While the global economy has performed outstandingly well over the last two years, a cloud now hangs over it. Anxiety has set in as oil prices have surged over the last three months from less than $50 to over $70 a barrel. Talk abounds of global slowdown – or even recession.
But these concerns have become entangled with two other assumptions: that we have reached an oil "peak" and that world supplies will begin to decline in the next five to 10 years, or even sooner. The coming shortage, it is argued, will be amplified by the growing demand from the two giants, China and India. This view has gained wide currency.
Worries about the economic impact of high oil prices are justified. After all, in the United States at least, every major recession over the last 30 years has been preceded by an oil spike. The fact that economies could take $50 oil into stride does not mean that they can as easily accommodate $70 oil.
Oil build-up
Whether or not oil is running out is another matter. A recent field-by-field analysis of production capacity around the world by Cambridge Energy Research Associates (CERA) leads to a striking conclusion: the world is not heading for a permanent oil shortage. Indeed, the next few years will see a large build-up of oil supply – virtually unprecedented in its scale.
Lead times are part of the oil industry, and this build-up will not happen overnight. Unless there is a major economic slowdown, the world oil market will remain tight well into 2006. This is not the result of supply disruptions, as was the case with the memorable crises of the 1970s, but rather it is caused by a "demand shock" from the rapid surge in consumption. This increase is the result of economic success – specifically, the best economic performance in almost three decades, economic growth in Asia, and the continuing integration of China and India into the world market. In 2004, world oil consumption grew by 2.6 million barrels per day (mbd), compared to an average growth of 1.1 mbd in the preceding seven years. This unprecedented and unexpected growth has eaten up much of the spare capacity that helps to balance the world oil market.
When a market is this tight, it is vulnerable to external events of one kind or another – ranging from hurricanes and refinery accidents to terrorism, social turmoil and political strife to geopolitical conflict. Simply anticipating such events feeds the apprehensive psychology that helps drive the market today. Prices could well spike much higher than today in the wake of further adverse events, particularly if such shocks are clustered.
Capacity increase
And yet there is no shortage of oil right now. Fundamentals and psychology are diverging: the oil market may be running on fear, but it is not running on empty. Supply and demand move in cycles, and the apprehension that the world is running out of oil is not borne out by the fundamentals of supply. In fact, CERA's field-by-field analysis identifies about 16 million barrels of net new production capacity that will come on line between 2004 and 2010 – a 20% increase in capacity.
Much of this new capacity is already in progress, and much of it was sanctioned on much lower price expectations. This increase of 16 mbd will likely exceed growth in demand by some margin, with a likely impact on price, although there will be some delays and disappointments. This scenario also foresees an increasing role for what are now "non-traditional oils" – ultra-deep water, oil sands, natural gas liquids and condensates. According to CERA research, the share of non-traditionals will grow from less than 10% in 1990 to 30% by 2010.
What is striking is that these new projects were not launched on the basis of $50 or $60 oil, but on much lower price expectations – $25 or $30. Much of the new capacity that will become available between now and 2010 is already discovered and under development. We are only just beginning to see the response to the higher prices, and the impact will be felt not only in mega-projects (albeit with higher and sometimes significantly higher costs), but also in terms of application and ingenuity in extracting more oil out of existing fields.
Digital oil
The current pessimism about future supplies seems to assume that technology has largely run its course. This is reminiscent of the 1970s – another era of supply pessimism – when the industry was supposed to fall off the "oil mountain". The impact of new technologies was greatly underestimated, and perhaps understandably so, since they were not very visible. Some of the technologies that will expand supply are pretty clear today. CERA estimates that the panoply of information technologies – the "digital oil field of the future" – could expand reserves by 100 billion barrels plus. That is equivalent (on today's estimates) of another Iraq.
We can expect oil supply to grow until at least 2025. After that, as one might imagine, the picture becomes hazier. But even looking beyond that, a "peak" is improbable. What's more likely, based on today's understanding, is that we will arrive at a plateau sometime before the middle of this century. But, by then, technology will have opened many other doors.
In this decade, 16 mbd net increment – in terms of investment, projects and activity – is a confident estimate. What the analysis cannot do is take into account unanticipated – or partially anticipated – shocks to the market. In other words, the bigger uncertainties and risks are not "below ground", but "above ground". One could list half a dozen potential trouble spots where brewing troubles could boil over, and so adversely affect supplies.
This is not the first time that the world has been said to be "running out of oil". It's more like the fifth. Cycles of shortage and surplus characterize the entire history of the oil industry. A similar fear of shortage after World War I was one of the main drivers for cobbling together the three easternmost provinces of the defunct Ottoman Turkish Empire in order to create Iraq. In more recent times, the "permanent oil shortage" of the 1970s gave way to the glut and price collapse of the 1980s.
Still, some maintain that this time is different. A common reaction in times of perceived shortage is to underestimate the impact of technology. However, technology is now critical. The familiar "proven reserves" are not necessarily a good guide to the future. The current Security and Exchange (SEC) disclosure rules, which define "reserves" for investors and companies around the world, are based on 30-year-old technology and offer a clouded picture of future potential. As skills improve, output from many currently-producing regions will be much greater than currently anticipated. The share of non-traditional oil will rise from 10% of total capacity in 1990 to 30% by 2010. In time, the non-traditional will become the conventional.
Challenges
However, the growing supply of energy should not lead us to underestimate the longer-term challenge of providing the energy for a growing world economy. At this point, even with greater efficiency, it looks as though the world could be using 50% more oil 25 years from now. That is a very big challenge.
The key challenge is to ensure that investment is made in the energy supplies the developing world will need. If governments make it possible for markets and industry to do their jobs, it will be more likely to achieve this.
The supply challenge is not limited to oil. A second global energy business is emerging in the form of a much expanded, more flexible, traded, global LNG business that will interconnect natural markets in a way that has never happened before. Hundreds of billions of dollars will be required by that new business over the next several years. This, too, will involve much interaction among governments, industry and the IFIs. Coal and nuclear energy will augment electric power, and there will be a growing emphasis on conservation and on developing renewables and alternatives.
But oil will remain centre stage. Comprising 40% of total world energy supplies, it is the critical fuel for transportation. And it is supplied through a remarkably complex, technologically-advanced, and highly-integrated global market. Growing production capacity will, over the next few years, allay fears of imminent shortage. That in turn will provide us with the breathing space to consider the investment needs and the full panoply of technologies and approaches – from development to conservation – that will be required to supply a growing world economy, assure energy security, fuel economic progress in developing countries and meet the needs of what is becoming a global middle class.
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Daniel Yergin is chairman of Cambridge Energy Research Associates (CERA). He received the Pulitzer Prize for The prize: the epic quest for oil, money and power