Middle East Economic Survey

VOL. L

No 51

17-December-2007

Shaping Long-Term Oil Price Expectations For Investment: Is It Workable? Is It Achievable?

By Ali Aissaoui

The following article by Ali Aissaoui, Head of Economics & Research at the Arab Petroleum Investments Corporation, is published concurrently in APICORP’s monthly Economic Commentary dated December 2007. The paper draws, partially, on a background presentation prepared by the author to support a panel discussion on the occasion of the 3rd OPEC Summit, (Riyadh, 15 November 2007) under the title “OPEC: Today’s Market Dilemma and Tomorrow’s Investment Challenge”. Comments and feedback may be sent to research@apicorp-arabia.com

Despite significant uncertainties over long-term demand and prices, oil is very likely to remain a major source of energy over the next 25 to 30 years. OPEC, whose share of global supply of crude oil and NGLs is projected in a reference scenario to increase from 40% in 2006 to 50% by 2030, would be shouldering a great deal of the burden of the total investments requirements.¹ To what extent the flow of these investments will be implemented depends on how several hindering factors are addressed.

Three sets of such factors have been identified in recent studies and analyses. The first highlights, inter alia, the specific institutional, legal and fiscal constraints within the oil-producing countries (Kochhar et al, 2005).² The second assesses the prospects of financing and the extent to which the cost and availability of capital can be improved (Horsnell and Norrish, 2004).³  The third focuses on a better understanding of OPEC’s behavior to determine what export-based expansion strategy best serves its members’ interests (Gateley, 2007).⁴ Few such studies, however, question the traditional framework for investment and none stresses enough the need to make up for the market’s consistent failure to provide a long-term price signal to enable capital expansion.

This commentary delves into that largely unexplored issue. The central idea is that, under an alternative investment framework, a price signal can be worked out as the unit present value of future fiscal petroleum revenue streams. The extent to which it is achievable depends very much on OPEC capacity to develop an effective policy to convey it.

Alternative Investment Framework

The current investment framework derives from the short-term analytical market approach used to assess oil demand and supply, which assumes that OPEC acts as a residual supplier. Accordingly, global oil demand is first met by supply from non-OPEC producers, then by OPEC producers. The role of residual supplier stems from the ability of OPEC to hold and use spare capacity to balance the market.

The conceptual and methodological problems involved when transposing this short-term analytical market framework to a long-term investment one are twofold. Firstly, while OPEC needs to coordinate production to meet the “residual” demand, there is no such collective practice when it comes to investment. The second is that in the short-term market framework oil prices changes are expected to reflect the shift in balance between supply and demand, while in the long-term investment approach oil prices are assumed exogenous and taken as given. This latter assumption, for instance, has been made very clear in the 2007 OPEC World Oil Outlook to 2030 (ibid.):

[…] the reference case OPEC benchmark crude price is assumed to remain in the $50-60/B range in nominal terms for much of the projection period, rising further in the longer term with inflation. These price levels are, of course, no more than assumptions, and do not reflect or imply a projection of most likely price paths, or of the desirability of any given price [page15].

As illustrated in Figure 1, the current investment framework can be extended to allow for the determination of an endogenous price path that reflects OPEC’s countries fiscal dependence on oil revenues and their long-term objective of achieving fiscal sustainability.

Figure 1

An Alternative Invetsment Framework

Is It Workable?

Milton Friedman’s permanent income hypothesis offers a useful conceptual tool for working out long-term price expectations. In its original and simplest formulation, Friedman’s hypothesis states that the choices made by consumers regarding their consumption patterns are determined not by current income but by their longer-term income expectations.⁵ When translated to governments, assuming they are forward looking, it means that their spending decisions would be, similarly, determined by longer-term income expectations as well. Under this assumption, a permanent income is calculated as the present value (PV) of petroleum (oil and gas) fiscal revenue streams consistent with a production profile and a depletion horizon.

a) Key Determinants And Basic Assumptions

The key determinants of such streams of revenues are fairly complex and the underlying assumptions are too numerous to discuss in any detail here. Only the most fundamental ones are summarized in Table 1 and reviewed below:

Table 1

Basic Assumptions

OPEC proven oil and gas reserves total some 200bn tons of oil equivatent (toe), 60% in crude oil and 40% in natural gas. Only proven reserves are taken into account on the assumption that the value of production from future not-yet-proven reserves would be heavily discounted.

Their life expectancy (as measured by the ratio of proven reserves to current production) is 93 years, starting in 2007. Although static, this ratio provides an average time to depletion and a timeframe for the analysis.

