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How Far Is Down for Oil Prices?

A. GARY SHILLING <i> is a New York-based economic consultant and author of "After the Crash: Recession or Depression?", published by Lakeview Economic Services. </i>

Several years ago, when the Iran-Iraq war was raging, the conventional wisdom was that an end to the war would bring a vast expansion of oil production by both countries that would overwhelm OPEC and result in a collapse in oil prices. But when Iran accepted the recent cease-fire, the consensus view shifted 180 degrees. Peace would bring a renewed spirit of cooperation with OPEC, the theory went, and allow the oil cartel to cut production and raise prices. In fact, when the Ayatollah decided to stop fighting, oil prices leaped.

Since then, however, oil prices have fallen several dollars per barrel, again raising the question of just how much discipline OPEC can be expected to muster. The reality is that OPEC has a strong uphill battle to maintain, let alone raise, oil prices. To begin with, the OPEC-engineered oil price increases in the 1970s were so huge that demand for oil softened considerably. U.S. crude oil consumption peaked in 1978 and then fell 21% in the recessionary period that ended in late 1982. Since then, consumption has risen 1.4% per year on average, the slowest growth rate in any postwar expansion.

High oil prices did exactly what high oil prices were supposed to do: They encouraged conservation of oil and other energy, and they promoted heavy reliance on other sources of energy such as coal and nuclear. Higher prices also stimulated supplies from non-OPEC oil sources such as Mexico and the North Sea, intensified the search for new oil deposits and made exploration of many high-cost deposits, including offshore deposits, economical.

Furthermore, the United States and other oil importers shifted away from questionable OPEC suppliers and toward other sources. Between 1978 and 1988, OPEC’s percentage of U.S. crude and petroleum product imports plummeted from 69% to 47%, to the advantage of non-OPEC oil producers, especially Canada and Mexico. As a result, OPEC production fell 37% in the decade to 19 million barrels per day (bpd) from 30 million, and its share of global output collapsed to one-third from one-half.

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Any cartel would have trouble maintaining discipline under these circumstances, and the disparate nature of the oil cartel members has made it all but impossible for OPEC. Cheating has been widespread in recent years. During the first half of this year, three-quarters of the 2.4 million bpd increase in oil production has come from OPEC. This clearly shows a lack of discipline, considering that in the same period, world demand for petroleum products rose only 1.1 million bpd.

Of course, OPEC may be able to persuade its members to cut production further and push prices back to higher levels. The threat of price wars and collapses in oil reserves does encourage cooperation. But history suggests that this is unlikely.

Both Iran and Iraq have major foreign exchange and debt difficulties that will spur them to increase oil exports and revenue. Financial problems are particularly acute in Iran, which has an estimated $4 billion in short-term debt due in six months and annual import requirements of at least $10 billion, against projected revenue of $8 billion. This means that Iran will have to find an extra $6 billion in foreign exchange.

To close the gap between revenue and foreign exchange requirements, Iran plans to increase its oil production to 5 million bpd by 1995. Meanwhile, Iraq’s crude oil production has already surged 45% during the first half of 1988, compared to the same period in 1987, to 2.7 million bpd, its highest level of output since 1979. Iraq plans to increase its production capacity even further and has the reserves to do it. Iraq’s proven reserves are massive--about 100 billion barrels, second only to Saudi Arabia. Together, Iran and Iraq will probably add at least 1 million, and perhaps as much as 2 million to 3 million, bpd of crude to an already glutted market by year-end.

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Substantial increase in oil exports by Iran and Iraq could have devastating effects on the fragile oil market and drive prices down substantially. Other forces could well turn that price decline into a collapse. If it becomes clear that OPEC can no longer effectively control oil prices, its financially weak members will increase their output rapidly, to get the foreign exchange they desperately need to service their huge international debts. As prices of their leading export commodity fall, those countries need to export more just to stay even. This quickly becomes a vicious circle--additional supplies depress prices, necessitating further production increases, leading to further price weakness, and so on.

In addition, declines encourage a disgorging of inventories, adding further to already excessive supplies. Finally, if prices fall rapidly, oil producers will rush to sign long-term contracts with customers to protect themselves from the volatile and declining spot market prices. With all these forces working to push down the price of crude oil, how low could it fall? A possible floor is the cost of producing oil in the Middle East, and estimates of that cost range from 50 cents to $3 a barrel.

The financial problems for deeply indebted oil producers in and out of OPEC that would result from a drop in crude oil prices to single digits are obvious. Countries like Mexico, Venezuela, Indonesia, Libya and Nigeria would be basket cases. But Third World oil importers like Brazil and the Philippines would not benefit that much, because oil imports represent only a fraction of those countries’ total imports. At best, the oil price decline would be a zero sum game.

A global collapse in oil prices could also bring down the curtain on the oil-producing sector of the United States and virtually all its financial institutions. Ironically, that could be the salvation of the Oil Patch, as the U.S. government responded to potential disaster by imposing an import duty that would push domestic prices back up and put a floor under them. The Oil Patch would be revived, but U.S. business would have the highest-priced oil in the world.


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