Deconstructing the Oil Crunch

The last time oil prices were this high was more than a quarter-century ago. Then, too, the Middle East was aflame. Following the 1979 overthrow of the shah of Iran, revolutionaries had taken Americans hostage at the embassy in Tehran. U.S. forces later mounted a failed rescue mission, prompting worries of escalating conflict. Now tensions with Iran are roiling again, as President Mahmoud Ahmadinejad vows to continue his country's nuclear program in defiance of the United States and other Western governments. Global demand for crude is growing, yet the business of finding and developing new oil fields is becoming more expensive. On Monday the price of a barrel of oil briefly topped $99.04—a level last reached in April 1980 (after factoring in inflation), according to Cambridge Energy Research Associates. How high can oil prices go, and what impact will they have? James Burkhard is managing director of the Global Oil Group at CERA, a private company that advises governments and corporations on energy trends. He spoke to NEWSWEEK's Jeffrey Bartholet. Excerpts:

NEWSWEEK: Oil prices are flirting with $100 a barrel. Do you expect them to continue rising?
James Burkhard:
As long as anxiety about the reliability of supply remains strong, prices will rise. They are going to be volatile, with significant upward pressure.

Why are analysts worried about supply?
Let me boil it down to one thing: what is behind this price rise is the perception that supply will not be able to keep up with rising demand. And the reason we have that perception has several facets. One is geopolitical tensions: concerns about the nuclear issue with Iran. One is the high-cost environment, meaning it's much more expensive to develop oil fields today than it was just five years ago. And there's great demand for people who can develop oil fields, so there's a shortage of qualified personnel.

What is the role of demand from China and India?
China is very important. China and the Middle East together account for more than half of the total world-oil-demand growth.

Iran and Venezuela have blamed high oil prices on the weak dollar. To what extent is that correct?
That's definitely a part of it. But it's certainly not the only variable … It's not necessarily the dominant variable.

Can you explain how the weak dollar connects to people paying more at the pump here?
Oil is kind of like the new gold, in that it's seen as a hedge against weakness in the dollar. When the dollar weakens, we tend to see oil prices rise as investors move away from the dollar and look to oil as a way to hedge against that exposure to the dollar.

In the past some people have pointed to limits in U.S. refining capacity as contributing to rising prices. Is that the case today?
It's tightness in the global refining market. It's a global issue, not just a U.S. issue.

Could OPEC bring prices down if it wanted to? Is Saudi Arabia still regarded as a swing producer with enough oil to turn the taps on or off at will, or is it pumping almost at capacity these days?
No single country or even group of countries can determine the oil price. Some OPEC countries are comfortable with prices at current levels; others, such as Saudi Arabia, would like to see prices weaken. Saudi Arabia is increasing oil production right now, and that could help to offset some of the supply anxiety that has been the driver of high prices.

What did you take as the headline from the recent meeting of OPEC heads of state?
One thing to take away is that OPEC is concerned about the impact of policies to fight against global warming. OPEC is taking that seriously, and they want to be part of the solution as opposed to part of the problem. That represents a change from the past.

They agreed to devote $750 million to projects to reduce carbon emissions and protect the environment. Where will that money actually go?
I don't know.

Is it a public relations measure—that they want to be seen as combating climate change? Clearly, their whole industry depends on people using oil, and doing so for the foreseeable future.
It's a recognition of the new global reality. A growing number of voices are saying that something needs to be done to curtail the rate of growth in CO2 emissions.

But how do they benefit from these changes? These changes are not good for you if you're producing oil, right?
Well, if the world develops ways—such as carbon-captured sequestration [storing carbon instead of releasing it into the atmosphere]—to use carbon-based energy in a more efficient way than in the past, then that could prolong the use of oil and coal.

With prices as high as they are, does that mean companies can now drill deeper for oil that was once too expensive to exploit? Does a region like the Canadian tar sands become more economical?
Not necessarily, because the cost of developing oil fields has doubled over the last few years. Also, many governments have increased "state take": the amount of revenue they get from oil-producing activities. An oil price of $90 [a barrel], which a few years ago would have been a clear, unambiguous signal to invest more and more, [does not necessarily have that effect] today. Because of higher cost and higher state take, the investment equation is not that simple.

When you say higher cost, what does that consist of? Is that because companies are drilling deeper or because it's harder to extract the oil from the shale or the sand it's embedded in?
It's a reflection of the fact that there's been a surge in the demand for the services needed to find and develop oil. So whether you are leasing a deep-water drilling rig or trying to attract welders to Alberta, the demand for those types of services has surged so much that it's placed significant upward cost inflation.

And yet we hear about oil companies making record profits. They can afford to do this, right?
It depends. Profits today are a reflection of investments made many years ago, when oil prices were much lower. When companies are looking at new investments, the investment dynamics are different today than they were in the past.

From an environmental perspective, the higher oil prices are a good thing because they will discourage people from using it.
One-hundred-dollar oil creates a strong incentive to use oil more efficiently, yes.

And what are the other knock-on effects of $100 oil?
It brings us closer to the point where oil prices could contribute to a significant economic slowdown. Keep in mind that the year-to-date annual oil price is just $70; it's not $100, or even $90.

That's when you average it out over the year.
Yeah. So we haven't been in a $95 oil price environment long at all. And it takes time for these high prices to work their way through. The key to this is how long prices will stay at that level.

What are you projecting?
Based on our outlook of fundamentals, we see prices on an annual average basis next year in the upper $70s, but with significant upward price risk.

Where do you stand on the question of peak oil: that we're on a slope of dwindling resources?
We believe there is plenty of below-ground resources to satisfy demand …

For how long?
We have an outlook that goes to 2030, so we don't see a peak in the supply. But what's really important is, will investment be allowed to go to areas that can move supply? If investment is not allowed to go there, we could have very tight oil supply … Venezuela has significantly altered its investment climate, so investments there are not as attractive as they used to be. Mexico does not allow foreign investment [in the oil sector].

When we started this discussion, you mentioned worries about Iran. It seems as if the situation with Iran has kind of cooled off a bit. But that's not reflected in the markets. Is there still concern that there's going to be a conflict with Iran?
There's been no resolution of the Iranian nuclear issue, so it's not off the radar screen by any means.

Is this something that's going to affect the markets for years on end?
It could affect the market when you look out at the next two, three years, absolutely.

Where would you see oil going if there were a conflict with Iran?
We're not predicting a military conflict with Iran. So we don't build that into our outlook.

So what are the markets worried about, if not a conflict?
If oil supplies in the Mideast were to be negatively affected—if the Straits of Hormuz were to be cut off even for a short period of time … that's a central concern of the market.

So if the United States and other countries were to impose strict sanctions or an embargo of some sort on Iran, then Iran might respond by cutting off the Straits of Hormuz? Something of that nature?
Yes, that's the deep fear in the oil market. [Iran] couldn't shut off oil exports for very long, but even shutting them off for a short time would lead to fear and anxiety sweeping over the oil market to a degree we haven't seen before.

What would you project for oil prices if that were to happen?
Fear and emotion would take over. Prices could go far higher than they are now—if that were to happen.