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Downward price pressure is unrelenting

Irrespective of what happens in the Gulf, the fundamentals underlying the low oil price have not changed

Prices also received some support ahead of a hastily scheduled meeting, in Madrid, of the oil ministers of Saudi Arabia, Mexico and Venezuela in the hope that some decisive action might be taken to cut crude oil production. The coincidence of the two events was enough to lift the price of Brent crude by more than 7% in a single day, to close at $11 a barrel ($/b).

The bombing raids duly arrived and the Madrid conference broke up with an announcement on the need for compliance with the cuts already agreed, even if there were no new cuts.

Perversely, the price of Brent crude for January delivery fell by $0.26/b when the London market opened.

Irrespective of what happens in the Gulf, the fundamentals underlying the low oil price have not changed too much oil chasing a contracting market. That doesn't look like changing much in the short term, even though the International Energy Agency expects demand in 1999 to average 75.6m b/d . In the IEA's Monthly Oil Market Report, the Agency says that is 400,000 b/d less than previously expected, but still an average of 310,000 b/d more than expected demand in 1998.

With demand declining, or not growing by as much as expected, stocks of crude oil have built up to uncomfortable levels. That stock overhang will keep prices low. The build-up of stocks is exacerbated in major markets, such as Asia, by refiners cutting their refinery runs in an effort to reduce stocks of refined products. Even two months into the northern hemisphere heating season, stocks of products, although falling, were still considerably higher than they were at the same stage of the 1997/98 heating season.

The decline in refined products prices has been even steeper than that in crude oil, which means refiners are not able to benefit from low crude prices through improved refining margins. The integrated oil companies are being squeezed on two fronts. And there is a cyclical downturn in the petrochemicals business.

Shell responded to the cost pressure and poor margins by taking the route of radical internal restructuring, rather than follow the route of British Petroleum, Exxon and Total with high-profile mergers. Most of the major integrated companies believed they had squeezed costs out of their businesses in the wake of the last oil price fall. The only course open to them is to merge, maintain the combined company's production base and reduce overall costs by eliminating overlap.

Many in the industry say Shell has not been as stringent in its cost-cutting as its main rivals were and now has to play catch-up, and that is an expensive exercise. Shell has been under pressure for months, if not years, to improve its return on capital. But while it continued to grow, the pressure on Shell was not too heavy. BP's and Exxon's merger plans raised the stakes, with a response demanded by the markets. 

Quality required

The scale of the response surprised everyone as Shell launched the most sweeping restructuring in its history. The low oil prices, which led to the impairment of asset quality, and restructuring led to a $4.5bn after-tax write-off in the fourth quarter of 1998 and 40% of the group's global petrochemicals business will be sold. Other parts of the company are also up for sale. It is in talks to sell its interest in the Altura, onshore Texas, oil production joint venture, with Amoco, and wants to restructure its Aera, onshore California, venture with Mobil. Tejas Gas, a US company, bought by Shell Oil last January for $1.45bn, will be written down by $500m-700m, after tax, restructured and parts of it sold off. The low oil price is largely blamed for Shell writing down its onshore US and Venezuelan assets by $1.8bn-2bn.

Shell thinks it can achieve the same level of cost savings, at $2.5bn a year by 2001, that Exxon can only achieve by merging with Mobil. That those savings have not been achieved by Shell years ago, when its main competitors were cutting costs, has drawn criticism.

Shell is aiming for a 14% return on average capital employed, trimmed from an earlier target of 15%, which it expects to achieve mainly by volume growth. Oil production is expected to rise by 10% and natural gas production by 25%, by 2001 a reduction in capital spending, which will fall by $5bn, to $11bn a year, and lower unit costs.

But it is not only companies that are subject to pressure. Pressure to sort out the chaos in Russia is mounting. The situation is so dire that Gazprom, the country's huge gas monopoly, threw its hat into the political arena, justifying its intervention on the basis of a "danger of a collapse of authority and a new paroxysm of destabilisation". The intervention, by Vyacheslav Kuznetsov, an adviser to Rem Vyakhirev, the chairman of Gazprom, appeared in an article in two newspapers owned by Gazprom, was a rebuke to the Duma for "opposing the cabinet's business-like mood and fomenting political passions, with some deputies relapsing into separatism".

Gazprom was repaying a favour owed to the prime minister, Yevgeny Primakov, who, soon after taking office, eased Gazprom's tax payment burden. However, what Gazprom can do to back up its intervention is unclear.

Perhaps it will disconnect gas supplies to any recalcitrant deputy. What Gazprom wants most is stability in Russia. Only then will it be able to set about attracting the funds it need to exploit fully its huge gas reserves and get gas to markets in Europe.

Russia has been hit hard by the fall in international oil and gas prices. Western companies are no longer streaming into the country, as they did a few years ago, because the cost of developing reserves, particularly in an unstable economic and political climate, is too high with oil prices at their current levels. The pressure is on Russia to get stability into its fiscal framework, as well as its politics and economy.

The world, and western Europe in particular, cannot afford to lose Russia as a supplier of oil and gas and Russia certainly cannot afford to lose its Western markets. One of the quickest ways of doing that is to become an unreliable supplier, which Russia risks doing if it doesn't quickly generate the funds needed to invest in its inadequate and crumbling oil and gas infrastructure. Some Russian oil companies might be able to borrow the necessary funds in foreign capital markets, but the price would be high.

Globally, producers don't have high expectations for crude oil prices this year. Before last month's presidential election, Venezuela planned its budget on the basis of an average of $11/b for its basket of export crudes. Mexico has trimmed its price expectations for a second time. Budget planning was originally done on the basis of $11.50 a barrel for its export basket of crudes. That was first trimmed to $11/b and then, last month, to $9-10/b. Shell has based its projections on an average price of $14 a barrel over the next five years. That could be optimistic.

As if the current pressures were not enough, fund managers around the world, according to the latest monthly survey from Merrill Lynch, are predicting a slowdown in the world economy this year, followed by a small rebound in 2000. With low growth in energy consumption, even when there is healthy economic growth, the portents for the oil price are not good, especially if Asian economies fail to recover some of their momentum.

The pressure is unrelenting.
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