To: Ken Lay, Jeffrey Skilling and the Enron Advisory Council
From : Gavyn Davies, Goldman Sachs

Re - The Global Oil Price Shock


Since our meeting in Houston, the spike in world oil prices has gripped the
attention of financial markets. I attach a paper which analyses the genesis
of the present oil price increase, the likelihood of it proving permanent,
and the probable impact on the world economy.

The bottom line is the following:

1. The recent increase in the oil price has been due fundamentally to
an increase in global demand, and not to the activities of OPEC, operating
as an oil cartel. In fact, OPEC does not seem to have enough immediate
supply headroom to make much difference to the situation for many months.
The danger of shortages will therefore be very acute this winter, even with
normal weather conditions. This could lead to temporary spikes in the price
to well over $40/barrel. We see a similar situation, or worse, developing in
natural gas.

2. However, we do not see this situation as permanent. In terms of deep
fundamentals, the equilibrium price for oil in the long term is still only
about $18/barrel. Within about 12 months, a large increase in the supply of
oil should push prices back down again, possibly quite sharply. Our present
forecast for the average oil price in 2001 is $27/barrel, somewhat below
today's spot price levels. But we do not expect to see this oil price
downturn before next summer.

3. If oil prices do indeed average $27/bl in 2001, this will prove to
be an oil shock for the developed economies which is the same in magnitude
as the Gulf War shock a decade ago. It will reduce net disposable income for
the OECD economies by about 0.7%, and add about 0.9% to headline inflation
numbers. All of these effects will already be in the data by about 2000 Q4,
so on our main forecast there should be little or no further adverse effects
through 2001.

4. On this oil price scenario, GDP growth in the developed economies
will slow from about 3.9% in 2000 to about 3.4% in 2001 - not a bad
out-turn.

5. What if the oil price sustains $40/bl next year? This would give us
another round of effects about the same as those mentioned in para (3)
above. Even then, however, these effects should not be enough to push the
world into recession. Growth should still be adequate at about 2.5-3.0%.

6. The main risks to this conclusion are that a spike in oil prices,
and possible oil shortages, this winter cause a drop in equity prices, and a
large dip in business and consumer confidence. This could then lead to a
more pronounced downturn in GDP next year, especially if it triggers the
kind of correction in the US that Larry and I have been worrying about for a
long time. But this should prove just about avoidable, assuming sensible
policy responses..

7. This may therefore all work out a bit like the winter of 1998/99.
Going into the winter, events occur which make people worry about recession.
Business and consumer confidence, and equity markets, take a dip. But then
things improve, and it all turns out to be a buying opportunity.

8. I hope so, anyway!


Best wishes,

Gavyn

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