BUSINESS/SPECIAL REPORT

A WAR AMONG TITANS

MARK NICHOLS March 3 1986
BUSINESS/SPECIAL REPORT

A WAR AMONG TITANS

MARK NICHOLS March 3 1986

A WAR AMONG TITANS

BUSINESS/SPECIAL REPORT

Late last summer the Kingdom of Saudi Arabia, frustrated with fighting a losing battle, resolved to start a war. For several years the oil-rich Middle Eastern power broker had tried to persuade members of the 13-nation Organization of Petroleum Exporting Countries (OPEC) to hold down production and prevent declining international oil prices from falling further. But the oncepowerful OPEC cartel, torn apart by competing interests among its members, could not keep to the plan. Then, early last fall Saudi Arabian Oil Minister Sheik Ahmed Zaki Yamani quietly turned up his nation’s own oil output. That triggered a furious international price war that has sent a black tide of bargain-basement crude gushing across the globe. And last week international crude prices dipped below $15 (U.S.) a barrel on futures contracts traded on the New York Mercantile Exchange for the first time in seven years. Now, the industrial world, driven into two severe recessions by exorbitantly priced oil, is again searching for policies to counter a second Yamani-led economic

war.

Severe: The impact of the new oil shock was clearly evident around the world last week. The Saudis and their powerful oil minister, Yamani, had successfully manipulated the price of the vital commodity—downward. Once again, the policies of a small country were reaching into homes, factories and political assemblies around the world. Industrialized oil-importing Western nations anticipated the benefits of cheaper fuel oil and gasoline—and at Canadian gas

pumps prices finally did start to decline. But falling oil prices also threatened major oil-exporting debtor nations with bankruptcy—and that in turn created severe problems for the lenders to those nations.

‘Bullish’: In Canada, oil’s free fall—Alberta light crude fell to a posted price of $22 (Can.) last week—cast a shadow over a suddenly vulnerable domestic energy industry. Cheap oil threatened the future of debt-ridden oil companies— including the giant Dome Petroleum Ltd.—and forced others to begin preparing for large-scale layoffs. The new arithmetic of oil has already doomed some new projects, including the $3.2-billion natural gas liquefaction plant planned by a consortium led by Mobil Oil Canada Ltd. and Petro-Canada in British Columbia to serve Japanese markets. And it has put in doubt the future of billions of dollars worth of other costly developments in Alberta and on the nation’s energy frontiers. For Ottawa and the governments of the oil-producing provinces, falling prices have presented a critical test of economic policy. But for everyone, the critical issues were the same: how far down, and for how long, will prices drop? The more optimistic forecasters calculated that after another three to six months of uncertainty prices would likely settle at the $20-a-barrel (U.S.) level. That would leave reasonable profit margins for most producers and create many economic benefits, including reduced inflation and increased consumer spending. Declared New York economic consultant Pierre Rinfret as the first wave of worldwide oil price-cutting took ef-

feet: “The decline in the price of oil is one of the most bullish things for the future that I have seen in 35 years of forecasting.”

But the immediate effect, many economists said, will be economic hardship simply because of the turmoil wrought by the suddenness of the decline. And the prospect—conceivable, but unlikely—of oil settling for a period of years somewhere below $15 (U.S.) would be even more damaging. Debtor nations such as Mexico, Nigeria and Venezuela would be unable to repay the $950 billion that they owe to the world’s banks. And some oil reserves in Canada and the United States would be effectively locked underground because the crude would not be worth producing.

Officially, spokesmen for the federal government and the Canadian petroleum industry continue to maintain that the drop is temporary and that they are not unduly concerned. Said federal Energy Minister Patricia Carney: “Essentially, we are keeping quite cool until we see whether this is a controlled parachute jump or a free fall in the prices.” She added, “This is not a panic operation.” Robert Peterson, executive vice-president of Toronto-based Imperial Oil Ltd., added: “Obviously if our income is cut in half, we won’t be able to afford some things. If you get to the $11-$12 range for oil, some wells are going to be shut in. It is a question of how far the Saudis are prepared to play their game.”

Serious: Still, for the Canadian energy industry, the timing of the price collapse could hardly have been worse. On June 1 the Western Accord engineered by Carney with Alberta, Saskatchewan and British Columbia ended 13 years of intricate regulation in the Canadian oil industry. With domestic oil prices freed to move to international levels, and Liberal-era oil industry taxes gradually phased out, Canadian oil companies embarked on record levels of investment and drilling. Then, last December, just as the Alberta economy—reeling under the impact of economic recession and the effects of the 1980 National Energy Policy (NEP)—showed signs of revival, world oil prices began to drop. Said Hans Maciej, technical director of the Canadian Petroleum Association: “We just had everything going the right way and everyone was optimistic. Then,

overnight, the situation has changed. The mood is not very good.”

