Pay-or-take agreements may bring oil price stability

Oil exporters and consumers need to strike a long-term agreement that will ensure compensation to producers for costly spare capacity to bring permanent stability to the volatile crude market, an international oil company's top executive has suggested.

Paolo Scaroni, CEO of Italy's largest oil company ENI, said such a deal has become imperative following the sharp rise in crude prices through 2008 and their sudden collapse in the last quarter because of the global financial crisis.

Scaroni attributed the decline of more than $100 in oil prices to a sharp fall in world demand, rising spare crude capacity, uncertainty about the global economic prospects and "ill-informed" speculators.

In a lecture at the Riyadh-based International Energy Forum this week, he said the sharp fluctuation in crude prices deeply hurt oil companies as that impact their investment and management plans.

He warned that persistent volatility in the oil market could hit the costly investment programmes by producers to expand energy output capacity worldwide, estimated at $1.5 trillion (Dh5.4trn) over the next five years.

"When oil prices are lower than expected, planned investments need to be delayed. And when prices rise too high, the surplus cash tends to cause asset-price bubbles, which are then pricked when oil prices come down again.

In the West, low oil prices encourage waste, and detract attention from the development of alternative energy sources," he said.

"High oil prices mean inflation and pinch consumer spending. Their impact is also regressive, hitting the poorest segments of the population disproportionately hard.

Oil-price spikes and falls have important geopolitical impacts, periodically shifting power between countries which have oil and countries which use oil.

"The time is ripe for the oil industry as a whole, producers and consumers, to move beyond short-term power shifts and work together in the interest of mutually beneficial stability…one idea would be to work towards a new contractual framework which ensures that producers can count on stable demand for their oil and stable revenues, perhaps taking a leaf out of the take-or-pay structures which are common in the gas market."

He said such an accord would give producers "rational" incentives to invest in exploration and production capacity.

"It would also make sense to work out some sort of remuneration for spare capacity, along the lines of what happens in the electricity market. Spare capacity has enormous value for consumers, ensuring security of supply and limiting the uncertainty that feeds speculation. But for producers it currently constitutes an investment which doesn't provide a return," he said.

"The exact shape and nature of a new model for the oil industry would need to be carefully discussed. But it is in everyone's interest to forsake their short-term interests and work towards a compromise…just as consumers need supply stability, producers need demand stability."

Scaroni was apparently referring to recurrent complaints by oil producers that large funds are wasted in maintaining their spare capacity, which could provide a cushion against crude price spikes but could also swell when demand weakens, putting further pressure on the producers' coffers.

Saudi Arabia, the world's largest oil exporter, has the highest spare capacity, estimated at around two million barrels per day at the end of 2008. But it is set to expand as the kingdom is slashing output in line with Opec agreements to reduce supplies by 4.2 million bpd since September.

According to industry sources, Saudi Arabia's oil output could average around eight million bpd this year while it has a sustainable crude capacity of nearly 11.5 million bpd, creating an idle capability of about 3.5 million bpd.

The kingdom has also been locked in a major programme to expand its capacity to 12.5 million bpd by the end of this year and Saudi officials have ruled out cancellation of such projects on the grounds they are near completion.

Speaking about the latest oil market developments, which saw crude prices tumbling from a record high of $147 in July to $40 at present, Scaroni said just few months ago, the big issue would have been high oil prices – whether they were sustainable, whether markets were functioning properly, and whether something should be done to regulate speculation.

"These days, energy ministers and oil executives focus instead on the oil-price collapse: the pros and cons of further production cuts, the new outlook for oil and the impact this will have on the projects needed to secure supply in future…

"Our sector is no stranger to cycles. But the turbulence we are currently experiencing – with oil doubling in the nine months to July 2008 and then losing two thirds of its value in the following six months – is unprecedented."

He noted that from the mid-1980s to the end of the 1990s, about 70 per cent of global exploration was carried out in the United States and Canada, mature areas which hold only three per cent of global reserves.

By contrast, only three per cent of exploration was carried out in the Middle East, which accounts for nearly 70 per cent of global reserves.

According to Scaroni, the price crash was driven by three main factors, including falling demand, uncertainty about the global economy and rising spare capacity. Other depressing elements are speculation, poor data by some consumers, mainly China and theories that oil has reached its peak.

"As if poor data quality and fears about the end of oil were not enough, the oil price is also buffeted by hoards of ill-informed speculators, who bought and sold 1.4 billion of paper barrels every day on average during the booming times, compared to daily global consumption of only 85 million," Scaroni said.

"And the Brent and WTI prices that the speculators influence have little to do with the price of real oil on any given day."

He explained that when crude prices rise beyond a certain level, demand for oil products in the developed world suddenly becomes elastic.

Given that the OECD still accounts for 60 per cent of consumption, this has a big impact on global demand, he added.

"When the barrel rises above $110-$120, even the most obstinate consumer just can't make his or her dollar stretch…for example, between 2000 and 2008, per capita energy spending in the US almost tripled to $7,000 a year, around a fifth of the average per capita annual income," he said.

"As a result, US demand fell by a million barrels a day. This trend was already starting to emerge elsewhere. In the last two years, consumption in France, Germany, the UK and Italy has declined by over 500,000 bpd, and by a quarter of a million barrels in Japan. And all over the developed world, high oil prices have sparked increased interest in energy saving measures, whether it is energy efficient city lighting schemes or new eco-friendly skyscrapers."

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