All productions are valued at international prices.

Prices for OPEC products are assumed to continue moving together. The ratio of the average export price to the price of Dated Brent, taken as a benchmark, is set at 0.75.

Figure 2

A Base Case Scenario Production Profile

With an average royalty of 16% and a petroleum tax of 75%, governments’ take, ie their share of the value of production, is assumed to decline from 70% in 2006 to 60% in 2030 as a result of ineluctably rising unit costs.

A further key assumption is the “residual” demand for OPEC. World oil demand, non-OPEC supply and the demand for OPEC oil are as estimated by the OPEC Secretariat in its current reference scenario (2007 World Oil Outlook, ibid). Under the OPEC benchmark price assumption of $50/B to $60/B nominal referred to earlier, the demand for OPEC would develop to some 50mn b/d of crude oil and 10mn b/d of condensate in 2030, or a total equivalent of 3,000mn toe. When including natural gas, total OPEC petroleum output would reach some 4,000mn toe at that horizon.

Figure 2 illustrates a base case scenario where production for both oil and gas is increased until 2030 to a plateau to be sustained over 10 years. Under this scenario, 2040 represents the critical point beyond which OPEC aggregate production starts to decline towards complete depletion for oil and near depletion for gas in 2100 (barring, as justified earlier, the not-yet-proven reserves).

b) Resulting Oil Price Expectations

By adopting a continuous-time and infinite horizon formulation, it can be easily demonstrated that long-term price expectations tend towards a simple algebraic fraction of the following factors:

• In the numerator: The permanent income, ie the PV of fiscal petroleum revenue streams;

• In the denominator: The product of both the PV of petroleum output and the real discount factor.

Considering that by mid-century OPEC’s population would have doubled, increasing from 572 million in 2006 to some 1,150 million in 2050, per-capita income and per-capita oil and gas production should better factor in the effect of population size and dynamics. On this basis, and as shown in Figure 3, the resulting oil price curve has been plotted as a function of the discount factor. It results from holding current aggregate per-capita income constant over the forecast period. Naturally, prices so obtained are illustrative only.

Figure 3

Price Expectations As A Function Of The Discount Factor

It is not intuitively obvious that higher discount factor should lead to lower price expectations. The argument we put to the test is that a change in interest rates (discount factor) affects the fiscal value (price) of petroleum assets. Higher interest rates might discourage producers from investing their net savings in production capacity, preferring higher returns from interest-bearing instruments, which reduces, as a result, the fiscal value of their petroleum assets. Conversely, we should expect lower interest rates to have the opposite effect. Therefore, if we assume that governments take a long perspective and adopt, implicitly, lower discount factors, then, under current economic conditions a constant price near $60/B (and not a nominal price as assumed by the OPEC Secretariat) should be the appropriate signal to stimulate investment.

Is It Achievable?

For an endogenous price based on Friedman’s permanent income hypothesis to be achievable, it should first be credible. The production profile, which underlies oil price expectations, results from the aggregation of diverse reserves and production profiles and the averaging of numerous royalty and tax rates. Country-by-country simulations that take into account various depletion horizons, cost structures and tax levels are likely to lead to a price band. While little can be done to change the underlying geology and associated costs, harmonizing royalties and taxes can help narrow such a band.

For that reason, working out a price signal based on long-term price expectations should be seen as a first in a two-step process to reach a common investment policy. The second corollary step should be directed towards the convergence of petroleum fiscal policies. This was a crucial objective of OPEC during the early period of its existence. Nowadays, it is a more complex move that needs a stronger political underpinning from the member states.

Ultimately, the key challenge is market acceptability. To what extent could market participants be influenced by OPEC eventual announcement of a proactive and price-band driven policy? The idea of conveying such a band to the market has already been tried within a short-term market framework. Extending it within a long-term investment framework can similarly only be achievable if OPEC demonstrates a genuine and firm commitment to a shared policy.

1. OPEC (2007), World Oil Outlook, OPEC Secretariat, Vienna.

2. Kochhar, K et al (2005), “What Hinders Investment in the Oil Sector?”, IMF Research Department, Washington.

3. Horsnell, P and Norrish, K (2004), “Energy Investments and Impediments”, Barclays Capital Research, London.

4. Gately, D. (2007), “What oil export levels should we expect from OPEC?”, The Energy Journal Vol 28 No 2.

5. Meghir, C. (2004), “A Retrospective on Friedman’s Theory of Permanent Income”, IFS Working Papers, W04/01, The Institute for Fiscal Studies, London.