One result, predicted James Hamilton, a Calgary-based energy analyst with Bell Gouinlock Ltd., would be a sharp decline in drilling activity in remote areas. He added, “Frontier exploration activity off Canada will probably to a large extent become history for three to five years at least.”

Declining oil prices have already led to layoffs in the West. At the same time, oil company planners have returned to their computers to revise drilling and development plans, with the almost certain prospect of a drastically reduced level of oilfield activity—unless international prices rebound quickly. In danger are Husky Oil Co.’s $3.2-billion upgrading plant planned for Saskatchewan, a planned $4-billion expansion at Syncrude Canada Ltd.’s Alberta upgrading plant and the start of production out of the East Coast’s offshore Hibernia oilfield. In some cases the consequences of a prolonged oil-price slump could be much more serious. In Toronto last week Dome Petroleum’s chairman, Howard Macdonald, met with the company’s 56 creditors to discuss how the firm could pay back the $6 billion that it owes. Many oil analysts also noted that a number of the medium-sized Canadian oil firms that emerged under the NEP to compete with Ottawa’s publicly owned PetroCanada, as well as U.S.-controlled multinationals such as Imperial Oil Ltd., Shell Canada Ltd. and Texaco Canada Inc., could be hard hit by slumping crude prices.

Exposed: While the major integrated oil companies have the diversified operations and financial clout to withstand the price shock, many smaller Canadian-owned firms rely almost entirely on oilfield production for earnings and will be hit hard by falling crude prices. Among the most vulnerable Calgary-based firms: Sulpetro Ltd., which announced plans this month to sell some oil and natural gas properties to reduce its $800-million debt load; Ocelot Industries Ltd.; Bow Valley Resource Services Ltd. and Canterra Energy Ltd.

The uncertain future of some of those firms—and the financial problems facing oil-exporting nations in Latin America—are a major concern to Canadian and international bankers as well. The Royal Bank of Canada, with more than $2.63 billion in outstanding loans to Canadian energy and mining companies, is the most exposed domestically, even though it wrote off $840 million worth of loans in Alberta in the past five years. Internationally, the Bank of Montreal faces the most pressing difficulties, with a total of $2.16 billion in loans to Mexico and Venezuela, 4.16 per cent of its total loan portfolio. Those nations also owe the Royal Bank $2.31 billion, but that is still only 3.62 per cent of the Royal’s total loan portfolio.

As oil prices crashed, many Canadians expressed frustration at how long they had to wait to see the effects at gasoline outlets. For at least eight weeks after the world decline began, retail prices at service stations remained stubbornly in the 50to 55-cent-a-litre range, while in some parts of the ; United States they dropped by an average of five cents a

gallon. And in the Commons, Carney faced a barrage of questions from opposition members. James Conrad, executive vice-president of the Petroleum Marketers Association of Canada, for one, said that the oil companies were being allowed to take “money out of the pockets of Canadians.” Finally Carney—who said that she accepted the oil companies’ arguments that it takes up to 60 days for price changes to work their way through the distribution system-fired off telegrams to the major oil companies urging them to reflect lower crude oil costs at the gasoline and heating fuel level as quickly as possible. By late last week Petro-Canada had taken the lead in reducing pump prices by two cents a litre, and other majors quickly followed.

But the companies are limited in their ability to lower prices. Federal and provincial taxes and royalties already account for about 50 per cent of every gasoline dollar. “As crude prices drop,” noted Michael McNeil, public relations director for the Canadian Automobile Association, “taxes represent a higher percentage of gas prices. That should be making the government nervous.”

Threat: Saudi Arabia and its OPEC partners now are pumping more than 17 million barrels of crude a day on to the world market—which can absorb just under 16 million barrels daily. That makes Canada’s deregulated and geographically fragmented oil industry vulnerable to future shocks. Canada currently produces about 1.5 million barrels a day of crude and imports about 250,000 barrels a day to serve Eastern Canadian markets. At the same time, nearly one-third of the crude produced in Canada—about 500,000 barrels a day—is exported to the United States. Last week a threat to that trade emerged as some Washington politicians began promoting the idea of a tariff on imported oil to simultaneously help reduce the $212.3-billion (U.S.) federal deficit and protect American producers from collapsing international prices.

