Jubak's Journal10/17/2006 12:00 AM ET

Oil prices will leap again -- blame Russia

Russia's leader is squeezing out Western companies, thus raising the stakes in the country's 2008 elections, which will drive speculators into a frenzy.

By Jim Jubak

Oil prices are in retreat. Oil producers are talking about cutting production. Projected oil demand has been revised downward.

So the oil crisis is over, right?

Wrong. I can clearly see the next oil supply crunch on the horizon. The next supply shock that will send oil prices shooting higher will come from Russia and arrive in 2008. In Russia, the forces are already clearly at work that will produce that spike.

Oil prices have fluctuated wildly in the past few months. The spot price of a barrel of benchmark West Texas Intermediate oil hit $74.41 on July 1. It's been down, down and down again since then, with the spot price of West Texas crude falling to $63.87 a barrel on Sept. 1 and $57.60 on Oct. 11.

That's a drop of 23% from July 1 to Oct. 11.

What's behind the plunge?

First, there has been a fall in current demand and a resurgence in current supply. Historic high prices cause some consumers of oil to get by on less. And at $75 a barrel, every last bit of supply that might have been shut down because it didn't pay comes back into production. Every month recently it seems that crude oil and gasoline inventories go up. An Oct. 12 report from the U.S. Department of Energy, for example, said U.S. commercial crude stocks rose 2.4 million barrels to 330.5 million barrels and gasoline stocks grew by 300,000 barrels to 215.4 million barrels.

Second, speculators have headed to the sidelines. On Oct. 11, the International Energy Agency lowered its projections for global oil-demand growth in 2007 to an increase of 1.45 million barrels a day. The drop in projected growth wasn't huge -- about 12% -- but if you're a speculator, it's the direction of the trend that counts. To keep oil prices climbing, projected oil-demand growth has to be going up, not down.

A relative peace

That's especially true because right now the oil-producing world seems a relatively peaceful place. Oh, sure, there's violence that on some days comes close to a civil war in Nigeria; Iran still faces possible sanctions from the United Nations because it persists in its plans to build nuclear weapons; Iraq seems about to move from unofficial to official civil war now that the parliament has given its approval to a future partition of the country; and Russia continues to threaten foreign oil companies.

But all this is pretty much business as usual -- it's all been going on for so long that the oil markets take it with a "ho" and a "hum." So what that Nigeria can't pump enough oil to meet its Organization of Petroleum Exporting Countries (OPEC) quota? The market has been living with Nigeria at 75% of production for months now, and the sky hasn't fallen. If you're a speculator, you need an upward trend in violence and fear to send oil prices up. "Normal" violence just won't do.

It's the flight of the speculators from the current market that has produced the huge price drop, just as it was a flood of cash from speculators that drove oil prices higher than the fundamentals justified to begin with. Beginning in 2004, when a huge 16% jump in oil demand from China shocked the oil markets, the trend was up over worries about supply and demand and fear of supply disruption.

The speculative "fear" premium now seems to be mostly out of oil prices. While the 23% drop from July 1 highs seems huge, recent oil prices have only returned to 2005 levels. The Oct. 11, 2006, spot price of $57.60 a barrel for West Texas Intermediate is virtually identical to the Nov. 1, 2005, price of $58.30 a barrel. Oil prices may still have further to fall, since market corrections almost always overshoot on the downside just as the market does to the upside in rallies, but we're approaching something like a fundamental price for oil.

But it's those oil fundamentals that made the speculators' job easy in the last year -- and are likely to do so again. The difference between oil supply and oil demand fell to a level well below the recent historical norm, so every minor threat of a supply disruption was amplified into a wave of fear that sent prices up by $1, $2, $5 a barrel.

The recent drop in oil prices has obscured the fact that this fundamental supply/demand condition hasn't changed. The International Energy Agency projects global oil demand at 86 million barrels a day. That's slightly above September 2006 levels of output at 85.4 million barrels a day. With some OPEC members cutting output recently (another 155,000 barrels a day in September), world oil supply will be able to meet demand in 2007, but not with a huge margin.

From Russia, with anxiety

It's that narrow margin between demand and supply that makes the oil market so responsive to any rumor of a potential supply disruption. And that brings me to Russia, where events are building, in my opinion, toward a scenario likely to spook the oil market again and give speculators new life.

Over the past few months, the Russian government has stepped up its campaign to give Russian companies, which in most cases has meant the state-controlled oil and gas company Gazprom, (OGZPY, news, msgs), controlling stakes in the development of Russian oil and gas resources. Nothing unreasonable about that, except that the Kremlin is trying to force Western oil companies with legal contracts to sell stakes in their projects to Gazprom.

