Middle East Economic Survey
VOL. XLVII
No 38
The Investment Challenge For Oil Producing Countries*
By Bassam Fattouh
The following article was written for MEES by Dr Fattouh, Lecturer in Financial Studies, Department for Financial and Management Studies, School of Oriental and African Studies, University of London.
1. Introduction
Until very recently, there were serious doubts about OPEC’s ability to cut production and maintain oil prices within the $22-28/B price band. In 1998, crude oil prices plummeted to very low levels in face of OPEC high production and decline in Asian demand in the aftermath of the East Asian financial crisis. In early 1999, the crude oil price slipped towards $10/B. Although crude oil prices shot up in late 1999 and 2000, they fell again in 2001 caused mainly by the US economic recession. Then, the 11 September 2001 terrorist attacks took place driving oil prices down amidst fears of worldwide economic downturn.
This period saw the emergence of one of the greatest misconceptions in the oil debate. This misconception, which was articulated in The Economist in March 1999, predicted a world “drowning in oil” and a future with very low oil prices: “The crude is gushing from the ground at the rate of 66mn b/d, half as copiously again as in OPEC's prime. The world is awash with the stuff, and it is likely to remain so.”1 In face of such ‘oil demand pessimism’, any plans to increase investment in upstream oil production and refining capacity would have seemed mad.
The oil scene has changed in the last two years. In 2003, oil prices witnessed sharp rises which continued throughout the second quarter of 2004. In August 2004, the US spot prices for crude oil rose to historic highs (in nominal terms) of more than $47/B. Nowadays, rather than talking about a world ‘drowned in oil’ and cheap oil, markets are concerned with spiraling prices and OPEC’s ability to meet the fast growing global oil demand. According to the US Department of Energy's 2004 International Energy Outlook (IEO2004), world oil consumption is projected to increase from 77mn b/d in 2001 to 121mn b/d in 2025, an average annual increase of 1.9%.2 Much of the increase in oil demand is projected to occur in the US and in developing Asia, mainly China. Oil demand pessimism has been replaced by oil demand optimism.
The current spike in oil prices highlighted the risks of a global spare capacity that is small relative to global demand. In its latest Short Term Energy Outlook, the EIA estimates that the current surplus capacity stands at its lowest point in the past three decades.3 In such circumstances, any small disruption in oil supplies due to clashes in Iraq or possible freezing of the Russian oil giant Yukos’ assets can send oil prices to very high levels. Tight market conditions have also attracted the attention of speculators especially hedge funds who are betting that prices will go up further. Traders are nervous about severe disruptions of oil supplies that can arise from possible attacks on oil infrastructure in Saudi Arabia, Iraq and elsewhere in the Middle East. Traders are also doubtful about OPEC’s ability to meet future global demand as markets realize the helplessness of OPEC in a very tight market and hence becoming bullish on oil prices.
What is less known though is that a dwindling spare capacity also hurts the position of OPEC, especially the role of Saudi Arabia as the world’s swing producer.4 When OPEC’s spare capacity is low relative to global demand, OPEC can no longer influence oil prices when they are rising to high levels, a situation which OPEC core producer Saudi Arabia has consistently declared that it is uncomfortable with. Recent events highlight this fact. In recent months, Saudi Arabia has gone to unusual length to provide assurances to markets and analysts that it can increase production to meet growing global demand. These assurances however have not been able to calm oil markets as doubts about spare capacity remain rife. Thus, to be able to affect prices on the upside, OPEC core producers do not only face the challenge of managing existing spare capacity – which is difficult in itself – but also face the challenge of expanding their spare capacity such that a reasonable cushion is always maintained.5 Without this cushion, OPEC’s dominant position in the global oil market will be considerably weakened.
Fears of possible oil shortages have placed the issue of investment in upstream oil at the top of the policy agenda. Calls for OPEC and non-OPEC countries and international oil companies to increase their production capacity are nowadays heard all over the world, with some observers blaming the current decline of capacity to long periods of under-investment. According to the US Department of Energy's 2004 International Energy Outlook, the projected increment in worldwide oil use would require an increment to world productive capacity of more than 44mn b/d over current levels. Although OPEC producers are expected to be the major suppliers of increased production requirements in the long term, non-OPEC supply is expected to remain competitive in the short to medium term, with major increments in supply coming from offshore resources, especially in the Gulf of Mexico, Latin America, and deepwater West Africa.
2. Investment in upstream oil production
The investment behavior of the oil industry and its structure remain poorly understood. The dominant underlying model for analyzing investment is a frictionless one where investment decisions are taken in a world with complete information and where lags between planning, investment and production are assumed away. This underlying frictionless model forms the basis of many analysts’ calls to increase investment in oil production to relieve the current tightness of the market. It also forms the basis as to what many observers consider a puzzle: despite robust oil prices in the past few years, why have so many oil producing countries and international oil companies been hesitant to increase their investments in oil production?
