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The New Economics Of Oil


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THE NEW ECONOMICS OF OIL

With technology dragging down the cost of finding and producing the precious stuff, prices won't rise--even as demand soars

Crude-oil prices have been careening like steel balls in a pinball machine this autumn in response to news and rumors from the Middle East. In the first few days of October, the threat of armed conflict between Iran and Iraq sent crude prices soaring from $20 a barrel to almost $23, before sinking back down again.

Even as the world is reminded of the vulnerability of its oil supply, consumption is soaring. Americans have fallen in love with gas guzzlers such as the Ford Expedition. In newly prosperous developing countries, ordinary people can afford cars for the first time. A recent survey in the China Youth Daily found that 75% of Beijing families planned to buy a car within the next five years.

Yikes. Are we in for another oil crisis? You might think so. Fort Worth investor Richard E. Rainwater has 30% of his $1.5 billion net worth sunk in oil and gas investments because he expects prices to rise 50% to 75% in the next 5 to 10 years. With free markets fueling economic growth, says Rainwater, "we should see a tremendous amount of pressure on prices."

Perhaps. But there's another, quite different scenario--namely, that oil prices, adjusted for inflation, won't rise at all over the long term. They may even fall. Why? First, because producers in the Mideast and elsewhere need the cash from oil too much to let their supply be interrupted for long, despite political and military skirmishing. Second, and more important, because demand growth can't push prices upward as long as it is balanced by supply growth. And the supply curve for oil--the amount offered at any given price--is being pushed steadily outward, thanks to technology.

PETRO-TREASURE. Technological advances are slashing the costs of finding, producing, and refining oil, creating a new economic calculus for the oil industry. The new alchemy runs from three-dimensional seismology to exotic wells that sit on the ocean floor, in some cases eliminating the need for billion-dollar offshore production platforms. Says Shell Oil Chief Executive Philip J. Carroll: "Technology always drives down cost. I don't think its effect in this industry will be any different."

Never mind the latest discord in the Middle East. Short of destroying another country's oil wells, as Iraq did to Kuwait in 1991, no nation can curtail the world supply of oil and force up its price for very long. Members of the Organization of Petroleum Exporting Countries still sit on the world's biggest and best oil reservoirs. But they can't raise prices--because if they do, non-OPEC sources will grab market share by developing fields where technology has made production affordable.

Rainwater's high-price theory notwithstanding, the end of the cold war and the spread of global capitalism aren't just adding to the demand for oil--they're adding to its supply as well. That's because more and more countries, from Venezuela to Kazakhstan, are welcoming the investment that's needed to exploit their petro-treasures.

The progress already achieved through technology is mind- boggling. The average cost per barrel of finding and producing oil has dropped about 60% in real terms over the past 10 years, while proven reserves are about 60% higher than in 1985 (charts, page 140). And these official figures far understate the amount of accessible oil in the ground. Smith Rea Energy Associates Ltd., a London-based researcher, figures that the world's oil producers could add 350 billion barrels to their proven reserves if they counted all the oil that has become affordable to recover because of the latest breakthroughs. That sum is equal to nearly 14 years' worth of worldwide consumption.

Experts have been underestimating oil reserves since 1874, when Pennsylvania's state geologist direly warned that "the U.S. [has] enough petroleum to keep its kerosene lamps burning for only four years." Later experts put the date of exhaustion in the 1920s, then the 1940s. In 1972, the Club of Rome said the world had only 20 to 31 years of known oil reserves. Yet today, measured reserves are higher than ever.

Indeed, the very notion of what oil reserves are is changing. Rather than being a fixed number of barrels, the reserve is seen as something that grows and grows as technology finds new sources of oil and extracts more from existing fields. Take the giant Forties field in the British sector of the North Sea. In 1970, British Petroleum Co. rated it at 1.8 billion barrels of proven reserves. Yet by 1995, it had produced 3.6 billion barrels, and BP said 2.8 billion barrels in proven reserves remained.

The impact of such progress on crude oil prices has been dramatic. In 1980, Stanford University brought together 10 of the top oil forecasters to run their computer models. The average forecast for this year, among the six that made predictions for 1997, was $98 a barrel. Even as recently as 1991, experts were predicting the price per barrel in 1997 would be about $45.

Instead, the inflation-adjusted price of oil has fallen by two-thirds from its 1980-81 peak. Oil is cheaper than bottled water. "Oil-price forecasters make sheep seem like independent thinkers," gibes Massachusetts Institute of Technology energy researcher Michael C. Lynch. "There's no evidence that mineral prices rise over time. Technology always overwhelms depletion."

BARRELING DOWN. Opinion is slowly shifting away from the doomsayers. Consider the new outlook of the Center for Global Energy Studies (CGES) in London, a research group set up by former Saudi Oil Minister Ahmed Zaki Yamani. Says CGES senior economist Julian Lee: "We just don't see any likelihood for oil price rises for other than political reasons." McKinsey & Co. has warned oil clients that "a downside price scenario" is increasingly likely.

Cheap oil greases the gears of the world economy. In the U.S., it's supporting today's fast growth and low inflation. If crude oil fell by $5 a barrel and stayed there for the next five years, the annual consumer inflation rate would fall by an average of 0.3 percentage points and economic output would rise an extra 0.2% annually on average, estimates Standard & Poor's DRI, a unit of The McGraw-Hill Companies. After a decade, the cumulative gain in gross domestic product from the price drop would be nearly $400 billion (charts).