At issue, from the Russian government's point of view, are production-sharing agreements dating back to the 1990s, when Russian oil production had collapsed, falling some 40% from levels in the 1980s. Desperate for Western expertise and technology, the Kremlin signed contracts that exempted Western oil companies such as ExxonMobil (XOM, news, msgs) and Total (TOT, news, msgs) from all taxes until they had recouped their investment costs.

Now that Russia's oil industry is back on its feet and the price of oil has soared in the past decade, these contracts don't seem like such a great deal to the Kremlin, especially when Western companies say their development costs have climbed far beyond earlier estimates. ExxonMobil, for example, recently announced that costs had climbed to $17 billion from an original $12.8 billion, and Royal Dutch Shell (RDS.A, news, msgs) reported costs of $20 billion rather than the original estimate of $10 billion. Western companies have been told to accept less-favorable deals or bring in a Russian partner (usually Gazprom), or both.

And if the Western company demurs? It can suddenly find itself looking at the withdrawal of its permit to operate because of environmental violations. That's exactly what has happened to Shell at its Sakhalin 2 project and to ExxonMobil at its oil terminal designed to process oil from Sakhalin 1. Given the lackluster (at best) record of the Russian Ministry of Natural Resources in enforcing pollution controls at Russian companies, the move seems a clear act of governmental intimidation.

The pattern is clear and has been repeated again and again recently, whether it's in pressure on BP's (BP, news, msgs) joint venture in Russia to force the private Russian investors in the deal to sell out to Gazprom, or in the recent decision by Gazprom to cut out all foreign partners and go it alone in developing the country's massive Shtokman natural gas field.

The coming oil shock

So why should this produce a supply shock and why in 2008? Two reasons.

First, the Russian government's energy grab now is based on a confidence in its own oil-field engineers. Gazprom can operate the fields, expand production and explore and develop new fields with its own know-how. What technology it doesn't have, it can buy from companies such as Schlumberger (SLB, news, msgs). It doesn't need ExxonMobil or Shell as a partner.

I certainly don't think that the Western oil companies have any monopoly on engineering skills, but Gazprom is entering unexplored territory. Any signs that Russian production is beginning to falter will be blown up into major catastrophes by those many Western oil industry analysts who have a belief in the unmatched technological prowess of "our" oilmen.

And there is certainly the chance that Gazprom and the Kremlin have overplayed their hands. A recent World Bank study concluded that "policy instability" has cut down the amount of global capital flowing into Russia. Despite its huge oil profits, Russia still needs foreign investment.

Second, there's a downside to creating companies that are creatures of the state, as Gazprom clearly is. In any uncertainty over who wields power in the Kremlin, Gazprom will be one of the major spoils the challengers fight over.

It may seem silly to even mention uncertainty about control in the Kremlin. Russian President Vladimir Putin has consolidated power in his hands not only at the center -- where, for example, Gazprom now owns the NTV television channel that once dared to criticize Putin -- but also in the provinces, where Putin loyalists have gained control. The United Russia parliamentary party that backs Putin controls more than 300 of the 450 seats in the Duma and is likely to gain even more in the next election, in 2008.

Even though there's no doubt about who will win that election, it's still a major problem for Putin-style capitalism. According to the Russian constitution, Putin can't run for president again in 2008. His options are to amend the constitution (he's certainly got the votes) or to pass leadership on to someone else in his circle.

You're not off base if either or both of those sound like a return to the good ol' days of one-party rule in the Soviet Union. And it's my memory of how traumatic those transfers of power used to be that leads me to pick 2008 for a Russian oil supply shock. That year will be filled with uncertainty and rumor, as the question of who will run the country rises to the top of the agenda for overseas investors and purchasers of Russia's oil. Even if, as I think is almost certain, power remains with Putin or someone in his circle, the uncertainty will be enough, with oil supply and demand in such precarious balance, to give the oil speculators plenty to work with.

Again.

New developments on past columns

3 stocks for a world running out of oil: OPEC has finally publicly announced that it will meet in emergency session on Oct. 19. There's only one item on the agenda: a cut in OPEC's oil production. There seems to be general agreement on the size of the production cut -- about 1 million barrels a day or about 4% of OPEC's current production. But the organization is deeply divided on how to allocate the cuts. Countries such as Saudi Arabia, Libya and Algeria, which have been producing more than their allotted quota to meet supply shortfalls, want the cuts to be divided among cartel members based on actual production. That would lessen the effect of any cuts on these overproducers. Countries such as Venezuela and Iran, which have seen production fall well below their quotas, want the reduction to be based on quota numbers. That would force the overproducers to take the brunt of the cuts and leave the underproducers facing very small reductions, if any. The fact that OPEC has announced the meeting at all makes it extremely likely that an agreement will be reached. A public meeting with no result would do immense damage to the cartel's efforts to set global oil prices. We'll know in two days.

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