Mr. Toalster: I've been following Royal Dutch Shell (RD.AS) and BP Amoco (BPA.L) in particular, with a watching brief on the US oil majors, that is, Exxon Mobil (XOM.N), as well as Chevron (CHV.N) and Texaco (TX.N). And I've also been covering the macro oil scene, focusing particularly on oil price prospects and on OPEC including developments on world oil demand, supply and stocks. It's also been necessary to examine the likely influence on the energy scene of gas developments. Recently, I have been concentrating on the macro scene with an emphasis on oil price prospects rather than the corporate developments. I've been known, as a superbear for many years. Post-1986, my view was very strongly that the price pressures were existing primarily on the down side with a distinct possibility that oil prices could have settled permanently at 12-14 a barrel. The fact that OPEC did succeed in maintaining relatively high prices - they averaged around 18 a barrel - was due more to good luck than good management! I wrote a report a few years ago looking at oil price trends since 1860 and tried to find out what were the principal driving forces, i.e. the main dominant features. Essentially, the key element was that supply always tends to exceed demand; therefore you do need a residual supply and you need a residual supplier to be acting very responsibly to avoid a price collapse. Therefore oil producers were very lucky to get the kind of oil prices which were achieved, even though the 18 a barrel outcome resulted in a continually declining real value for crude oil. So the industry has really been on the defensive; it's been on the defensive since the 1973 and 1979 oil price increases, which represented anomalies. My view had been that there were pressures on the down side and there was always a danger of oil prices possibly falling back substantially. When oil prices tumbled in 1997-1998, it traumatised OPEC. It certainly traumatised the oil companies; and having for many years really believed that I was being too pessimistic on oil price prospects, they then thought probably there is a real danger of an oil price collapse. In fact they started to think that maybe the long- term norm is more like 14 a barrel, and could even be 10-12. So the industry itself changed around 1998 from being very positive indeed to believing that a new long-term low oil price scenario had actually emerged. However, what happened in 1998 was that OPEC reacted very strongly indeed to the steeply falling oil price. There was a rapprochement between Saudi Arabia and Iran and particularly between Saudi Arabia and Venezuela. Venezuela was important because it was a founder member of OPEC back in 1960, but it was acting more like a non- OPEC producer, i.e. as a private company. In other words it was simply maximising production which was annoying Saudi Arabia intensely. So that once that rapprochement occurred, there was the potential for much more unity within OPEC, and that's actually what happened. In order to regain control over the world oil market OPEC made three cuts in production in order to remove about 4.3 million barrels a day from the market, and they had a very high level of compliance with those agreed cuts, notwithstanding the fact that the agreed cuts were absolutely huge. And I believe the sea change actually occurred in that period, 1998-1999, such that now we have a very much stronger market, and this is why the United States is getting very worried about the increasing power of OPEC. It also explains why the United States is putting pressure on OPEC to raise output, as they did massively before the 27th March 2000 OPEC ministerial meeting. The US succeeded in intimidating OPEC to such an extent that it restored 1.7 million barrels a day of the production cuts despite the fact that this decision risked alienating Iran. Notwithstanding the increase in OPEC output in April 2000, oil prices have continued to rise. The conventional view amongst oil companies and investors in oil shares is that the 1999 to 2000 oil price rise represents merely a temporary blip up. However, I believe that we've actually reached a new era now with the potential for substantially higher prices. Therefore having been contrarian before for many years, I now think that the risk to oil prices exists on the up side. Just observe the fact that OPEC is nearing capacity; there's a great dependence on a small number of OPEC producers to increase output and they will need to be persuaded to increase output. OPEC has now realised that prices can be higher than in the past which is why all the conversation now and thought is regarding what is the correct long-term price for oil. The current thinking is that a satisfactory level is about 25 a barrel, with a 3 range either side. OPEC is focusing on its own basket of crudes, which is about 70 cents a barrel below Brent, which in turn is about 1.5 a barrel below West Texas Intermediate. Essentially we think that power has returned to OPEC, and now they are using that power very responsibly. Certainly talking to a very senior person in one of the OPEC countries recently there's a strong belief that oil prices could remain above 22 a barrel for the next five years. He was very confident that it could actually happen I think there's an increasing probability it could happen, whereas most people in industry think it's virtually certain not to happen. The conventional wisdom given out by companies such as Royal Dutch/ Shell is that the long-term norm is about 14 a barrel and could even be as low as 10-12 a barrel, and we could return to that scenario within the next one to two years. They think what's happening now is purely a temporary phenomenon. I take the opposite view, thinking that there's considerable potential for getting much higher prices. In particular, the market share of OPEC is increasing, notwithstanding the fact that non-OPEC production increases are temporarily relatively strong. The long term potential supply of conventional oil from non OPEC sources is limited due to the paucity of its resource base vis-a-vis OPEC. Hence, there will be some falling-back in non-OPEC production over the medium to longer term. We have got the potential for most oil additional oil to be supplied by OPEC and I think it probably will act pretty responsibly. You can always say, well, they'll always squabble and cheat which has been the case in the past, which is why I was very nervous in the past about oil price prospects always foreseeing the potential for a price collapse. Now I think there has been much greater unity and much greater confidence within the group and a greater determination to act responsibly. They are likely to move prices up to what they see as much fairer levels. And they do draw attention to the fact that 80% of the current price of gasoline in western Europe is consumer taxes with only 20% of the selling price accruing to the oil producer. They also recognise the fact that oil is an irreplaceable resource. They feel very strongly that higher oil prices are justified. So I think there is a much better overall background now than we've had for many years. That again is completely contrary to conventional wisdom. We've had one of the highest oil price forecasts in the market now for about the last 12-18 months, and we're still there. I think if anything, we could well nudge our forecast up. So we're very comfortable indeed with the overall background, certainly on the crude oil price side. However, we are much less confident on the refining side. Recently refining margins have been relatively strong due to the volatility of crude oil prices, but generally the market in refined products is hugely competitive. Refiners tend to use short run of marginal cost pricing policies, in other words, any contribution over and above the variable cost, which is the cost of the crude oil input, is usually competed away. So that there is a minimal contribution towards recouping the fixed costs of the refinery itself. Plus the fact that you have so-called refinery creep of something like 1-1.5% per annum, which basically means that even without any investment in building new refineries, just by using information technology etc to improve efficiency levels, it is possible to get extra output from the same capital equipment. In fact, that's almost equivalent to the world increase in oil demand, which is running about 1.5-2% per annum. And, of course, there are new refineries being built, particularly in the Far East. So I think many people in the industry now are beginning to feel very fearful that perhaps refinery profitability will never improve. On the other hand the marketing side seems to be doing very well with convenience stores in service stations. Also the companies are making strong margins on lubricants, as well as car washes and fast food. So companies can improve the margins on the marketing side. And efficiencies can be gained by maybe doing swaps of service stations with other oil companies in order to minimise the distribution costs. So there's a possibility to improve there. Turning next to the chemicals business: one has the usual chemical cycle, but it seems to be improving somewhat. The hope in the chemicals business is that participants can achieve bonanza profits in one or two years and that produces a good long term average return which compensates for the lean years. You can always expect to have two or three lean years in a typical chemical business cycle. If you're going to get one or two bonanza years out of every six or seven years, then you can make a great deal of money. The bonanza years occur when scarcities arise. So that's been the macro background.
Tickers included in this excerpt: BPA.L, CHV.N, CNE.L, NHY.OL, RD.AS, SHEL.L, TOTF.PA, TX.N, XOM.N
For more information call (212) 952 7433. The Wall Street Transcript does not endorse any of the comments made by interviewees, and does not make stock recommendations.