Economic growth continues weakecovery is not now expected until the latter half of the year.
o Unseasonably warm weather in the Northern Hemisphere has held oil and energy use sharply below normal winter levels.
o Because consumption is lower than expected. Inventories remain surplus to company needs. Adding to the pressure to reduce inventories is the perception that purchases should be postponed because future prices will be lower.
o Conservation and substitution away from oil continue albeit at rates slower than the past three years.
These factors haveramatic effect on tho oilPEC crude production has fallen fron about9 to2n January.
February production may be oneower.
o Free World oil consumption has declinedillion
o aboutpot oil prices, which peaked0 ater
barrel for African light crudes, fell to tha present
level ofer barrel,7 below official
prices. F)
The next several, weeks willritical period for tha oil market. Oil demand ia trending sharply downward aa consumption remains weak and buyers postpone liftings in anticipationuture price decline.
o Confrontedeveral hundred thousand barrel per day reduction in oil sales since the beginning of the year, Mexico is now facing the prospect of either lowering prices to increase sales or further reducing output.
o The UK is under pressure to cut in prices amid falling exports.
o Nigerian production in January fellompareduring the fourth quarter.
o Production in Saudi Arabian January with prospects of further declines in February.
SFXRZZ fJOFORN
So far individual oil producers have been reluctant torice drop in an attempt to avoidound of competitive price cuts by other producers. F)
The demand outlook for the balance3 offers little relief for oil producers. Oil demand trends will depend on the shape of the business cycle, the pace of energy conservation and substitution and inventory patterns. Even with modest economic growthercent in the OECD countries, demand for OPEC crude oil, in our estimation, will average3 no more than last year and possibly less. Surplus Free World available capac-ity will average.
o We expect OECD energy consumption to be about the same as Non oil energy use will probably increase
--by.
O Free World oil consumption Is projected to fall byercentncluding refinery gain. Consumption is expected to remain far below year earlier levels during the first half3 before beginning to rise2 levels later in the year in response to the economice expect non-OPEC supplies will rise by36. This figuro includes natural gas liquids, net Communist exports and refinery gain. Most of the increase will come from Mexico, the North Sea, andil inventories are projected to fall againompanies are unloading stocks of oil as expectations
all in itsheightened, if inventories measurod in terms off supply were to be restored to thoso prevailing in thend, before the increase in the oil pricet leastillion barrels of oil would be in surplus. Much or all of this might be run down If so, stock reductions would averageith most of the decrease occuring in the first half of this year. (C) Unless an agreement on production quotas or price cuts is reached soon, Saudi Arabia and the other Arab producers in the Persian Gulf will continue to bear the brunt of the sharp decline in demand that is already underway. However, the Saudis have little willingness to cut output further, and. have throotened price cuts ofoer barrel to arrest eroding oil sales androduction sharing agreement. Such action, however, wouldajor policy shift by Riyadh, and the Saudis realize that lower oil prices would not boost oil demand appreciably in the short run. Moreover, such action coulderies of price cuts by other producers or possible retaliation by Iran against Saudi oil facilities. F)
On balance, it is highly likely that oil prices will decline. The OPEC states will probably succeed in preventing an uncontrolled price decline by agreeingroduction sharing arrangement in the coming weeks. OPEC members realize that widespread price discounting couldrice collapse that
SECRET NOFORN
would lower rovanues drastically for all producers in the short run. (C)
Still we cannot rule out the possibilityuch larger oil price decline. 4 price decline would not increase demand significantly for soma time, oil producers would see their total revenue fall. This would generate pressures, in the absenceiable production sharing scheme, for individual producers to shave prices- in an attempt to their increase market
sharo. Moreover, political animosities between Saudi Arabia, Iran, and Libya may be sufficient to override rational thinking in favorore emotional response to setting prices. The Saudis and their fellow members of the Gulf Cooperation Council with huge financial reserves could more easilyrop in revenues resultingrice cut. They are also the world's lowest cost oil producers. In the long run they will gain production share if the real price of oil is lower. (CJ
In addition, if the expected economic recovery fails to materialize and oil consumption continues to fallapid rate OPEC wouldore difficult timeharp price decline. (C)
If prices begin to slide, we cannot predict how far they might fall shortrico equivalent to the current cost of production for marginal oil fields around the world. This cost is uncertain but probably very low, perhaps. At well above that price, we believe OPEC members and other oil producers would agree on some rationing scheme to arrest tne price slide.
