Yergin on the Return of Oil - TheStreet

Yergin on the Return of Oil

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Markets turn, and that certainly applies to the oil market now, almost exactly a decade after the collapse that seemed to brand it a sunset industry.

Today oil is a growth industry, running to keep up with its customers. But the buzzwords of this new movement in oil are "affordable growth" -- the memory of the last boom, and subsequent bust, remains too painful. Higher prices are registering the fact that supply and demand have caught up with the market. Or, to be more precise, demand is closing the gap on supply. The increase is substantial. At $24 a barrel, prices are 35% higher than 18 months ago.

Economic growth and rising standards of living explain the new tightness in the market. For the past several years, global oil demand has been charging along at a 2%-plus growth rate, driven more than anything else by the strong performance of Asian economies. We would have seen higher prices sooner were it not for the continuing growth in production, in particular the "quiet evolution" in information technology, which has allowed the global industry to drill profitably in what have been regarded as near-impossible (at least, impossible in terms of profits) circumstances.

But the cold winter of 1995-96 tipped the balance. It drained supplies out of inventories, which companies are keeping leaner to control their costs. Then, in 1996, the growth in non-OPEC supply turned out to be only half what many had predicted. Moreover, Iraq was slower than expected in coming back into the market with its limited shipments, owing to

Saddam Hussein's

September foray after the Kurds.

The result of all this is a tight market. There are only 3 million barrels per day of available extra production capacity, most of it in the Middle East, to help balance out an industry pumping almost 75 million barrels per day. Any kind of modest shock to supply and demand -- be it severe weather, a political disturbance or merely technical problems -- registers higher prices. Not, by any means, necessarily a crisis. But higher prices. In addition, the taut supply-demand balance means higher daily volatility. Barring such shocks, however, we do expect prices to decline by several dollars over the course of the year.

But the basic fact remains: Oil is now on a higher playing field. An industry that has over 10 years constantly re-engineered itself and battled its break-even down to $16 or $17 a barrel is now reliquefied. That means more money chasing the opportunities that have opened around the world with the collapse of communism and the muting of nationalism. It also means more demands on a service industry that has scraped down its capacity of rigs and other equipment in order to survive. That is resulting in higher prices for the services needed to drill for new reserves. Keep your eyes on those costs, as well as the effects of the increase in drilling.

Daniel Yergin is president of Cambridge Energy Research Associates and the author of the Pulitzer Prize-winning book

The Prize: the Epic Quest for Oil, Money, and Power.

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