High oil prices have not yet produced the long-feared economic shock among consuming countries, but further rises, especially sharp ones, would undoubtedly damage the world economy, inevitably harming producers too. Harm is already being done. But the question remains how permanent the changes are to the market.
Oil markets
The surge in oil prices – from $10 a barrel in 1998 to above $70 in mid-2006 – has prompted talk of a new era of sustained higher prices. Is oil heading for $100 per barrel, or has it passed its peak? Paul Horsnell, head of energy research at Barclays Capital, says that, looking out to the five- and 10-year horizons, there’s a big divergence of views, particularly on suppliers’ response to high prices. “The fault line is between those analysts who see the present tightness as a temporary aberration, and those who see something more profound happening. We tend to the latter view.”
Today’s debates don’t differ substantially from those of 2001, when oil was around $25 a barrel, Horsnell recalls. “People assumed that there would be a huge non-Opec [Organization of Petroleum Exporting Countries] supply response that would send prices back down to a range of $15-17. They assumed 3.5 million barrels a day of incremental non-Opec supply by 2005.” New non-Opec fields came on stream, he says, but mature fields declined more rapidly than had been expected.
The effect was sufficient to leave the world market short of spare capacity, vulnerable to political and other shocks. That’s why, now, Barclays’ base case for 2015 is $93 oil – and Horsnell says that, although the oil industry is now investing, it did not start doing so fast enough to loosen the pressure on prices for some time.
Those who focus on the short to medium terms see things differently: they expect an economic slowdown and weaker demand as a result: “Our view on oil is tied to our pessimistic view of US growth next year,” Eoin O’Callaghan, energy analyst at BNP Paribas, says. “Right now spare capacity is low, and the market is very vulnerable to geopolitical news, hurricanes and all the rest. But the US slowdown will play a very important role, not just for the US as a consumer [of oil] but for the world economy. And that will feed through.” BNP sees prices falling at the end of this year and throughout next.
Adding to the froth has been the sudden influx of new kinds of financial investors into the oil market over the last two years. In this sense, financial markets offer another possible route to a sharp fall in oil prices. Pension funds have usually shunned commodities in the past, but in the past year or two they have poured tens of billions of dollars into securitized investments in oil, hoping for returns above those they can get on stock markets. As returns inevitably decline over time, investors may leave en masse and prompt a price collapse; the oil-price boom may yet prove a bubble.
Stephen Roach, chief economist at Morgan Stanley, says that oil is likely to retreat to “somewhere in the $40-50 range” by next year. “We’ve had an overshoot. Energy prices will not stay this high for much longer, and I’m certainly not of the view that prices are moving to even higher highs. We’re near the peak.”
Supply and investment
Investment decisions taken now will be crucial to the producers’ ability to supply the market over the medium and long term. But it’s exactly on investment that international organizations, and the oil companies, cannot agree.
Opec argues that its member countries should not be expected to invest in new capacity without being more convinced about long-term demand. Rehearsing the argument for “security of demand”, Hasan Qabazard, Opec’s director of research, complained recently that OECD countries’ unpredictable taxation of oil products alone could potentially cause demand uncertainty of five - 10 million barrels a day to 2025.
If Opec members are not sure of sales in OECD countries, “the incentive to undertake investment will be reduced”, Qabazard warned the International Chamber of Commerce annual meeting. High volumes of unused capacity would put downward pressure on prices and produce “huge revenue losses” for Opec member countries.
Fadhil Chalabi, executive director of the Global Centre for Energy Studies (GCES), a former deputy secretary-general of Opec (1978-88), argued in an Emerging Markets interview that “Opec does not have a valid argument” on demand. “Security of demand does not exist, in economic terms,” he pointed out. Demand is a function of economic growth, the type of growth, of politics, and of prices.
The problem is that “Opec doesn’t deal with oil commercially, but politically”, Chalabi says. “Opec is 100% under the control of states, who spend revenues on social, political and economic requirements. So despite the large revenues that have accrued in Opec countries, investment has been stagnant for years.”
Worse, Chalabi says, Opec countries under the sway of “oil nationalism” have shut the door on international oil companies coming in to invest. “If countries don’t want to take the risk of spending billions of dollars on investment, they should at least let the companies come in and do it.”
Would the companies invest billions, though? They shouldn’t just because prices are high, Lee Raymond suggested just before his retirement this year as chairman of Exxon Mobil, the biggest oil company. He told a US Senate hearing, at which the oil majors were accused of excessive profiteering, that Exxon’s capital expenditure was about $15 billion in 2004, when prices averaged just under $40 a barrel, i.e. at much the same level as in 1998, when prices dipped to $10. Neither companies nor politicians can afford simply to “follow the ups and downs of energy prices”, Raymond argued.