(o
Tn anyrop in oil prices would have major impacts on the world economy. There are substantial positive aspects that could occur including:
o Lower inflation
o Higher economic growth
o Higher employment
o Lower oil import costs and
o Reduced interest rates. <C) At the other extreme, lower oil prices could lead to intensified international financial stress as well as increased Third World political-instability, unsettled conditions in key oil exporting countries could eventually translateupply disruption threatening an oil price runup well before the positive impact of the-initial price decline worked its way through the system. Sharply lower prices would also dampen conservation, slow exploration and delay alternative energy development. These effects could take time to be felt, in contrast, the most immediate concern brought onharp price decline would be the risk of damage to the international financial system from the impact on high debt countries that are dependent on income from oil, especially Mexico. Nigeria, Venezuela, Indonesia, and Egypt would also be in trouble. For more details of the impact of an oil pricethe potential gains as well as thethe attached DDI Intelligence Assessment "The Global Implicationsossiole Oil Price Decline." (C)
Despit-i- the substantial capacity cushion and outlookoft oil market, the continuation of hostilities between Iran and Iraqisk to oil supplies. The outcome of the conflict could affect the oil market in widely different ways. An
escalation of the conflict to neighboring states could disrupt oil flows and eliminate the supply cushion. Alternatively, a
quick end to the war could allow Iraq to increase exports to prewar levels within six-months. The addition
would add further to downward price pressures. {C)
Prospects and Risks3
SECRET/NOFORN
harp oil price decline is avoided this year, almost all petroleum industry projections of oil and natural gas markets indicate only moderate growth in consumption, ample supplies, and little or no upward prossure on real prices well into the. Over the next several years, real oil prices could continue to declineesultombination of lower-than-expected oil demand, an increase in Mexican oil production, and an end to the Iran-Iraq war. Major industrialized countries will remain heavily dependent on imported oil, and West European countries and Japan will become Increasingly dependent on imported natural gas. If the market gradually tightens later in the decade as it would if future non-OPEC supplies fail to grow at their recent rate, the present cushion of surplus productive capacity is likely to shrink and the market would become more vulnerable to supply disruptions. (C)
SECKEIX NOFORH
If, as is more likely, prices break in the near term, the
greator economic growth and In time higher oil consumption would
hasten this vulnerability period. Much uncertainty exists
regarding the response of oil users to sharply lower prices.
