Statement of Constantine D. Fliakos, Managing Director
Securities Research Division, Merill Lynch & Co.
Testimony Before the Subcommittee on Oversight,
of the House Committee on Ways and Means
Hearing on the Incentives for Domestic Oil and Gas Production and Status of the Industry
February 25, 1999
Excessive Inventories Have Been The Cause Of The Oil Price Collapse
Oil, like any other commodity, can exhibit wide inventory swings influenced by near-term factors?including weather, economic conditions, political developments and miss-judgements by both the oil companies and governments. We have witnessed a major shift in inventories from very low levels in 1996 to adequate in 1997 and to excessive levels in 1998. Inventories remain very high today.
The factors that contributed to the low level of inventories in 1996 included ?just-in-time? inventory management by the oil industry; the absence of Iraqi oil exports; and unusually cold weather during the winter of 1995/1996.
Following delays throughout 1996, the UN and Iraq finally agreed on a plan of limited oil sales for humanitarian purposes and oil exports began in December of 1996. Oil exports from Iraq coincided with a fairly mild winter throughout the Northern Hemisphere in the winter of 1996/1997. Those factors contributed to the replenishment of inventories to normal levels at the end of 1997 from very low levels in the beginning of 1997.
As we headed into 1998, there were clear signs that inventories would become excessive. And yet OPEC agreed to increase production when it met in November of 1997 resulting in higher output by Saudi Arabia, Kuwait and the United Arab Emirates in the beginning of 1998.
In the meantime, the economic slowdown in the Far East and another unusually mild winter lowered the growth in oil demand substantially in 1998. Iraqi oil exports also expanded in 1998 because of an increase in the ?oil-for-food? program. All these factors converged to raise inventories to very high levels in 1998.
The oil price extremes we experienced in the last two and a half years have been caused by the extreme changes in inventories. Unusually low inventories in 1996 drove oil prices sharply higher?they reached more than $26 a barrel in the beginning of 1997. Excessive inventories caused oil prices to collapse to the low teens in the beginning of 1998?which is where we are today.
The only way the oil price slide could have been reversed within a relatively short period was to curb oil production. OPEC, in cooperation with some non-OPEC countries, agreed, in fact, to curtail production last year and reductions of more than 2.0 million barrels a day were implemented since the middle of 1998.
The production cuts occurred, however, at a time when market conditions were deteriorating rapidly. In addition to weakened oil demand, production and exports rose very substantially in Iraq. The output restrictions by oil producing countries proved to be inadequate to reduce excessive inventories.
Complacency Is Unjustified . . .We Should Be Concerned
Despite low oil prices there is considerable complacency about the outlook. The widespread belief seems to be that oil supplies will remain abundant, and oil prices will, therefore, remain weak for a long time.
When oil prices were strong in 1996 and in early 1997, the inclination was to argue that oil prices would never again fall to low levels because there was presumably a secular tightness. Now we are told we are entering a period of secular weakness.
Today's complacency is, in my judgment, unjustified and dangerous. Unless the current trend is reversed soon, we may be heading inexorably toward another energy crisis sometime in the next five years.
The oil situation today is, I believe, quite different than it was in the mid-1980s--the last time we experienced a major collapse in oil prices.
Leading up to the price collapse of the mid-1980s, the oil industry was in a major secular decline. Oil demand was declining; OPEC's share of total supplies fell sharply; Saudi Arabia's oil production fell to unsustainably low levels; and surplus production capacity amounted to nearly 25% of demand and was clearly excessive. The secular weakness was the main underlying cause for the 1986 oil price collapse, and the collapse was unavoidable.
As I indicated earlier, the recent oil price collapse was caused by excessive inventories rather than by a secular weakness. The price collapse was, in fact, avoidable.
Despite abundant inventories and very low oil prices, the underlying conditions in the oil business are much tighter now than they were in the 1980s--and they are likely to get even tighter--and should be cause for considerable concern.
