recent “Special Report” on oil in the Economist (April 22, 2006). Among other things this half-baked contribution contains a quote by the “boss” of a prominent consultancy, who tells his clients not to worry because e.g. “Kuwait has 50 years of production left at current rates”. He apparently is still blissfully oblivious of the widely known fact that almost every intelligent person with other than a superficial interest in oil realizes that the crucial issue is identifying when the production of a country like Kuwait peaks. At the current output, that will be well under 50 years, and it will not be good news for the oil-importing world.
More important for any neophyte “masters of the universe” reading the present discussion, that overrated compendium of London wine bar gossip also quoted Professor Kenneth Rogoff of Harvard University – formerly chief economist of the International Monetary Fund (IMF) – who calls our attention to “long-dated futures going out five to seven years”, which therefore might make it possible to lock in present oil prices until 2012 or thereabouts. In making this ridiculous claim he is more optimistic than Professor Henrik Houthakker of the same institution, who some years ago cited oil futures with maturities of three years as being available to hedge price risk, and at the same time referred to options.
In dealing with this kind of bunkum, think about what it means to be on the short side of a futures transaction when talk is in the air about the likelihood of the oil price rising from its present $74/b to between $90/b and $100/b dollars, and more alarming the Houston investment banker Matt Simmons is openly predicting an oil price of several hundred dollars a barrel in a few years. If the price zoomed up, margin calls on short positions could be ruinous. By the same token, long hedgers would be facing intolerably high premiums, regardless of what the actual price turned out to be. Here it should be appreciated that liquidity shortages in a long-dated market of the kind posited by Rogoff could severely punish transactors who succeeded in opening a position anywhere in the vicinity of the putative maturity. Something else to focus on is that in reality it would be difficult to find a long-dated contract that ‘went out’ more than 5 to 7 months, if that. I can note that in New York, 1,420,734 futures contracts were traded in one day in the middle of April 2006, thereby exceeding the previous record of 1,383,616. There was a great deal of nervousness behind these figures, and average maturities were probably in weeks rather than months.
Part 2 of this article will be published tomorrow on EnergyPulse.