Some argue that demand will rebound quickly; others say that
because of structural changes in oilharp price drop will
notajor rebound early in oil demand. As between these
two views, there are strong reasons forlow recovery
in oil demand even if the world economy grows strongly for
several years. For example, oil use by electric utilities has
shrunk dramatically in recent years around the world. It is most
unlikely that the utilities or their regulators will permit
es
growth in oil use to earlier levels. Another exampleuse of In
motor fuel, fern the US, auto efficiency standards have built in downward pressure on gasoline use. Horoover, the US is increasing auto fuel taxes and other governments are likely to do likewise as tha price of oil falls. (C)
Tho Stable Market Scenario
Economic growth assumptions and energy price trends are critical in forecasting long-term energy demand. mall change in annual GNP growth canubstantial change in energy requirements. Most projectionsree World GNP growthercent annually during. Even if GNP growth on average approximates this level over the next several years, oil demand could still change because of sharp variations in year-to-year growth caused by the business cycle. (C)
Host forecasts assume flat or declining real oil pricesith prices rising thereafterercent per year. The price path, however, may notmooth one. Most forocasts0 expect tho price of benchmark OPEC oil, the Saudi Arabian light crude, to rangeer barrel2 dollars even if prices tumble in the near term. Of course, the record of most forecasts has been so poor that one should attach little importance to their estimates. (C)
Barring an unexpected supply disruption, supplies of oil and natural gas should be ample to meet anticipated Free world demand at least through. Most forecasters now expect oil productive capacity in the Free World to averagen the latter half of the decade. The objective
r
range of uncertainty must be larger than this. eak oil market could cause some erosion in productive capacity later in the decade. Industry projections indicate non-OPEC productive capacity will increase slightly in the, with growth in Mexican capacity accounting for much of this increase. Except during periods of unusual weakness in the oil market, non-OPEC producers will be operating at or near capacity. (C)
Overall, we estimate that Free World oil consumption in theill2 levels. Given these consumption estimates and non-OPEC supply forecasts, we believe that the demand for OPEC oil will climb to aboutillion by the. esult, the Pree World will remain dependent on OPEC oil for about half of total oil requirements. Most industry and
Y
government forecasts expect OPEC oil productive capacity to average severalbove the expected demand. Thiseturn of the combined productive capacity of Iran and Iraq to pre-war levels. (C)
Under these circumstances, oil supplios could support several years of fairly rapid economic expansion without strong upward pressure on prices, possiblyeal oil price wellarrel2 dollars. Surplus productive capacity through thehould be sufficient to protect the oil market from all but major supply disruptions. This ample supply situation should give the United States wider freedom in dealing with individual oil-exporting countries than enjoyed in the past. Oil exporters whose interests are inimical tofornot have the financial flexibility they have previously enjoyed, other exporters, however, including Nigeria, Venzeuzela, Indonesia, Mexico, and Egypt will have to cut back imports further and could face economic austerity so severe it may generate some degree of political instability. Countries losing access to aid from OPEC nations also could face more hardship, F)
Oil Disruption Risks
These unsettled conditions in key exporting countries could heighten the riskupply disruption, perhaps of major proportions. isruption could drastically and quite suddenly alter the energy picture. The oil price run-ups ofere direct results of major market disturbances:
S EC RET/NOFORN
o Libya's move to reduco foreign company productionoincident with pipeline sabotage in Syria,
resulted5 percent rise in oil prices.
o3 Arab oil embargoripling of oil
prices and contributed to an abrupt curtailment of GNP
growth.
o Supply losses resulting from the Iranian revolution contributedoubling of oil prices between9 and (C)
Although the odds areajor internal or external disruption in oil exports in any particular exporting nation or region, the probability of some sort of disruption is quite high. The uncertain political climate and recent escalation of hostilities in the Middle East has heightened fearsotential supply disruption in that region, which is expected to continue to account for about one-third of Free World oil production. The Persian Gulfarticularly high concentration of petroleum production and export facilities highly vulnerable to damage from war or sabotage. hange in regime or political policies can alsohreat to oil flow patterns. F)
The impactupply cutoff would depend on the nature of the disruption. Despite the present supply cushion, the United States and its allies could be hurt by deep, sustained production cuts that could occurariety of circumstances. Among the possibilities that could occur are:
SECRET HOFCRN