Because of growing demand, surplus production capacity globally has been limited to about 5% of total demand during most of the 1990s and is now 7-8% of demand despite the cutbacks that have been implemented by oil producing countries. This is in contrast to the mid-1980s when surplus capacity, as I mentioned earlier, amounted to nearly 25% of demand.
Once the economic problems are solved around the world, global oil demand should begin to grow once again by 2.5% a year which will be equivalent to about 2.0 million barrels a day of incremental demand each year.
I expect that supply sources outside of OPEC will be able to satisfy only a small portion of the projected growth in demand. In fact, one of the most devastating consequences of low oil prices will be the very negative impact that they are likely to have on non-OPEC supplies. Low oil prices has already led to the shutdown of some high-cost production--and the shutdown is likely to be permanent. Moreover, sharply low levels of capital spending will curtail the development of new supplies as well.
We will have to depend more and more, therefore, on OPEC supplies in order to satisfy growth demand. But even within OPEC, capacities may erode because the budgets of producing countries are strained and not enough money is being spent to maintain let alone to increase capacities.
The amount of surplus oil capacity is limited and could become even more limited if oil prices remain low for a while longer. It is a disquieting phenomenon for a commodity such as oil that is so susceptible to supply disruptions that can result from political and social upheaval, as well as accidents.
Timely Adjustments Are Difficult To Achieve In The Oil Business
Because of the idiosyncrasies of the oil industry, it is almost impossible to ensure a continuing flow of oil supplies at reasonable prices by relying exclusively on conventional, market-related adjustment processes.
An important characteristic of the oil business is the geological fact that a major portion of the world's low-cost oil supplies are located in parts of the world that tend to be politically vulnerable. The "economic" cost of those supplies is indeed low but their "political"> or "national security" cost can be quite high. Any adjustment process must, therefore, take into account the large discrepancy that can exist between economic and political costs if resources are to be allocated optimally from both an economic as well as a political perspective.
Another important aspect of the oil business is the long lead-times entailed in the capital investment process--from the planning of capital prospects to their implementation and their ultimate commissioning.
Because of the long lead times, supply and demand adjustments in response to signals given in the marketplace through the price mechanism are not instantaneous. Adjustments ultimately do occur, of course, but in the meantime there can be severe dislocations that may be unacceptable for a commodity that is so essential for our nation and the world's economic well being.
Another way to view this dilemma is to point to the divergence that sometimes exists in the price of oil--as it does today--from a near-term versus a longer-term perspective. The near-term price of oil can be depressed, as it is today, because of the influence of temporary factors. In the longer-term, the price needs to be high enough to ensure continuing the availability of supplies at reasonable prices.
The dilemma that stems from a possible divergence between the price of oil in the short-run and the appropriate price in the long-run is exacerbated by the changes that have occurred in the attitudes of the managements of the major oil companies as they try to be more responsive than they have been in the past to the near-term demands of the financial markets.
It is fair to say, I believe, that in trying to reconcile immediate financial performance with longer-term growth considerations the pendulum has probably tilted in the oil industry--as is probably the case for "Corporate America" generally--in favor of immediate financial performance.
The immediate response to lower oil prices, therefore, tends to be to retrench, to restructure and to curtail capital spending in order to protect profits. For some companies, of course, particularly the smaller ones, retrenchment is a necessity dictated by cash flow considerations and by the need to survive financially.
The inevitable consequence of such retrenchment is lower future growth--and in the oil business, in particular, it means lower oil supplies in the future.
If oil prices were to recover, the industry will no doubt accelerate capital spending and will focus on growth once again. But the adjustment is likely to be slow. And in the meantime, the consequences for our nation and the world could be quite severe because we are so dependent on supplies that are susceptible to politically induced supply interruptions.
Today's low oil prices are no doubt contributing to today's unprecedented economic prosperity by keeping inflation low. Unfortunately, however, we may have to pay a high price in the future for the benefits we are enjoying today.