March 2004

Oil's Future Continues to Be Unpredictable

By ROBERT PEGG

The Arab oil embargo of 1973 has become a symbol of political chaos and economic problems endured by the U.S. during the oil shocks of the 1970s. After the 1950s and 1960s Ñ decades of gradual price decline in real dollars, oil prices quadrupled overnight. At the time, many forecasters predicted that oil would cost $100 per barrel by the year 2000.

Today observers of the oil industry could claim that little has changed from the tumultuous times of 30 years ago. Again, there is talk of scarcity and crisis. There is war in the Middle East and the Organization of Petroleum Exporting Countries (OPEC) has apparently emerged with new life. Although oil prices remain at about $30 per barrel, there are continuous threats that output will be cut and prices will rise.

In reality, the Arab embargo of 1973 failed completely. OPEC oil shipped to Europe was resold to the U.S. Non-OPEC oil was redirected from Europe to the U.S. and displaced OPEC oil. It turned out that price increases affected all oil consumers, not just Americans. In time, prices fell when consumer countries were forced to cut output and producers cheated on their quotas.

Theories of oil scarcity heard in the 1970s also proved to be wrong: the world has not run out of oil. Due to advances in exploration technology, there are more proven reserves of oil today than there were in the 1970s. The technological innovations were the result of investment by big Western oil companies in non-OPEC areas such as Alaska and the British North Sea. The development of fields in these regions partly helped check the market power of OPEC.

However, the bad news is that these fields are rapidly becoming mature, meaning that they are about to enter a period of irreversible decline in output. This problem will eventually be a growing challenge for the big oil companies, which must replace these lost reserves or see their market share prices decline on Wall Street.

A look at the news headlines suggests that Russia might become a major industry supplier. Russia has the largest reserves of any country outside the Middle East. Even if Russia's turbulent internal politics allow foreign investors in, that does not mean that Russia will replace OPEC anytime soon. It costs significantly more to extract a barrel of oil out of Russian turf than it does in the Middle East, particularly Saudi Arabia. Moreover, Saudi Arabia, the world's largest exporter, maintains a large amount of excess oil capacity in order to manage prices and lessen disruptions in supply.

Because Rus-sia's oil rests in private hands, that country will never be a buffer like Saudi Arabia because no private company could justify a waste of shareholder money by letting extracted oil lie idle. Finally, even if Russia develops more capacity, many of the country's ports are frozen for part of the year, handicapping transport. Presently, fully 25 percent of the world's proven oil reserves are in Saudi control. Add in the rest of the Middle East and you have about two-thirds of the world's reserves concentrated there. Russia, by contrast, has only five percent of the world's reserves. Alaskan oil, by comparison, is insignificant.

Because of this concentration of supply and the political volatility of the Middle East, the risk of disruption to oil flows will continue to be a threat to the economy, which could increase in the future. Even if it doesn't, American appetite for oil has been costly. By one estimate, OPEC has managed to transfer $7 trillion in wealth from American consumers to producers over the past 30 years by keeping oil prices above their true market level. Another cost of burning oil is the damage it does to the environment and human health. Oil consumption is the principal source of global emissions of greenhouse gasses.

The only long-term solution is to reduce the world's reliance on oil. Hydrogen fuel cells may offer a promising alternative. Hydrogen is a fuel that can be generated from a variety of sources, even natural gas and nuclear power. Every big carmaker is now busy investigating how best to develop this technology.

This and other technologies will need to be exploited in order to reduce domestic oil consumption. However, such changes will not happen overnight. Despite the last 30 years of oil dependence and the lessons learned, it will take additional time to produce the new technologies needed and for the U.S. government and people to muster the will to rid itself of its Middle East dependency.

About the author: Mr. Pegg is managing director of Tocqueville Asset Management LP, the New York City-based investment advisory firm which serves businesses, institutions and private individuals.