The reality of the oil industry is very far from this frictionless world. OPEC’s existing spare capacity is not the outcome of an investment plan but the result of historical developments in the 1970s. Nowadays, the challenge for oil producing countries and in particular OPEC is to plan both the timing and the size of a new capacity such that a reasonable spare capacity is maintained but not to over-expand so prices fall sharply. Planning such a capacity however is not straightforward as the proponents of the frictionless world want us to believe. The oil market is driven by its own logistics, by the lags between planning investment and production, by incomplete information and ambiguous signals, by its capital intensity and by political and historical developments. These factors and the interaction between them imply a very complex investment decision making process which may produce suboptimal results. The failure to take this into account will not only misguide our understanding of past investment decisions which produced the current oil market structure, but will also affect our assessment of future patterns of investments in oil production.
To understand how the structure and the logistics of the oil industry influence the investment decision regarding oil production, it is useful to highlight the following observations. First, the so called under-investment problem does not only apply to crude oil production but is more general to include shortages of refining capacity, pipeline systems and storage facilities. This has an important implication. No matter how high OPEC or non-OPEC oil production goes, bottlenecks in refining capacity and pipelines means that higher crude oil production will not necessarily translate into higher volumes of petroleum products which consumers want. Since OPEC has little control about the global oil logistics systems, a close coordination of investment plans is required between oil consuming countries and oil producing countries to address the bottlenecks in the oil industry in order for increased oil production to reach ultimate consumers.
Second, the current bottlenecks and low spare capacity should not be viewed as the product of inefficiencies and irrational decision by oil producing countries to under-invest in the oil sector. They have been to a large extent determined by developments in the oil markets during the 1980s and mid 1990s. In the early 1980s, OPEC countries developed huge surplus capacity estimated at around 14mn b/d. In face of such huge surplus capacity, the incentive for OPEC to invest in oil production simply was not there. However, oil producing countries outside the OPEC lacked such spare capacity and thus continued to increase investment in oil production to meet global oil demand. What is not well recognized is that during the mid-1980s, the oil market reached a turning point in which demand for OPEC oil slowly started to increase. As a consequence, OPEC’s spare capacity began to diminish. The persistent decline in the amount of available surplus capacity should have given rise to a realization that the continuing downward trend will eventually eliminate the capacity cushion. Investment to increase the volume of surplus capacity was required early on to avoid this situation. The question is: why did not this investment materialize? Many factors explain the failure to invest. One of them was widespread demand pessimism. The growth of global oil demand was consistently underestimated particularly by the IEA and was expected to be met by non OPEC oil producers. And as demand pessimism was associated with exaggerated expectations about non-OPEC output, the incentive for OPEC to invest to increase spare capacity was not there. Thus the decision not to invest in upstream oil can be understood in the context of the following paradox raised by Robert Mabro: “The West wants surplus capacity to be provided by OPEC but expects demand increases to be met by non-OPEC.”
This trend of oil demand pessimism continued until very recently. Furthermore, the 1998 and early 1999 price collapse threw the industry into a deep recession and reduced the incentive to invest and the attractiveness of existing investment plans. Thus, the current bottlenecks in oil production, refining capacity and pipelines systems which reduced the flexibility of the system are in large part due to past history of low oil prices, long periods of oil demand pessimism and poor financial returns on capital employed which created an environment that is not conducive to investment in upstream oil.6 This applies both to oil producing countries and international oil companies which in recent years have also considerably reduced their investments in upstream oil exploration and production.
Third, in the last five years or so, oil prices have been highly volatile and unpredictable. As suggested in the literature of irreversible investment under uncertainty, this had the effect of increasing the value of delaying investment until new information about market conditions arrive, especially information about expected global demand and oil supplies from other countries.7 After all, the decision to wait and not to increase production is much more profitable than to invest and increase production in face of falling demand. In other words, it is more profitable for oil executives and OPEC to err on the side of under-producing as opposed to over-producing. To be sure, investment in upstream oil production will ultimately materialize. What is of importance also is the timing of investment and the market conditions at the time the investment materializes.
The difficulty of forecasting quantities for the oil industry has contributed to higher uncertainty. Historically, the various international agencies have made poor predictions regarding future demand and supply conditions. In analyzing this issue, Paul Horsnell finds that over the period 2001 and 2002 alone, the various forecasts overestimated global oil supply by 1mnb/d and underestimated global oil demand by 2mn b/d ie a combined swing of 3mn b/d for year 2003. This was equivalent “to finding out, with no notice at all, that the world needed the oil production of another Norway.”8 In this particular case, the gap was met by OPEC’s spare capacity. Poor predictions however can easily work in the opposite direction ie agencies can overestimate the quantity of global oil demand and underestimate the global oil supply. In such a case, an investment decision based on such predictions will look very foolish later on. Such flips in oil gap predictions increase the degree of uncertainty and reduce their value in formulating investment decisions. This problem of poor prediction is amplified by the fact that any investment should not only look at incremental demand and its sources, but also should look at maintaining existing capacity determined by the natural decline of oil fields. Paul Horsnell claims that “if we are to make major mistakes in assessing the need for more capacity, it is more likely to come from misjudging the rate of depreciation of capital in energy rather than imputing incorrect energy demand growth.”9
Finally, geopolitics can also prevent capacity expansion in many oil producing countries. For example, political strife in Iraq, Venezuela, and Nigeria may prevent these countries from undertaking the necessary investment in their oil sectors restricting oil supplies. Economic sanctions on Iran, Libya and Iraq hindered investment. Even in the absence of political strife the decision to invest in oil production is to a large extent subject to political considerations. The decision to invest is by no means centralized within the national oil company, the most capable institution to take advantage of any available profitable investments. In most oil producing countries, the capital budget for the national oil company is controlled by the finance ministry, the oil ministry or by some other authority. What is important to note is that the capital budget is usually not determined according to availability of investment opportunities in the oil sector, but is subject to general government budgetary requirements. This implies that the capital budget for national companies is quite tight most of the times preventing them from undertaking all profitable investment projects. The relationship between the owner of the natural resource (ie the government) and the national oil company which extracts the resource is not the subject matter of the paper. What matters for our discussion is that this relationship is highly inefficient yielding low rates of investment.
