Depletion of non-Opec oil reserves puts more control in the hands of Opec and offers technology-based profit opportunities.

In the United States, exploration and production has been a declining industry for more than 20 years, and it is beginning to decline in the rest of the world. The likely result is that exploration and production will become more profitable because of higher prices and continuing improvements in technology.
On the supply side, oil and gas are characterized by high fixed costs vs. variable costs. On the demand side, they are classic "intermediate goods," of no value other than as means to ends - getting from place to place, heating a house, handling garbage. Prices of oil and gas are one element in the total costs, with the result that consumption does not change much over a range of prices.
The combination of characteristics is a prescription for markets in which small changes in supply or demand have large effects on prices. The two periods of stable prices in the oil industry, 1878 to 1914 and 1935 to 1972, were anything but accidental. The first resulted from dominance of the refining industry by Standard Oil. The second was caused by prorationing of production in Texas by the Railroad Commission. In the gas industry, regulation by the federal government of the United States imposed stable prices from 1954 to 1985.
Opec and non-Opec
In the oil business, Opec has been a poor successor to the Railroad Commission. A basic problem has been the large increase in crude oil production in other countries (Table 1).
Eastern Europe is unique because of logistics and the Soviet Union. In the Soviet Union, development of the area around the Caspian Sea was neglected in favor of Russia. The collapse of Russia's economy, which began in 1990, forced production in Russia lower because of inability to export. The combination of events in Eastern Europe averted the increasingly rapid depletion that occurred elsewhere.
Development of the Caspian Sea has begun, and privatization of the industry has been a major contributor to increasing exports from remote interior fields. Production in Eastern Europe is gradually returning to the level one would expect, with normal declines from peak production of 12.5 million b/d in 1988.
Amid the growth of non-Opec production, Opec production of crude oil has been as recorded in Table 2.
Until near the end of 1985, Opec policy was to defend official prices by reducing production - despite the large increases in non-Opec production. Recovery from only 16 million b/d in 1985 has been a slow process. Along the way, Ecuador and Gabon left Opec, and Iraq invaded Kuwait.
Excluding Eastern Europe, it appears the peak year for non-Opec crude oil production was 1997, with just less than 30 million b/d. Stable or declining non-Opec production is a major change in circumstances for Opec. Reaction to it was hampered by two "lessons learned":
• reducing Opec production results in loss of market share to non-Opec producers; and
• like non-Opec producers, the members of Opec make more money by increasing production (i.e., growth is the way to prosperity).
As time passes, the December 1998 election in Venezuela is becoming more clearly an important event in the oil business. The rejection of growth and expansion as a policy was the third such occurrence in an Opec country. The previous occasions were Kuwait's unilateral decrease in 1973 and Venezuela's cut in 1976 (which accompanied the nationalization of foreign operators in the country).
In March 1999, Opec members reduced quotas and production and were pleasantly surprised. In 2000, they increased quotas four times, and in the first 9 months of 1999 they reduced them three times. As a procedure, it is essentially what was agreed to at the Opec meeting in July 1990. The elements of that agreement were:
• Opec members are to agree on a combination of price and quotas;
• no member is to have a quota in excess of producing capacity;
• any increase in the total quota is to be distributed among the members with spare production capacity; and
• members will meet quarterly.
Iraq authored the July 1990 agreement, and the invasion followed when it became clear Kuwait intended to disregard it.
Reason does tend to prevail, but it can take a long time. Opec's problems have become issues of mechanics rather than objectives. As they are resolved, oil prices can be expected to be more stable. Declining non-Opec production will make the task much easier - the members of Opec can have both increased production and higher prices.
Natural gas
A basic difference between gas and oil is the lack of an Opec. Deregulation of gas in North America has resulted in no control over supply. Gas has more to do with what can be produced or imported. Gas supply is everything that can be produced or imported. With demand for gas subject to all sorts of influences - weather, other fuel sources - there is nothing to prevent continued large swings in gas prices.
Commodity markets originally were developed for farmers and miners. Futures and options for oil and gas are new by comparison. The study of markets is an entirely different discipline from geology or petroleum engineering. As such it is not an activity in which an exploration and production company is likely to do well. People with a talent for speculating in commodities are well advised to do that and forget about exploration, production, farming and mining. The typical commodity speculator loses money, and that is pretty much the exploration and production industry experience with hedging.
In refining and gas processing, volatility in margins - differences between prices for input and output - is an old story rather than a relatively recent development. Refiners can lock in most of their margin by buying crude oil contracts and selling contracts for gasoline and distillate. Typically they do not. Processing plant operators are even more reluctant, and the efforts to develop a futures contract for propane have met with only limited success.
For the most part, refiners and gas processors cope with volatility in margins largely by ignoring it. Refineries and processing plants do not become more valuable when margins are good - because that is likely to change. They do not become worthless when margins are bad for the same reason. In either case, the plants keep operating. It is a marked contrast to the behavior in exploration and production, where the usual reaction to changes in prices is to change the amount of exploration being conducted - particularly by public companies.
Other factors
In the non-Opec countries, large volumes of oil and gas remain to be found, just not enough to maintain production (in other words, continue at the same rate of depletion). Greater stability of prices is, of course, more important to exploration than it is to production. In addition to prices, the other critical elements of exploration success are technology, equipment and access to prospects.
Progress in technology continues to be somewhere between impressive and amazing. It can be expected to cope with the challenges of increasingly difficult environments - deeper formations and deeper water, for example. Access to prospects and equipment are the serious issues for the exploration and production industry.
In the Opec countries, funding for national companies and the access allowed to foreign operators are a question of depletion policy. Depletion is as inevitable in Opec countries as it is elsewhere, but the question "What happens when the oil runs out?" is more pertinent. England was wealthy before oil, but Saudi Arabia was not. The best bet is that foreign companies will get as much access to most Opec countries as is needed to maintain capacity or increase it slightly. Iraq, with its high potential, is the obvious exception.
Public financial markets are oriented toward growth industries - real or imagined. Since it is difficult to tell a growth story in a declining industry, being a public exploration and production company is likely to become increasingly difficult. A private corporation is the usual structure in businesses such as construction or farming that have more in common with exploration and production than manufacturing or retail.
In the exploration and production outlook, the diminished capacity of service industries is a major limiting factor. After years of boom and bust, volunteers to provide more equipment are hard to find. Term contracts are required to construct rigs for deep water. And they are likely to be required for everything else needed to support any significant increase in exploration.
A more rational approach would be for exploration and production companies to pay little attention to fluctuations in prices - easier for oil than for gas - and maintain an essentially constant level of activity. Whether, or when, reason prevails in exploration and production remains to be seen. It is safe to forecast that financial markets will continue to be driven by short-term considerations.
The longer term
All things considered, the outlook for the longer term - through 2010 - compares with history as shown in Table 3.
In the short term, a great deal will depend on how the conflict over Israel is conducted. Afghanistan is a convenient target for the "war on terrorism" because there is no oil there. The first two Middle East wars in 1948 and 1967 had little effect on oil prices. As late as 1967, Texas could still come up with 1 million b/d of additional production. The 1973 war had a big effect. The effects of the next may well be spectacular.
It is hard to understand much of the pessimism about exploration and production outside of the industry. The oil balance is shifting toward reliance on the Middle East, demand for gas is increasing faster than supply, and technical progress continues. Perhaps the best explanation is that the volatility of prices - and the industry's reactions - provide continual cause for undesired worry.

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