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Oil’s Slide Set to Leave Dark Trail

THE WALL STREET JOURNAL

Price Dive Threatens Renewables Push, Production Projects; a Bust in Texas

By ANN DAVISBEN CASSELMAN and CAROLYN CUI

Already in free fall, the price of oil could soon push much lower as the effects of a global recession take hold.

Crude fell $3.12, or 6.7%, to settle at $43.67 a barrel on the New York Mercantile Exchange on Thursday. Many oil-industry insiders and traders now say prices could slump much lower, into the $30s, before supply cuts push prices back up, perhaps much later into next year. The changes come from a combustible mix of factors — a rise in inventories, shifts in the quality of oil used by refiners, and severely deteriorating demand.

A file photo taken on May 6, 2008 shows a worker of state oil company Pertamina cycling past barrels filled with fuel in Jakarta

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A worker of state oil company Pertamina cycles past barrels filled with fuel in Jakarta on May 6.

“I don’t think we’re through with the drop. I don’t know where it stops, but I don’t think we’re through,” said Steve Chazen, president and chief financial officer of Los Angeles-based Occidental Petroleum Corp.

Lower oil prices are a short-term gain for consumers and businesses, from carpooling parents to households using heating oil to airlines. But a sustained decline in the price of oil also has painful downsides. Energy-driven economies — in areas from Texas and Alaska to Venezuela and Russia — can face huge busts, with job losses affecting employment for engineers and roughnecks on rigs as well as the accountants, hotels and restaurants that support them.

Sinking oil prices also reduce the political will to push ahead with costly renewable-energy projects, and reduce the urgency to prioritize energy-policy debates on topics ranging from auto efficiency to offshore drilling. The danger is that when demand does bounce back, prices will boomerang far higher because the supply cushion has shrunk.

The swift decline in prices — crude hit an intraday high this summer of $147 a barrel — is hurting industry players, who have less cash to spend on projects as lower prices hurt their revenues.

They also have less incentive to invest as their margins get crushed. Wednesday,Schlumberger Ltd., the world’s largest oil-field-services firm by market capitalization, said its 2008 earnings will miss analysts’ estimates as oil and gas production slows world-wide. Industry drilling-rig counts have begun falling sharply.

Research firm Sanford C. Bernstein & Co. puts the oil industry’s average break-even cost zone at $35 to $40 a barrel, though the figure can vary by project and based on other factors. Thursday’s closing price is well below the $70 to $75 marginal cost at which producers this year could earn an expected return of roughly 9% on new drilling projects.

North America is likely to see the sharpest retrenchment, but Schlumberger’s announcement suggests international projects could follow. Projects that revived long-dormant wells in Oklahoma, used new technologies to salvage old West Texas oil fields or extracted oil from tar sands in Canada require prices above current levels, in some cases far above, unless costs also fall. Some deepwater projects in the Gulf of Mexico or the North Sea would be imperiled if prices fell below $40 for an extended period.

Occidental’s Mr. Chazen says even announced production cuts may be months from taking place, adding to the glut. “Slowing it down is hard. You sign contracts, you make plans,” he says. “It may take you two or three quarters. It can’t be done instantly.”

A further collapse in prices could be forestalled by unexpected supply disruptions. Producers are still struggling long-term to keep pace with global consumption trends. The price drop could stiffen the resolve of the Organization of Petroleum Exporting Countries to slash production when members meet Dec. 17 in Algeria. King Abdullah of Saudi Arabia, the world’s largest oil exporter, recently was quoted as saying $75 a barrel is the “fair price” of oil. If anything, unpredictability is the only certainty in today’s volatile oil markets.

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But a growing number of industry insiders say conditions are now ripe to test the market’s lows. It has historically taken OPEC many attempts to stem price declines. A sea of excess inventory is building from Cushing, Okla., to Singapore. Even in China, one of the few growing markets around the globe, stockpiles are rising.

One of the most striking short-term pulls on oil prices is a futures-market condition called contango. Simply put, oil is vastly cheaper to lay hands on now than it is for delivery months or years in advance. Thursday’s settlement for January delivery, $43.67, is roughly $14 cheaper than delivery a year from now, $23 cheaper than two years from now, and a whopping $39 cheaper than delivery in 2016.

Not only does the opposite condition often occur, where spot oil is more expensive, but the contango conditions present today also feature spreads at their widest in years, Barclays Capital says. Contango incentivizes those who can afford to hold oil to hold on to it. Storage fills up, and that causes the spot price to fall because people need to unload oil.

The debt crisis is one reason for the imbalance, since inventories tie up scarce working capital. “Even people who require physical barrels are trying to take it on Jan. 2, so it won’t show up on their balance sheet at the end of the year,” says Mike Loya, an executive with large international oil trader Vitol Group.

Industrialized countries in the Organization for Economic Cooperation and Development saw stocks rise to 56 days of forward consumption as of the end of October, well above historic levels, according to the Energy Information Administration.

In the U.S., crude-oil stocks are above five-year averages. Traders have also found it profitable to lease tankers for floating storage, which helps inventories to build.

It isn’t just financial maneuvers threatening the price of oil. The premium that the market gave light, sweet crude oil, which is well-suited for making diesel, has dwindled as diesel demand has shrunk.

Deutsche Bank AG analyst Adam Sieminski expects further weakness in the widely quoted Nymex and London light, sweet oil benchmarks “that generate pricing headlines” because substantial new refining capacity is starting up in India and China designed to make products from lower-quality crude.

For example, Reliance Industries Ltd.’s Jamnagar refinery complex in India, set to become the world’s largest single-location refinery with a major new expansion, is expected to start full operations in the first quarter of 2009.

On top of this are stark demand statistics. Despite a drop by more than half in the price of gasoline, consumption until last week remained listless, and only jumped slightly. In China, inventories have risen in recent months after the government increased retail prices for gasoline, diesel and jet fuel by nearly 20% in June. In India, car sales recently saw their first decline in three years, says Sanford C. Bernstein.

A popular research note brimmed with pessimism from energy executives at the end of Thanksgiving week, when Houston research firm Tudor, Pickering, Holt & Co. Securities Inc. invited clients to help write its morning missive. One unnamed exploration and production executive wrote in: “Is E&P where the banking sector was six months ago — recognizing the fundamentals have deteriorated but not yet seeing the cliff we’re headed for?”

Write to Ann Davis at [email protected], Ben Casselman at [email protected] and Carolyn Cui at [email protected]

WSJ Article

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