Pressures were also likely to surface in Canada for government action to cushion the impact of the price war—or risk having exploration and the development of expensive new petroleum sources slow dramatically. In the West, every $1

drop in world prices will take about $100 million annually from Alberta’s treasury and $22 million annually from Saskatchewan’s. Still, the Conservative governments of premiers Don Getty in Alberta and Grant Devine in Saskatchewan have pledged royalty holidays and loan guarantees to Husky Oil’s Saskatchewan upgrading plant. Federally, the New Democratic Party and its leader, Ed Broadbent, have demanded that Ottawa invoke a clause in the Western Accord that allows for the establishment of floor prices for oil if sudden price changes threaten “potentially negative impacts on Canada.”

Submit: Whether oil prices strengthen depends mainly on Saudi Arabia. The desert kingdom is involved in a costly game of nerves with other oil-exporting

nations. Last summer Yamani was faced with a complete breakdown of the oil cartel. After 13 years of effectively controlling the oil market, OPEC countries began to exceed their fixed quotas by steadily increasing amounts, gradually weakening prices.

Non-OPEC countries such as Britain, Norway and Denmark were pricing North Sea oil at levels dictated by market forces —and those levels were well below the posted OPEC prices. Yamani began to forge a strategy to force competitors and other OPEC members to adhere to a single price and new quotas.

Yamani decided to simply increase cheap Saudi output dramatically, driving down the world price until other producers were forced to submit to his policies. In the past four months he has more than doubled his nation’s production to 4.5 million barrels a day. The action swamped already glutted world markets and sent the international spot price of crude Nova Scotia from $26 (U.S.) a barrel at the end of 1985 to

$16.50. Then, Yamani served notice that until other countries reduced production, “there will be no limitation to the downward price spiral.”

Invaded: Saudi Arabia is well equipped to win the pricecutting war. Indeed, Yamani is orchestrating an almost complete and stunning reversal of the devastating price hikes of 1973. In that year a rapid sequence of events suddenly sent the price of oil spiralling upward. Just as key members of the 13-year-old OPEC were locked in negotiations to break the control on prices by major oil companies and raise the benchmark level of oil from just $3 a barrel, Egypt and Syria invaded Israeli-occupied territory. As the Yom Kippur War raged, the Arab OPEC nations declared an embargo against pro-Israeli nations and a production cutback, triggering a supply crisis that made OPEC fully aware for the first time of its power. By the end of the year posted world oil prices had risen to nearly $12 a barrel. Six years later, when the Iranian Revolution disrupted oil exports from that nation, the result-

ing shortages and panic drove the spot price of oil as high as $40 a barrel, before settling back to around $30. Those actions forced the industrial world to shift its growth strategy. Countries explored alternative energy sources and imposed conservation measures—and brought new oil reserves on stream to compete with OPEC oil.

After 1983, cartel members gradually began ignoring production quotas in a mounting effort to keep their share of a dwindling international market. By late last summer Saudi Arabia’s financial reserves, which still stand at between $60 to $70 billion, were hemorrhaging at the rate of more than $1

billion a month as the country held down its oil exports in an effort to keep OPEC together.

Yamani’s worst nonOPEC threat was posed by Britain, which ignored repeated Saudi requests to restrain production and which is now officially the target of the price war. Since 1981 Britain has let its North Sea production soar to 2.7 million barrels a day from 1.8 million. Still, that is only six per cent of the Western world’s current crude oil supply, and many analysts say that Saudi Arabia’s real concerns are quota-violating OPEC members such as Ecuador, Indonesia, Iran and Nigeria —Third World nations that cannot afford a long fight. Already, some oil-producing nations have reacted to Saudi Arabia’s harsh marketplace discipline. Last month Iran and Egypt agreed to cut oil production by as much as 50 per cent, and last week the oil ministers of Algeria, Libya and Iran called for a toplevel meeting of all oilexporting nations to starefinery; Macdonald: turmoil bilize oil prices.

Still, there were no

certainties for any nation as the decline became steadily more dramatic. But the prospect of the Canadian petroleum sector once more acting as “a mighty engine of the economy”—as Carney predicted last year—was clearly receding. Ultimately, oil prices are almost certain to rise, providing relief to Canada’s oil and gas sector, which in 1984 generated $24 billion in revenues.

Until that does happen, Ottawa will likely be forced to follow a difficult policy line to maintain the support of both consumers and provincial governments. It will have to ensure that the oil industry stays in good enough health to bring onstream the new reserves that Canada will need in the future—long after Saudi Arabia’s Yamani has made his point.

MARK NICHOLS with MARC CLARK in Ottawa,

BARRY NELSON

IAN MATHER

in London and correspondents’ reports