by Andrew McKillop
Friday, December 10, 2004
VHeadline.com oil industry commentarist Andrew McKillop writes: One hangover from the ultraliberal 1980s, during which the New Economy emerged from the wreck of “Keynesian economics”, is the myth of supply side solutions. For oil and the oil price this myth itself was in fact built on the real world, realpolitik process of first destroying demand.
The 1979-81 entry to the world’s most severe economic recession since 1929-31 and the beginning of the Great Depression, led to the first and only fall in world oil demand since World War 2.
At the same time, there was a rapid increase of North Sea oil output, and increasing
exports from other non-OPEC, resulting in the world being “awash with oil”. From
about 1983 prices began to fall from highs above US$90/barrel (in today’s dollars),
attained during the 1979-80 Iranian crisis.
Since 1999, oil prices have increased about 350% from a low of around $10/barrel.
The intense recession of the 1980-83 period, the heyday of Reagan-Thatcher’s ‘restructuring’ of the world economy, was brought on by swingeing interest rate hikes, and triggered massive business failures and joblessness for millions of persons around the world. Falling oil demand was an unsurprising spin-off from this ‘fiscal rigor’.
After this, the ‘supply side solution’ could be presented as being the cause of Cheap Oil’s return, along with fire sale, low prices for any raw material or agrocommodity. Following the ‘courageous medicine’ of using high interest rates to provoke economic recession and ‘destroy demand’ for oil, which also generated the debt crisis in many low income, raw materials exporter countries, Cheap Oil was in theory locked-in by slow rates of economic growth, de-industrialization, and increasing oil supplies. These increasing supplies, however, were only and in fact due to the certainly final burst of major world oil discoveries, in the 1970-1983 period.
Since 2000, world oil discoveries declared by the 10-biggest oil and energy corporations have never exceeded 4.25 billion barrels in any year. World oil demand is currently running at about 82.5 million barrels/day or 30 billion barrels/year.
In the 1980s, continuing increase of North Sea, Mexican and Angolan oil output led to OPEC experiencing falls in its market share. For this reason, and through Saudi-US political arrangements, Saudi Arabia increased oil production despite the context of slow world oil demand growth — resulting in the oil price collapse of 1985-86, with prices (in today’s dollars) falling below $20/barrel.
Then followed the 13-year ‘Cheap Oil interval’ of 1986-1999, interrupted only by a brief price spike at the time of Gulf War I and the ‘liberation of Kuwait’. In the 1986-99 period there was only one bottom line to oil prices — they were low and trending lower.
Any business or finance guru could prove their credentials by using the slogans ‘OPEC overproduction’ and/or ‘sunset commodities’ to explain why real resources like oil, copper, coffee or tin were cheap and getting more so, and entirely virtual financial services generated big profits.
As late as March 1999 that cheerleader of the New Economy, the ‘Economist’ magazine, could peek into its New Economy crystal ball and announce a future price trend for oil of ‘probably not much above $5/barrel’.
Oil prices approximately tripled in 1999 for the simple reason that world economic growth had begun to shake off the so-called ‘natural rate of stable growth’ set by New Economy gurus, of under 2%/year for the real economy, but 10%/year for almost any equity holding. Rising economic growth outside the OECD countries, especially in the emerging new industrial superpowers of China, India, Brazil, Pakistan, Turkey and Iran (with a combined population close to 2.8 billion), levered up world economic growth.
This hike in world economic growth trends inevitably resulted in world oil demand growth breaking out of its ‘long run trend rate’ of around 1.4%-per-year. Since then, and with superb disdain for its price, world oil demand has grown with the oil price, to a 27-year record rate of over 3%/year in 2004. The ‘break point’ for world oil demand growth, and harbinger for oil prices moving out of the ‘preferred price range’ of $22-28/barrel was in fact in the years 1995-1997.
No ‘price elastic’ response to demand growth: Through 1999-2003 world oil demand growth has progressively ratcheted itself ever upwards, to attain the current rate (estimated by the IEA in September 2004) of about 3.2%-per-year. Higher oil and natural gas prices themselves played and play a major role in underpinning and reinforcing this demand growth process.
This totally contradicts the cozy New Economy notion of ‘price elastic adjustment’,
or an ‘inevitable’ reduction in demand when prices rise, despite the simple facts
of world oil demand growth being now, in 2004, at its highest rate for 27 years,
with prices also at their highest since 1985.