The relationship between national oil companies and international oil companies is also subject to serious tensions that may affect investment and it is timing. Even if a decision is made to allow international oil companies in upstream oil production, disagreement is likely to arise on the purpose and the form of foreign presence. Is foreign investment just for capital or technology or both? What type of contract should these companies be granted? What is the appropriate rate of return? Who should undertake the negotiations with the international oil companies? These are only a few of the issues that make the relationship quite complex. What matters for our discussion though is that such frictions imply a long lag between plans and actual investment. Take for instance the case of ‘Project Kuwait’, a $7bn 25 year plan formulated in 1997 to increase Kuwait’s oil production by permitting international oil companies in upstream production. To date (ie seven years on), this project has not moved forward much mainly due to political opposition and resistance of the parliament to allow foreign companies into the oil sector.
3. Implications and Conclusions
Thus, the investment decision should be placed in its complex context which takes into account the logistics of the oil industry, historical developments of the oil market and local political factors of the oil producing nations and how these interact with each other. Ignoring the factual context can lead to seriously misleading policy decisions. Our analysis also suggests the following important implications for the current debate on upstream crude oil investment.
First, investment in oil production has long lead times and does not respond instantaneously to current market developments as the frictionless model would like them to do. Global market conditions combine with local factors to determine the length of the lead in each country. Thus, there is not much that OPEC or other oil producing countries can do to alter the current market conditions in the next two or three years to come. Unless the geopolitical problems cool down or the high oil prices depress the global demand for oil, the tight conditions which are producing high oil prices are likely to continue. Such factors are beyond any nation’s control. The only action that oil producing countries can take is to send signals to market participants of their intentions to increase investment in oil production in the future. To what extent these signals can alter expectations in the future markets remains to be seen.
Second, because of the uncertainties engulfing the oil market, the option to wait and not to invest has become very valuable. This implies that oil producing countries and international oil companies may decide to delay their investments. If demand continues to grow as many observers nowadays predict, this will produce a worst possible scenario for both oil producers (especially OPEC) and consumers. For OPEC, it means the loss of power to influence prices on the upside; for consumers it means higher oil prices and greater price instability.
Third, the investment problem is compounded by the inefficient relationship between the government and the national oil companies and the strenuous relationship between national oil companies and international oil companies. Larger revenues due to higher oil prices can relive the tight capital budget in these few years, but this relief will be only temporary. The fundamental problem lies in the nature of the relationships and the environment it creates which is not conducive to investment. The nature of these relationships is very slow to change implying long delays in investment.
Fourth, planning investment capacity requires a large degree of coordination between oil producing countries themselves. The current situation in which OPEC is supposed to expand spare capacity while non-OPEC countries produce at will creates a disincentive for OPEC to invest at least in the medium term. In face of expected growing demand and lack of coordination, spare capacity will ultimately disappear.
These implications are quite dire. However, if the current features of the oil market persist – and it is most likely they will – then the world has to get used to the emergence from time to time of very tight oil market conditions with large swings in crude oil prices.
* I would like to thank Professor Robert Mabro for his constructive comments on an earlier draft of this paper.
1. The Economist (1999), “Drowning in Oil”, March, Vol 350 Issue 8109, p 19.
2. Energy Information Administration, The 2004 International Energy Outlook.
3. Energy Information Administration, The Short-Term Energy Outlook August 2004.
4. See Bassam Fattouh, “Misconceptions Dominate the Oil Debate”, The Daily Star, 10 August 2004.
5. Adrian Lajous, “Global Supply Constraints”, Oxford Energy Comment, Oxford Institute for Energy Studies, 2000.
6. Adrian Lajous, “Global Supply Constraints” Oxford Energy Comment, Oxford Institute for Energy Studies, 2000.
7. On the importance of the impact of option to wait on the investment decision, see Robert Pindyck, “Irreversibility, Uncertainty and Investment”, Journal of Economic Literature, Vol XXIX, pp 1110-1148, 1991.
8. Paul Horsnell, Energy Investments and Impediments”, Paper presented at the International Energy Forum, The Netherlands, 2004.
9. Ibid.