On the edge of the precipice?

1. On the edge of the precipice? Implications of the US$ 40+ oil price for oil buyers and sellers UNCTAD NOT AN OFFICIAL UNCTAD RECORD Lamon Rutten Chief, Finance & energy, UNCTAD Managing risks and seizing opportunities for local companies in the oil and gas sector Rio de Janeiro, 8-9 June 2004

2. Overview Have we reached a watershed? Forecasting oil prices – worse than predicting the weather Not managing oil price risk can spell trouble If you can’t rely on forecasts, what can you do?

3. Source: cover of National Geographic, June 2004 issue

4. Prices since early 2003 Source: NYMEX

5. On the one hand, oil is getting scarcer while demand may well increase • Proven oil reserves will last for around 40 years. • Depleted reserves are continuously replaced by new discoveries, but the speed of new discoveries is going down – it is now one quarter of what it was in the 1960s. And instead of finding new large fields, one now finds medium and small ones. All the major areas that can contain oil have already been studied. • The production peak for oil is expected to be in the 2010-2020 period, and for natural gas, around 2060. • High prices and improving technology are still not allowing “mature” producers to maintain production levels – e.g., USA. • Rapid growth in China and other Asian countries will continue sucking in large volumes of oil.

6. After oil production has peaked, it may well fall rapidly… Assuming 1750 gigabarrels of recoverable oil Production (mln barrels/day) .From The Twenty First Century, The World's Endowment of Conventional Oil and its Depletion, by Colin Campbell, 1996

7. On the other, oil is (still) not that expensive to find, or produce “Non-OPEC finding and development costs dropped from $22/bbl in 1981 to $6/bbl in 2001 (2001$).” E. Baird, President & CEO, Schlumberger Ltd, “Fossile Fuels, the key to sustainable development”, World Energy, 2003, Vol. 6(1) For new fields, higher exploration, development & operation costs – although in OPEC, still < $5/bbl.

8. From a presentation by John Crowle, Shell, at UNCTAD’s 8th African Oil&Gas Trade and Finance Conference, April 2004

9. So there is much more than 1750 gigabarrels of oil, and production may well continue increasing for a few more decades. Source: IEA, US Department of Energy, 2000

10. The forward futures price curve on the New York Mercantile Exchange shows a heavy backwardation – but still, even for the 6-years futures contract, prices are above 29 $ a barrel.

11. So, have we reached a watershed? Is it « the end of cheap oil »? Not yet. The balance of evidence suggests that prices will fall to a level below 30 US$/barrel. And this could be quite fast, as it is estimated that the current price includes a 5 to 8 US$/barrel « terror premium » which could disappear from one day to the next. But this « fundamental analysis » applies only to longer-term equilibrium prices. In the short run, the market will remain highly volatile. Buyers remain exposed to the risk of price peaks, sellers to precipitous price drops. With hedge funds moving the market either up or down, depending on their sentiments, volatility will remain an major problem. Companies as well as governments have to be ready to survive these market movements. It is of little use to know that « on average, the river is not too deep for crossing » before attempting to cross it. What matters is how deep it can get.

12. Can one base decisions on forecasts? The herd instinct among forecasters makes sheep look like independent thinkers.Edgar R. Fiedler

13. Delphi VIII forecast, California Energy Commission, 1995 He who lives by the crystal ball soon learns to eat ground glass.Edgar R. Fiedler

14. Not managing oil price risk can spell trouble. For example, in an oil-importing country: Pressure on the currency Pressure on the government budget Oil import bill increase Oil import rationing Crowding out of other imports Worsening of debt service capacity Oil price increases Pressure on energy-intensive industries The terms of trade of farmers producing export crops deteriorates Increase in energy and transport costs Public transport requires even larger part of the expenditure of the poor Social and political unrest

15. And exporters are also exposed, e.g., government budgets…. Mexico --> budget USD 15.5 per barrel Price drop from USD 17 to USD 9.69 per barrel Venezuela --> budget USD 15.5 per barrel Drop in price to USD 10.60 per barrel 1998 Informed decision-making comes from a long tradition of guessing and then blaming others for inadequate results. Scott Adams Ecuador --> budget USD 12 per barrel Drop in price of 40% to USD 9 per barrel

16. Even high oil prices can be bad for exporters, leading to Dutch disease effects, wasteful investment programmes, and other negative effects. And if oil prices stay high for a longer period, there will be a demand-side response, which may lead to a displacement of oil by other energy sources. So even OPEC is not in favour of (too) high prices. The Business Times, Malaysia 4 June 2004 Oil a double-edged sword for Malaysia and Indonesia High prices may push up earnings but will hit Malaysian export markets and boost Indonesian price subsidies (KUALA LUMPUR) Record high oil prices are a double-edged sword for Malaysia, boosting its oil earnings but potentially also damaging the global economy and so its major export markets.

17. Nigeria's fuel protests gather support By our correspondent23 March 2001 INDONESIA: Fuel price rises spark protests - Jakarta, 3 October 2000 Protests by tens of thousands of workers and students have rocked Indonesia since the government of President Abdurrahman Wahid and Megawati Sukarnoputri, under pressure from international creditors, decreed an average 12% increase in the price of domestic fuel on October 1. May 25, 2004  California truckers protest high fuel prices Widespread protests against fuel increases in Zimbabwe By our correspondent23 June 2001

18. If you can’t rely on oil price forecasts, how can you improve your decision-making? • The key is to pro-actively deal with risk: • understand the risks to which you are exposed; • know how much risks you can afford to take; • have a view on your optimal risk/reward equation; and then • actively use a range of risk management tools to reach your risk/reward objectives.

19. Looking for a solution If you understand risks, there is a wide array of tools available that can strengthen your capacity to deal with unfavourable oil prices. This goes from reviewing operational modalities to using financial market instruments.

20. US solution

21. European solution

22. Some of the available market instruments: • Contracts that mitigate price risk exposure (e.g., fixed price contracts) • Securitization (e.g., State of Rio de Janeiro, securitization of tax revenue) • Traditional insurance solutions • “Alternative risk management” solutions (e.g., linking loans to oil price levels) • Derivatives contracts (futures, options, swaps). • At the end, a risky market place provides dangers, but also, opportunities. You may be standing at the edge of a precipice, but if you understand the risks and properly manage them, then you realize that you are also standing at a vantage point, giving you a priviliged view of the competitive terrain.

23. For further information on UNCTAD’s work on Commodity risk management Commodity finance Energy Lamon.Rutten@unctad.org