o An expansion oi the Iran-Iraq war to other Persian Gulf countries, which could affect as much aan oil productivelosure of the Strait of Hormuz, the only sea route into the Indian Ocean from the Persian Gulf, wouldomparable disruption. Moref crude oil was shipped through Hormuz last year,o OECD countries. Four pipelines totalling closen export capacity circumvent the Strait, but these also are vulnerable to disruption, and two transitting Syria ara currently closed for politicalisruption in Saudi Arabian oil- production could affect more than half of Persian Gulf oil supply although prospects for political stability in Saudi Arabia appearn Iranian victory in its war with Iraq would likely result in greater instability in the Persian Gulf, and heighten the threat to the Saudis and other conservativehe ever present threat of terrorist attacks against key oil facilities could increaseesult of Palestinian setbacks in Lebanon. F)isruption occur, its impact would depend heavily on the availability of onergy supplies froio surplus productive capacity, alternative fuels such as coal and gas, and stockpiles. To some extent, the impact of future oil disruptions
will also de modifiedumber of changes in energy use. Price controls have been eliminated in several countries, more efficient capital stock has been installed, and many industrial oil users have converted to other fuels orual-fuel capability. Stock drawdowns canajor role in offsetting lost oil supplies. Commercial stocks represent the bulk of oil inventories held in consuming countries, however, and in severaL past disruptions oil companies have been reluctant to draw down inventories beyond certain levels. Sizable strategic stockpiles are located only in the United States, Japan, and West Germany. At present, the foreign countries have no specific plans on how to distribute this oil in the eventrisis, (s)
Surplus productive capacity will afford the OECD considerable protection against an oil disruption at least for the next several years. Surplus capacity in the Free World available toupply cutback currently stands at more than. This, of course, assumes that none of the countries possessing excess capacity is involved in the disruption. Little moref surplus capacity are outside the Persian Gulf. Over the next several years, the market may be vulnerable onlyutoff of Saudi oil production or to the flow of oil from the Persian Gulf. The expected reduction In commercial stocks this year will increase this vulnerability. (S)
After the, the capacity cushion is likely to shrink as OECO economic growth rebounds and productive capacity
a
erodes in some OPEC countries. Oil market vulnerability to
smaller supply disruptions could greatly increase. He have estimated thatigh demand scenario, available surplus capacity would shrink to lessoaving the market vulnerable to even small supply disruptions. (S)
The Price Break Scenario
A price break in the near term which stimulates consumption and leads to cutbacks in'capacity development projects could greatly accelerate the convergence between available capacity and demand. We are already witnessing cases where major producers are postponing or canceling capacity development plans, both because lower than expected oil revenues have reduced available investment funds and'because lower demand levels make it doubtful additional supplies could be,marketed. Such cutbacks could significantly impair the ability of producing countries to respondupply disruption later in the decade. Considering the importance of imported oil to US allies, there is no way the United States could insulate itself fully from the economic reverberationsupply disruption, F)
Gas Markets
The natural gas outlook is, for the most part, similar to that for oil. Ample supplies are anticipated at least through then each of the three majorEurope, Japan, and North America. Because of the high cost and inflexibility of gas transportation, however, the capability of
9
the market to shift supplies from one region to another in
responseisruption is much more limited, making consumers more vulneraDleupply cutoff. (C)
In Westorn Europe, the Netherlands will remain the largest single supplier of natural gas and will be Europe's critical source of surge capacity in the eventisruption. Substantial new supplies are expected to come from Algeria by means of the recently completed Transmediterranean pipeline to Italy if pricing issues Can be resolved. Additional deliveries of Soviet gas are likely to begin5ither through spare capacity in existing pipelines or the Siberian pipeline when completed. Given the Soviets' need for additional markets in Europe, it Is likely that price competition will prevail lato Into. P)
Rising gas requirements in Japan will have to be satisfied by increasing LNG imports, largely from Indonesia, Abu Dhaoi, and Malaysia. If all of the LNG projects now under way in countries supplying Japan are completed on schedule, supplies to Japan should begin to exceed demand (C)
Gas supply disruptions appear toajor throat only to Western Europe through the. Because of its ability to switch fuels, Japan probably couldajor gas cutoff if alternative oil supplies could be obtained. US gas imports willmall share of supply. (C)
Growing dependence on imported gas could leave Western Europe dependent on Algeria, Libya, and the Soviet Union for almostercent of its gas needs These three suppliers could be providing as much asercent of total
Italian gas supplies,ercent ot Prench requirements, and more thanercent of West German needs. Under theseas supply disruption is potentially quite serious, especially if it occurred in winter when European gas use peaks at more than twice the summer level. Even given an unlikelihood that these oxporters woud act inutoff by any one or more would provide the remaining suppliers with consideraole leverage that could be used to political or economic advantage, F)
Original document.
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