Posted by: donmihaihai | June 10, 2009

Lousy at predicting prices

Published June 10, 2009

In search of the happy median in oil price

The oil price is not the equilibrium between oil supply and demand, says Shell CEO

By RONNIE LIM
ENERGY EDITOR

IS THERE a Goldilocks oil price – not too hot, not too cold, but just right – to help global economies through the downturn?

True to form, Shell chief executive Jeroen van der Veer – who participated in a media dialogue on the sidelines of the Asian Oil and Gas conference in Kuala Lumpur this week – shied away from commenting directly on this. ‘We are very lousy at predicting prices,’ he has often said.

The current recession, he cautioned, masks various hard truths, especially that when the economic recovery comes it will be very difficult for the oil industry to supply all that extra energy needed. This doesn’t include the rising greenhouse gas emissions problem then.

The International Energy Agency (IEA) has said that investment in the upstream exploration and production (E&P) sector will fall by more than 20 per cent this year. And investments in renewables are falling even faster – by almost 40 per cent compared to last year.

‘All this points to new price spikes and volatility further down the road,’ warned Mr van der Veer.

Asked if he thought last week’s run-up in oil prices to US$70 a barrel denoted a market which had run ahead of itself, he said: ‘Shell’s key message is regardless of whether the oil price is high or low, or volatile, we simply monitor it to see if we can do a better job than the competition. If you know that, then you take the oil price as it is . . . so we see ourselves as a price taker.’

‘But having said that, in the long term the world will find difficulty securing supplies, so the oil price will not be really cheap. Short-term we don’t really have a clue on how oil prices will develop,’ he said. Just as the IEA has indicated, ‘it’s hard to forecast when the next oil price hike will come, as we don’t know exactly when the recession will end, and whether it’s U-shaped or V-shaped, and we don’t know what Opec will do, and what’s going to happen with energy efficiency, and whether the habits of consumers will change. Will people buy smaller cars, or the Chinese use Hummers?’

Mr van der Veer said that his short answer to the question of ‘What is a fair oil price?’ posed by Malaysian Prime Minister Najib Razak at the Kuala Lumpur conference was: ‘We don’t know.’

The oil price is not the equilibrium between oil supply and demand, he said. ‘I’ve learnt in life that that’s not correct, as the oil price is basically expected demand compared to expected supply and we’ve seen a lot of that in the derivatives market.’

‘The reason it is (the equilibrium between) expected demand and expected supply, is because both sides have huge uncertainties. That’s one of the reasons why you have a lot of volatility to come and that gives opportunity to derivatives markets, which thrive on this,’ he said.

Asked if he thought the recent rise in oil prices was indeed indicative of economic ‘green shoots’, the Shell chief said: ‘We follow it. We think that towards end-2008, when oil prices fell to US$35, it had to do with people closing positions in the paper market then.’

‘At this moment, when we look at the world, there’s still a lot of floating storage around, again it’s about expected demand and expected supply, and maybe people are being optimistic about economies turning. But I’m just a simple businessman and not a macro-economist.’

Be that as it may, what would Shell consider a ‘comfortable’ oil price to stimulate E&P again? Rival BP CEO Tony Hayward had indicated earlier this year that US$60-US$80 oil could do the trick.

On this, Mr van der Veer said that Shell is spending a net US$31 billion to US$32 billion on capital expenditures this year, adding that ‘indeed we screen all the projects from the viewpoint of relatively low oil and gas prices, otherwise we wouldn’t do it’.

The oil giant, he said, had delayed an extension of a very large oil sands project in Canada – but this was not because the low oil prices could not support the oil sands project, he explained, but because the project market (costs of construction and materials) was overheated last year.

‘So the point is you have to balance oil prices with construction and material costs, and at this moment you get more from lower (project) costs than outguessing the oil market.’

But doesn’t this still beg the question of how the oil industry is to reconcile the dilemma of low prices depressing investments and the need to do more to gear up for increased energy demand in future?

Responding, Mr van der Veer said that ‘first of all, we’re very glad we made our final investment decisions (on various big projects) before construction costs went up, so we could avoid the top of the market, for example like offshore rigs three to four years ago before prices shot through the roof. We still benefit from that today.’

‘For the next expected oil price spike, we expect that construction prices, while down now, may go up again, so it makes a lot of sense to continue to be a high investor at this time so as to benefit from lower construction costs. Besides, if you are a constant investor, then you have constant staff and engineers, and you do a better-quality job.’

Besides, the days of easy oil are over, and that huge investments and long lead times are needed to extract oil.

Shell’s Sakhalin LNG project – expected to produce four billion barrels of oil and gas – cost just a total investment of US$20 billion, or about US$5 a barrel in costs. This was because it started work on the project way back in 1977, and it is only now that the project is starting to produce, he said.

On the role of speculators pushing up oil prices, Mr van der Veer said he was more ambivalent today about them playing a major in this than he did previously.

‘Shell did a lot of studies on this last year, and compared to two years ago when I said that the extent of open positions in the market played a major role in pushing up oil prices, now we say: We don’t know.’

‘It’s a more complex phenomena. It’s chicken-and-egg but what’s the chicken and what’s the egg? What is psychology and undercapacity and overcapacity?’

‘The only thing we can say is that the size of the paper market compared to the physical or real market has now decreased. Yes, derivatives and open positions played a role in driving up oil prices, but we feel less sure they say they were the culprits,’ concedes the Shell chief.

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