Abstract

This paper contains observations about crude oil price forecasts and the way oil companies respond to price forecasts and the way oil companies respond to oil price uncertainty. The industry is shown to act as though current oil prices are a good indicator of future prices. Industry earnings are shown to be less sensitive to low oil prices than might be expected. strategically, it is important to recognize the inefficiency of the industry responding to rising and falling oil prices with "on/off" spending patterns.

Introduction

Every industry undergoes change. The oil industry has experienced an impressive series of changes in the past 15 years, and more is likely to come. The comments which follow are observations on how some of these changes were seen, as they were in progress, from the viewpoint of a large integrated progress, from the viewpoint of a large integrated oil company. The focus is on oil prices, oil price forecasts, and the response of the industry to changing oil prices. A good place to start is the 1960's or early 1970's — back in the days the world seemed predictable. The pre-1973 model of the oil business predictable. The pre-1973 model of the oil business was fairly simple. Oil was a low cost, readily available commodity. Oil prices were flat (actually declining in real terms). Producing profits were the principal source of earnings Refining and marketing were generally not considered to be stand-alone businesses. Involvement in the downstream (refining and marketing) was necessary to provide an outlet for crude, thereby assuring continued crude producing profits. Volume was the universal indicator of profits. Downstream investments were made and long term supply contracts were signed based on the notion that crude oil production volume growth was all- important. Today, this pre-1973 model looks surprisingly up to date. But in late 1973 it seemed that the old way of thinking about the future had to be changed. Since 1973 there have been greater efforts to turn each segment of an integrated oil company into a healthy, stand-alone business. Upstream, this has taken the form of a tendency to move away from political risk, while accepting greater geological political risk, while accepting greater geological and technical risk. Downstream, the term rationalization has been used to describe efforts to pare down and restructure refining and marketing operations. What thought processes drove this activity? What new models of the future evolved to replace the old model? How good have our forecasts been since 1973? Was the old model better, after all? These are fascinating questions, and they deserve our attention in an effort to help us learn more about the oil business, and possibly about ourselves.

A CRUDE PRICE FORECAST

Figure 1 shows a recent Chevron crude price forecast. It actually shows a range of possible future crude price trends that are thought to have a reasonable chance of developing, depending on economic growth, the degree of oil conservation, the extent to which world conflicts interfere with the production of oil, and other assumptions related to crude oil supply and demand. Prices are in 1985 dollars per barrel. The price changes shown are therefore "real" price changes which exclude background inflation effects. The trends show that prices, which were on the order of $5/bbl (in 1985 dollars) in 1973, are expected to rise until they reach $60-70/bbl (in 1985 dollars) sometime between 2010 and 2040. The uncertainty indicated in the trends revolves around the question of when the price will reach $60-70/bbl, not if it will reach this level. In the year 2000 the price range is shown as being between $20 and $45/bbl in 1985 dollars. This is a fairly optimistic outlook from the standpoint of an exploration/producing company, in the sense that oil prices are shown to be rising in the long term. There are other forecasts (by other forecasters) that suggest a long-term downtrend for oil prices, based on the view that essentially all commodities tend to become less expensive in real terms over long time periods and that oil is unlikely to be an exception.

THE IDEA OF A SYNTHETIC FUELS "WINDOWS"

The concept behind the price trend shown in Figure 1 is that, as conventional oil production begins to decline (sometime between 2010 and 2040), prices will increase to stimulate production of prices will increase to stimulate production of costlier oil, to limit oil use to higher-valued transportation fuels and petrochemicals, and to justify major investments in synthetic fuel production. Current estimates, based on today's production. Current estimates, based on today's technologies, indicate a price level of $60-70/bbl (1985 dollars) will be required to justify such investment in large scale synthetic fuel production facilities. The synthetic fuels "window", towards which oil prices should tend to move, is therefore shown as $60-70/bbl during the time period 2010-2040. What price path will be followed in moving from current crude oil price levels to the target $60-70/bbl range? In the near term, OPEC production actions strongly influence oil prices. Longer term, the fraction of OPEC production capacity needed to meet world demand and the responses of oil consumption and production to price are expected to play key roles. In the future — as in the past — play key roles. In the future — as in the past — the actual path of oil prices is expected to oscillate as a result of the influence of business cycles, government actions, and the lag associated with adjustment to changing supply-demand conditions.

THE OIL SUPPLY-DEMAND BALANCE

Figure 2 shows an oil supply-demand forecast which is thought to be consistent with an oil price trend part-way between the extremes of the price trend part-way between the extremes of the price trend range shown in Figure 1. The top line in the top plot in Figure 2 shows non-Communist world oil plot in Figure 2 shows non-Communist world oil consumption, which has been declining since 1979 as the result of oil conservation and a slowed world economy. Will growth in consumption, starting in 1985, develop as indicated in Figure 2? Will the "other" oil supply, which is shown as the lower line in the top plot in Figure 2, reach a peak in the next few years and then begin to decline?

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