It's not Saddam, this time

Don Coxe
Financial Post, Toronto
Saturday, November 27, 1999

With crude oil trading at its highest level since Saddam Hussein invaded Kuwait, casual observers are not surprised that Iraq's Glorious and Perpetual Leader is crudely back in the news.

He has announced his refusal to continue with the UN's oil for food and medicine program, calling it an affront to Iraqi sovereignty. He is backed in this demarche by the usual Security Council suspects -- France and Russia. The prospect of a cutback of 500,000 barrels a day at a time of tight global supplies has excited the already feverish oil market.

Shares of oil producers have responded modestly to the immodest leap in oil prices. This disjunction is rooted in the virtually unanimous skepticism of Wall Street analysts, who have been talking oil down since June.

Oil has been behaving like a high-tech stock after bottoming out at $10 (US). At that time, the urbane Economist magazine ran a cover story predicting endlessly cheap oil, with a likely long-term price of $5 (US). That story may come to rank with the famed Business Week covers "The Death of Bonds" and "The Death of Stocks" that signalled runaway bull markets for those assets.

The pundits say oil's rally is due to "an OPEC deal" on production cutbacks. They note that all past OPEC deals were followed by large-scale cheating, and have warned would-be oil stock investors that $20 oil would trigger big production increases from petro-producers with perfidious pasts.

They have misrepresented the situation. The deal that cut oil production by more than three million barrels a day was between some leading members of the Organization of Petroleum Exporting Countries and non-members Mexico and Norway. It was the willingness of these big producers to join in the cutbacks that distinguished this deal from past, porous OPEC agreements.

OPEC is dominated by Arab sheiks and strongmen with histories of fearing each other before (and after) oil made them rich. If this were a club with secret blackball privileges based on real trust and respect, it might include only the Saudis and Emirates.

That is why the deal with prominent non-members is so historic: Oil production from democratic Mexico and Norway is scrupulously recorded, so the kind of cheating historically practised by autocracies such as Nigeria and Iraq will not occur.

Another aspect of the oil boom the analysts have overlooked is soaring demand from renascent Asia: The International Energy Agency recently noted that Asian demand is running 750,000 barrels a day above forecasts.

The analysts have contributed to the current squeeze by their assurances that oil would peak out at $20 (US), then fall back because of cheating. Big oil buyers like airlines did not hedge heavily against higher prices, not wanting to face huge losses when oil collapsed.

What makes the current situation so dramatic is Y2K. Oil consumers have rather suddenly awakened to the realization that there are embedded chips everywhere from the wellheads in the Persian Gulf to the loading docks to the tankers to the unloading facilities across the world. Reasonable observers can wonder whether Nigeria, Iran, Venezuela et al will be millennially correct.

Mistaken assumptions and predictions from the prominently skeptical have created a squeeze that promises to enrich oil companies and delight shareholders. Companies levered to refining and marketing may not benefit hugely, because they may not be able to get full pass-through on their costs of crude. Pure plays, such as Canadian Natural Resources or Apache, look like bargains.

If you own a 4x4 and use heating oil, you may wish to consider the advisability of hedging your petro-risk by acquiring shares of some producers. Alternatively, you can pray for a balmy winter and a no-fault Y2K for the oil industry worldwide.

[ENDS]

-- John Whitley (jwhitley@inforamp.net), November 28, 1999