Like any major movement in a major market, the decline in oil prices since July is the result of multiple factors. But two stand out:
The first is the increasingly evident weakness in the global economy. Ever since the credit crisis hit in the summer of 2007, there has been a debate as to whether the rest of the world economy is “decoupled” from the US. Some thought that Europe and Asia would not be affected because of their own dynamism. Others thought that the impact would show up, but with delay.
The weakness of the dollar was predicated on the view that the US would weaken and that Europe and other regions would not. The Dallas Federal Reserve has identified a relationship between a weaker dollar and higher oil prices going back to 2003. That dollar weakness in turn fuelled commodity prices, including that of oil, both as a repository of value against the dollar and on the notion that global demand for these commodities would remain strong.
Over the last few months, it has become evident that the economic weakness is spreading around the world, all the more so with the seriousness of the credit crisis in the United States. And that in turn means weaker oil demand. With the sharp price decline, the oil market is voting against the idea that Europe and Japan are decoupled from the US economic downturn, and instead the market is now focusing on a weaker global economy and thus a weaker global oil demand.
Breakpoint
As oil prices moved up over $100 and then over $120 a barrel, they entered into what Cambridge Energy Research Associates (CERA) calls the “Breakpoint scenario”. Prices at that level – and the apprehensions and insecurities that go with them – set in motion a series of reactions that would start to undercut those prices.
We see that happening: consumers are in the market for more efficient cars. They are also managing their transportation differently. Businesses are making decisions predicated upon higher prices. Government policies are changing, notably reflected in the first new fuel efficiency standards in 32 years.
The reality of Breakpoint was already becoming evident in the spring when our analysis indicated a point of “peak demand” for US gasoline had been reached in 2007, and that a continuing decline was likely. At this point, gasoline demand in the United States is down almost 2% compared to last year – the result of greater efficiency, behavioural changes, and economic circumstances. Overall oil demand is down more than 4%.
Avoiding Either/Or
So often, it has seemed over the decades, energy policy debate in the United States turns into an either/or debate, which sets conventional supply against renewables and conservation – as though one partial approach or another is sufficient. We need an ecumenical approach and indeed a portfolio strategy. America’s $14 trillion economy runs on 100 quadrillion Btu (British thermal units) of energy per year – 50 million barrels of oil equivalent per day (of which actual oil is currently somewhat over 20 million barrels per day).
Alternatives and renewables have and should have an important role to play in our energy economy, and their role will and should grow. The CERA study on these options, Crossing the Divide: the future of clean energy, outlines how that could happen. At the same time we also have to keep in mind the overall scale of our energy needs, costs and time. A great deal of effort is going into innovation, and the impact will be significant. But the timing and scale remain uncertain. And, as renewables grow in scale, the question of how they are integrated into the existing energy infrastructure becomes more important.
Today, oil and natural gas together represent a little over 60% of total US energy consumption. Most of the rest is coal and nuclear. Renewables are about 6%; most of that is biofuels and hydropower. Given these proportions, and in light of today’s high prices, it is urgent to ask how to ensure the adequate supplies of oil and natural gas that are needed on an environmentally sound basis and at a price that does not damage the overall economy.
Invest on time
The current oil shock underscores the need to encourage timely investment across the energy spectrum – in the United States, in the developed world – and most certainly in the developing world. Investment has to be stepped up in order to play a vigorous game of catch-up with a growing world economy. That, in turn, requires efficient and timely decision making, whether in the United States or in resource-holding countries, as well as the facilitation of large, complex projects that bring on significant new supplies.
It also requires consistency. An on-again, off-again production tax credit (PTC) for wind in the United States is not a way to promote stable development of renewable energy. A PTC needs a longer-term time horizon. At the same time, there is also greater recognition of the role of investment in developing offshore resources.
Uncertainty is the enemy of investment, whether for renewables and alternatives or for conventional energy. Predictability, by contrast, is a vital ingredient.
Market reality
Markets themselves, with their decentralized decision making, generally provide faster and more effective mechanisms for responding to high prices and shortages than systems of price control, which can have unintended and very painful consequences.
The US is more integrated into the global marketplace than in years past, and yet it has less leverage over the market. America’s oil imports today are twice what they were in the 1970s. Yet its share of world markets is less, and the role of other nations greater. In the 1970s the United States represented 30% of world oil consumption. With economic growth elsewhere, the US share is down to 24%. The balance is changing in other ways. National oil companies – which vary greatly in their character and capabilities – control over 80% of world oil reserves. The five “supermajor” oil companies account for less than 15% of the world’s total oil production on a net basis. China and India are now significant players in the market. The list of shifts goes on.
The realities of the global markets and America’s integration into them emphasize the need for a cooperative, multifaceted approach to relations with both producers and other consumers and put a premium on how the US manages, thinks through and structures its relations with other countries.
Great expectations
The final point to consider is the role of expectations. Part of the pressure driving up oil prices into July was due not only to the short-term situation – the latest disruption in Nigeria, the ratcheting up of tension over Iran’s nuclear programme – but also to expectations about very tight supplies three or five years down the road, particularly because of the anticipated high growth in countries such as China and India. These longer-term expectations fed back into current prices. Prices are now lower due to a refocusing back to shorter-term demand.
The focus may change again. More general expectation of very tight supplies in the future is based upon the assumption that the global market cannot generate the responses that are warranted – in terms of demand and efficiency; in terms of new supplies and timely investment; and in terms of renewables, new technologies and alternatives.
A major contribution to a sounder energy future would be to create around the world an economic and political environment, based upon realistic assessments, that ensures that timely investment is really and convincingly on the way.
The answer to today’s energy problem is not either/or: we need an ecumenical approach – a combination of new oil and gas supplies, renewables and greater efficiency – all developed with appropriate environmental and climate change considerations in mind.
Such an approach would be a great contribution not only to relieving the pain and pressures that consumers are feeling and the difficulties that are faced today by businesses, small and large alike. It would also be a fundamental contribution to the future prosperity of the global economy.
Daniel Yergin is chairman of Cambridge Energy Research Associates and executive vice-president of IHS. He is author of the Pulitzer prizewinning book The Prize: the epic quest for oil, money and power, the new edition of which will appear in December.
© Daniel Yergin, 2008