Oil industry profits still rise and fall with changes in the price of crude, but technology lets the companies maintain healthy earnings at steadily lower oil prices. Today, most majors have cut their costs so much that their newest projects can make money even with oil as low as $15 a barrel. Norway's Norsk Hydro uses $12 as a benchmark.

That's not to say all companies will fare equally well. Those that master technology and efficiency, such as Shell, Exxon, and British Petroleum, are leaping ahead of those that don't. What's more, many independent oil companies have moved to the cutting edge (page 146).

DEEPWATER DRILLING. The new economics of oil are built on advances in every corner of the vast oil industry. In refining, for example, more gasoline and diesel are being squeezed out of every barrel of oil because of more efficient catalysts and the elimination of processing bottlenecks. In the U.S., the oil industry closed 29 refineries since 1990 and still increased output by 105,000 barrels a day.

Even bigger strides have come in finding and producing oil. For exploration, there are now "geosteering" drill bits that snake down, across, even up again to follow the trail of oil miles underground. Sensors that do magnetic resonance imaging--like the MRI machines in hospitals--peer ahead of a drill bit to find the least expensive route to black gold. Exxon Corp. says such technologies have helped it cut exploration costs by 85% in 10 years.

Deep waters that were once off limits to oil explorers are suddenly accessible, partly because of advances in floating rigs. Computer-controlled thrusters keep drilling ships and floating rigs in place even in stormy seas. The thrusters "know" which way to nudge the floating craft because of coordinate readings from global-positioning satellites.

One deepwater newcomer, British-Borneo Petroleum Syndicate PLC, next year plans to launch off the Louisiana coast the first ultra-low-cost production platform for deep waters. A scaled-down version of a tension-leg platform--that is, a floating platform tethered to the ocean floor--it will cost just $85 million and produce 35,000 barrels of oil a day. By contrast, Shell's first deepwater floating platform in the Gulf of Mexico cost $1.2 billion in 1994 yet was designed to produce scarcely more: 46,000 barrels a day. "We've wholly changed the cost structures of doing business in deep water," says British-Borneo Chief Executive Alan J. Gaynor.

The lower costs open the door to tapping smaller fields, too. To be worth exploiting, a field once had to hold 80 million barrels. The British-Borneo platform can profitably drain fields with as little as 30 million barrels, "and we'll probably push it lower," says Gaynor.

Everywhere, the quest is for speed and lightness. The last hurrah for the old guard may be the $4.2 billion Hibernia oil project on Canada's Grand Banks, which will begin producing oil in November. To withstand giant icebergs, the fixed platform was constructed with 550,000 tons of steel and concrete. It took seven years to design and build. Its sister, the Terra Nova, will float--and be pulled away from approaching icebergs by tugboats. It will cost $2.2 billion and take three years to design and build.

Meanwhile, the amount of oil that can be extracted from a given field is on the rise. The average field gives up just 35% of its contents as the pressure naturally lifting the oil dissipates. Yet Amoco Corp.'s test wells retrieve 70% of a reservoir using an air-injection technique the company has been evaluating for the past 2 1/2 years. Under the right conditions, the oxygen in the air ignites, forcing the oil out of the well.

Actively managing a reservoir will be the next big trick. Instead of producing blindly until the wells run dry, producers take periodic seismic snapshots of an oil field. Then, armed with better information, they can use "smart" wells to boost production--possibly using high pressure from one field to drive out oil from a nearby low-pressure field.

FOREIGN CAPITAL. Just emerging from laboratories at Amoco, Exxon, Syntroleum, and South Africa's Sasol are ideas for producing synthetic oil from its underground partner--natural gas. The concept is to reassemble plentiful and cheap natural gas into petroleum liquids such as methanol or refined products such as diesel or gasoline.

Now, oil-rich countries that once spurned Western oil companies as imperialists realize that they're missing out on a good thing. So they're welcoming the companies and their technology. Venezuela is working with Conoco, Arco, and Texaco. Algeria, the first Arab member of OPEC to invite in foreign capital, has landed deals with companies such as Louisiana Land & Exploration Co. Iran is working with France's TOTAL and Elf Aquitaine. Indonesia, Malaysia, and Qatar have partnered with Exxon. Russia is ambivalent toward joint ventures. But, says Richard A.D. Freeman, head of Texaco Inc.'s Moscow office: "It's Western technology that has allowed us to be considered."

Add all that up and you have the recipe for a possible explosion in oil production. The only way Saudi Arabia can discipline OPEC quota violators is to step up its own production dramatically, which would cause oil prices to plummet. That's what happened in the mid-1980s, when the world price of crude briefly dipped below $10 a barrel. Says Yamani, the former Saudi Oil Minister: "What happened in 1985-86 might be repeated."

Of course, it's possible that prices could spike up for awhile, because the buffers are thinner today. Cost-conscious oil producers don't build rigs until they need them, and refiners have cut crude inventories to a minimum. Meanwhile, Western governments, feeling safer, have shrunk their strategic reserves. For example, on Oct. 6, the U.S. Energy Dept. announced it was selling its 78% interest in the Elk Hills reserve to Occidental Petroleum Corp. for $3.65 billion.

But war and politics aside, technology is the driving force in the oil industry today. And although nature gave us only so much oil, technology will pull more from the ground than people ever dreamed possible.By Peter Coy in New York and Gary McWilliams in Houston, with John Rossant in Rome and bureau reportsReturn to top


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