As in the past, only swingeing interest rates hikes, and near instant economic recession exist as demand side solution to higher oil prices — together with trade or economic sanctions and military action against recalcitrant or ‘under-performing’ oil producers, as handy ‘supply side’ tools.
Again using IEA estimates, world oil demand in 2004-2005 is running at well over 2.5 million barrels/day per year (mbd per year). Four years of growth at this rate generates an increase in world oil demand of 10 mbd, or about 1.5 times the net exports of Saudi Arabia at current rates. Seven years of growth at that rate will increase world oil demand by much more than the combined production of Saudi Arabia and Russia, the #1 and #2 world oil exporters.
Fantasy solutions — supply side miracles: Stoic defenders of cheap oil in a real world context of strong demand growth, but only weak and hesitant growth of supply, such as the International Energy Agency (IEA) and the dwindling coterie of quotable energy ‘experts’ and oil analysts, claim that world oil production might be cranked up to 120 mbd by 2020. They also claim that world oil demand growth will magically shrink to below 2%-per-year, from early 2005, for example through China ‘diversifying its energy sources’.
Taking the claim that world oil production can be increased to 120 mbd by 2020,
and based on a current daily demand average of around 82 mbd, world oil production
would have to be raised by 38 Mbd in about 14 years.
The simplest challenge to this laughable fantasy is to ask if anything like this has ever been done before, to which the definitive answer is NO.
The next challenge is to compare net additions to world production capacity needed to satisfy this fantasy, or about 2.7 mbd per year, not including compensation for annual losses of capacity, running at about 2-3 mbd per year, with actual results in the real world during the last 10 or 20 or 30 years.
This returns the same bottom line: world oil output growth at this rate has never been achieved in any past period. Completely ignoring depletion losses to world production capacity, something more than four “new Saudi Arabias” must be found, proven, developed and placed into reliable supply in less than 15 years. Surprising or not, this calculation (around 36 mbd of new capacity needed by about 2018) has been published in the ExxonMobil in-house journal ‘The Lamp’ under the name of ExxonMobil Exploration Company’s CEO.
Only three of the oil major corporations (BP, ExxonMobil and Shell) have production capacities above 2 mbd, and declared discoveries of the 10-largest oil corporations in 2002 and 2003 were respectively 3.34 and 4.02 Billion barrels, according to WoodMackenzie.
During the run-up to invasion of Iraq by the US and UK in 2003, overblown estimates of Iraq’s oil reserves, and production capability were given large media coverage. In fact, as for all other Middle east OPEC producers, national oil reserves of Iraq were ‘doubled on paper’ during the 1980s, but in reality Iraq’s likely current average production, depending on war and sabotage action, is probably below 1.75 mbd.
The ‘supply gap’ in the next 14 years is therefore about twenty-two “new Iraqs” of the ‘liberated’ variety.
That is, the actual and real world numbers for Iraqi production, not the fantasy figures, talked up to ‘10 mbd by 2009’, with reserves of ‘above 150 Bn barrels’, claimed by some analysts and ‘experts’, such as D. Yergin of CERA at White House dinner debates. According to the US Geological Survey, Iraq’s real reserves of oil may only be about 70 billion barrels, equivalent to about 28 months of current world demand.
Demand side reality: One part of the IEA fantasy equation is however shaping out to be real : world demand growth is now closing towards the 2.7 mbd-per-year figure set by IEA analysts in its Chateau de la Muette HQ in Paris as the average annual growth rate for the long period of 2000-2020.
This is a quantum leap, a doubling of the so-called ‘long-term trend rate’ of around 1.4%-per-year which held from the mid-1980s until about 1995, generating annual demand increments of well below 1.25 mbd for world oil consumption.
For BP Amoco, manfully struggling to beat the Poutine mafia and stay afloat in Russia, while trying to recoup its massive investment in pipeline routes to ship out unimpressive amounts of high cost, sulphur and heavy metals contaminated Caspian oil, a single culprit can be named. The leader writers in the 2003 and 2004 editions of BP’s ‘Statistical review of world energy’ can and did finger the culprit — China.
Unexpectedly or not, this country is rapidly becoming the world’s biggest industrial producer and although currently using no more than about 1.85 barrels of oil per capita per year (bcy), for a total daily demand at around 6.5 Mbd, is on a fast and unremitting upward track in oil, gas and electricity consumption.