That thinking is asymmetrical, critics say: at low prices, the companies invest on the assumption of long-term low prices, and at high prices, they don’t commit. Robert Skinner, director of the Oxford Institute for Energy Studies, says the industry’s record profits for 2005 were “not a result of what it did last year, but what it didn’t do for the last 15 years – invest, not only in capital stock and capacity, but in skills and people”. Under-investment is “a root factor” in current tight capacity, Skinner argues.
Barclays Capital’s Horsnell says many senior oil executives have been in the wrong mind-set. Many of them reached the top in the 1990s, when “they thought oil was a dying industry” – and cutting costs was the key to making a profit. “Privately, most executives admit that they overdid it on cost cutting,” Horsnell says, “and now they are starting to invest. But they don’t have the projects, the skilled manpower or the equipment to make a big difference soon. They have hit bottlenecks in getting projects up and running.”
Demand and alternative fuels
Supply constraints coincided with a huge boom in oil demand. Who would have thought that demand would hold up with oil at $60 or $70 a barrel? The lesson of the 1970s and 1980s is that, over the medium and long term, it won’t, says Chalabi at GCES. “The price shocks of those decades caused a decline in consumption in western Europe and Japan, although with a long lead time.” The question now is whether China, where demand has surged most substantially, will do the same in the 2010s. “Some people argue that since China is at an early stage of industrialization, there is no analogy. I do not agree,” Chalabi says. He sees China moving to nuclear power, as well as coal-fired power stations, to reduce its oil consumption.
Claude Mandil, executive director of the International Energy Agency (IEA), told Emerging Markets in an interview thatinternational cooperation to cut demand is crucial to “give the market a breathing space”. “Most countries recognize this, at least in words,” Mandil says. “The G8 summit recognized it. The energy ministers, meeting in St Petersburg, recognized it. But is it possible to go further? To implement the proposals? That’s another question.”
Reflecting shifting opinion about nuclear power among decision-makers, Mandil strongly welcomed the UK energy review, which favours investment in nuclear power. He says that the IEA respects the stance of countries which, after democratic public debate, decide not to develop nuclear capacity – but adds: “We need nuclear, as part of a long-term, world energy strategy. If we want energy, with a continuing reduction in carbon dioxide emissions, we can do it without nuclear power – but at a much higher price.
“The challenge of global warming is increasingly visible and looks increasingly difficult to solve without nuclear power, without carbon capture and sequestration, and without energy efficiency measures.” The nuclear industry, and governments, have to come up with “credible” solutions to nuclear waste issues, if public opinion is to be shifted towards nuclear options.
In the poorest countries, getting rid of subsidies on fuel products is an urgent priority, Mandil says. Bio-fuels will also play an important role in changing the energy mix there.
Producer-consumer dialogue
What does the future hold? Skinner at the Oxford Institute says that rather than repeating sound-bites about security of supply or demand, political and industrial leaders should focus on the “market-resource mismatch” that will define 21st century geopolitics: that is, that most energy resources are in one group of countries (oil and gas in the Middle East, Russia and North Africa) and most markets are in other countries (North America, western Europe, China and Japan).
The mismatch will increase, and it means that oil and gas – which account for 60% of total world energy consumption – will pass in even greater quantities through “choke points” such as Hormuz, the Straits of Malacca and the Bosphorus.
“The IEA estimates that by 2030, two-thirds of net inter-regional oil trade and one third of liquefied natural gas will pass through the Straits of Hormuz,” Skinner points out. And because gas is more difficult to transport than oil, the consumer and producer countries will become more co-dependent as the proportion of natural gas in the energy mix rises at oil’s expense.
So the governments of producer countries and consumer countries will have to work together, even as their interests will diverge still further. The two sides must start saying what they mean to each other, Skinner argues. “Opec and its leaders repeatedly call for ‘stability and predictability’. Is this merely code for agreement on prices and supply management? Indulging such notions out of diplomatic politeness raises expectations that are simply unrealistic in an open, pluralist, market-based system of trade and investment.”
Dialogue should lead to “better information and analysis of drivers of demand and supply, to examining the factors that cause uncertainty and dislocations of supply, and therefore to an expanded circle of key consuming countries with strategic oil stocks”, Skinner concludes. Such initiatives are expensive and “not politically sexy” – but they go to the core of the problem: “providing surge capacity to meet upsets in what, at the end of the day, is a technical system”.