China’s car fleet, like that of India, is growing at around 20%-per-year on average (with about 35% growth in 2003). In 2004-2005, even using IEA figures, China’s growth of oil demand may attain 0.6 mbd for 2004-2005, translating to China’s import demand rising by more than 0.7 mbd as domestic production continues its accelerating decline.
Fingering China as the unique culprit, BP Amoco’s well-paid analysts and a swath of finance journal leader writers can hope out loud that China’s rulers act against ‘overheating’ (Chinese demand growth also being held as the main driver for surging non-oil commodity prices), but this entirely ignores the other two-thirds of current oil demand growth at the aggregate world level.
Not only China, but even the world’s ultimate oil-wasteful society and economy … the USA using a record 25 bcy … is consistently increasing its oil demand at well over 2%-per-year.
Joining the world’s second and first-biggest oil importers (China and USA) are a swath of new industrial and re-industrializing countries that are rapidly increasing their oil demand, stretching from India and the Asian Tigers to Brazil and the re-industrializing economies of East Europe. In ‘rich Europe’, the EU-15 countries with an oil intensity of about 12 bcy, a mix of factors result in strong oil import demand growth.
On the supply side there is fast depletion of North Sea oil and gas; on the demand side European car fleets are increasing, with larger average engine sizes, while habitat redevelopment, immigration and secular changes (e.g. increasing 1-person households) result in overall European (EU-25) oil imports rising by as much as those of China, at about 0.7 mbd each year.
In total, the trend for world oil demand growth is firmly set in a range of 2.3-2.7 mbd/year, and without intense economic recession is likely to stay there. About 4 months or 150 days of world oil demand growth at this rate will make the Saudi princely boast of ‘raising exports by 0.8 mbd’ a vital necessity … and not a weak attempt to help the Bush administration obtain a few more months of fragile economic growth, with volatile oil price trends that are a godsend for traders.
The ‘new crude’ offered by the Saudi princes, like the majority of Caspian region oil, is sulphur and heavy metals contaminated heavy crude, not at all the light ‘sweet’ crudes sought by refiners. We are therefore left with the vagaries of world inventories, and the key element of weather trends and traders’ expectations and fantasies, to decide oil price movements.
No way out but energy transition: With an ironclad determination to deny
and thwart reality, the leaderships of most countries pursuing the US-European-Japanese
energy intensive model of high consumption growth are each day moving the world closer
to the very opposite of ‘sustainable’ anything, except international conflict, the
clash of civilizations and runaway climate change.
Oil shortage made worse by spiraling demand growth and stagnating supply can only raise prices, then raise them again, leading finally to invasion of oil producer countries.
Extreme high prices will likely be accepted by the more arrogant and weaker minded
leaders and societies for only a short period, before invasion and occupation of
producer countries is decided and applied in the so-called ‘defence of vital national
As the Iraq tragedy shows, the end result of pre-emptive invasion of oil producer countries (to ensure their output performance matches the ideas of so-called experts) is long-lasting war, both civil, international, and North-South. Rivalry between the nuclear armed, oil import dependent superpowers for diminishing oil production capacities is the only bottom line, until clear and courageous decisions are made to limit then decrease oil and gas demand, on a long-term, universal and rapidly progressive base.
Energy transition will need international cooperation and negotiation to set binding,
long-term programs for reducing fossil energy intensity (measured in barrels and
barrel equivalent per head of population). This could be compared to the much
modified and weakened engagements set by the Kyoto Treaty and process, boycotted
by the USA and not including China (the #1 and #2 emitters of climate change gases).
The Kyoto process has been set for the 180-plus nations signing and ratifying the
Treaty, for first application from spring 2005. Similar frameworks, specifically
for limiting oil intensity, are urgently needed.
For energy transition, and firstly oil transition the length of time set by the Kyoto process for greenhouse gas emissions reduction is not available. Under current real world conditions … even assuming that Iraq might regain its early 1980s peak of oil output (4 mbd) by no later than 2008 … world oil supply will almost certainly fail to match demand within 2 to 3 years.
With Iraq submerged in conflict, the date when world oil markets fall into ‘structural undersupply’ is anytime now, and late Autumn/early Winter stockbuilds and drawdowns through late 2004/early 2005 will likely show very strong upward oil price spikes, and volatile, sometimes strong, but shorter downward spikes.
The bottom line will however not change: energy transition for reduced oil-intensity and natural gas-intensity in the OECD countries will need to start in the very short term. Only economic slump starting in early 2005, and hitting the USA, then Europe and Japan can buy a little more time.