5 Responses to “The market sets high oil prices to tell us what to do”

Comments

1. Desmond Lachman: One has to wonder whether Martin Wolf is not painting too gloomy a picture of oil price prospects over the next few years and whether he is not giving too much credence to Goldman Sachs’ gloomy prognostication that oil prices might soon spike to US$200 a barrel. More specifically, one must wonder whether Mr. Wolf is not underestimating the serious damage that the recent run-up in international oil prices is inflicting on the global economy and whether he is not overlooking the very grim overall macroeconomic context within which the current oil price shock is occurring.

   Mr. Wolf correctly observes that over the past year international oil prices have approximately doubled to their present level of around US$125 a barrel. Past experience with oil price increases would suggest that, if sustained, such a run-up in oil prices could very well shave a full percentage point off US GDP growth in the near-term and a further full percentage point over the longer-run.

   A key factor distinguishing the present oil price shock from previous oil price shocks is that it is not occurring in isolation. Rather it is playing out in the context of the bursting of the largest US housing price bubble in the post-war period. It is also occurring at a time that the US economy is experiencing the “mother of all credit crises”, as Paul Volcker so aptly describes it, and at a time of major de-leveraging in the global financial system.

   In the face of these two major non-oil price shocks, it is difficult to see how the US economy could sustain the currently record high international oil prices without experiencing a prolonged recession. By the same argument, one must suppose that the US economy would experience a major recession were Goldman Sachs’ US$200 a barrel forecast to be realized for any meaningful length of time.

   With the US still consuming around 25 percent of the world’s oil production, one would have thought that any significant slowing in US growth would have a significant impact on global energy demand and hence on world oil prices. There are, of course, those who argue that China’s very rapid economic growth rate makes it of relatively little consequence as to what occurs in the industrialized economies. However, a crucial point that they overlook is that China’s very rapid economic growth is primarily export driven and that the prospects that US and European markets stay open to China’s exports has to be considered rather minimal in the event of a prolonged and deep global economic recession.

   As a final point, I think that Mr. Wolf is too dismissive of the possibility that speculation might be playing a big part in the recent dramatic run-up in oil prices. One knows that pension funds and insurance companies have of late been allocating meaningful amounts of money to commodity purchases. If they are doing so by buying forward contracts, it is not clear that one would expect to see a big build up in physical inventories.

   Posted by: Desmond Lachman | May 14th, 2008 at 5:14 pm | Report this comment
   

2. Philip Verleger (guest): While you are correct that prices need to rise, the current high level of prices is caused primarily by policies of the EU and US. Consider the following facts:

   Iran is chartering ships to store 20 million barrels of heavy crude because they cannot sell it. Iran may cut production.

   US refiners are cutting operating rates because they cannot profit today if they run at higher operating rates. The problem is a surplus of gasoline. The surplus is caused by a last minute change in the amount of ethanol refiners are required to use in 2008 in the US.

   There is a shortage of low sulfur diesel fuel. Prices have surged sharply in Europe, pulling up Brent - a crude that makes low sulfur diesel fuel.
   To make more of this product refiners need hydrogen. The hydrogen is produced when refiners make gasoline. The cutback in gasoline leads to a reduction in hydrogen production which leads to lower diesel production.

   Hydrogen is required to turn Iran’s (or Saudi Arabia’s) heavy crude into diesel fuel meeting today’s environmental standards.

   Diesel prices at retail are up almost $2/gallon in the US from last year while gasoline prices are up $0.60 in the US. A similar trend is observed
   in London.

   There are several remedies to this problem.

   1. Environmental standards on diesel production can be relaxed a little. This would allow more diesel to be produced.
   2. Governments could release low sulfur diesel fuel from strategic reserves. Germany has done this.
   3. Governments could release low sulfur crude from strategic reserves while taking back unwanted heavy crudes. In an emergency environmental standards could be relaxed and the heavy crudes used. In time refiners will be able to make more low sulfur diesel from heavy crudes.

   These changes might bring crude down to between $60 and $80.

   I would argue we should bring prices down to slow the wealth transfer while accelerating the adjustment to future higher prices.

   I would also argue that central bankers need to pay more attention to the messy details of energy markets.

   Philip Verleger is a visiting fellow at the Peterson Institute. He is president of PKVerleger and a senior adviser to The Brattle Group

   Posted by: Philip Verleger | May 16th, 2008 at 8:57 am | Report this comment
   

3. Peter Odell (guest): The current 60% contribution of oil and gas to world energy supplies will be only modestly reduced by mid-century. Thereafter, the contribution of hydrocarbons to energy demand will continue slowly to decline, but it is likely still to account for over 40% in 2100. By then, however, natural gas will be two-and-a-half times more important than oil. The latter will, however, still be an industry larger than that of 2000, albeit one which will become up to 90% based on non-conventional oil.

   Meanwhile, natural gas will undoubtedly have become the prime energy source in the second quarter of the 21st century when it will be twice as important as renewables. Initially this will be achieved through a near three-fold increase in conventional gas production to its peak in 2050 and, thereafter, through the rapid exploitation of the even more prolific non-conventional gas reserves.

   The ultimate physical sufficiency of the world’s oil and gas resources to yield more than 50% of global energy demand until the end of the third quarter of the 21st century is thus not in doubt. One can, indeed, thus ignore the present-day Jeremiahs on near-future “peak oil and gas”. Their predecessors in the 1960s, the 70s and the 80s were all quickly proved wrong and a like-fate will overcome these pessimists by the end of the present decade. Any under-achievement in levels of future oil and gas production will instead be the result of a combination of organisational, economic, political and environmental factors. All of these can, however, be overcome, as they always have been in the past – except for short-term lapses.

   The current generally accepted politico-economic wisdom favouring globalisation, liberalisation, market competition and dependence on speculative trading exchanges (such as NYMEX and the IPE) for price determination will, indeed, soon fall from favour as a consequence of the turmoil which they have created over the past four years. The policies pursued have been to the detriment of consumers the world over as the high prices created have had adverse impacts on economic and social development in many countries, especially in the developing world. The continuing growth of the world’s use of oil – averaging less than 1.5% per annum over the past decade – now clearly demands and requires the establishment of an international oil organisation, whereby order can be brought to the markets. The current unacceptability of any such proposal by policy makers in the OECD countries will continue, but such opposition will hardly be relevant beyond the middle of the next decade, given the now declining importance of these countries in the expansion of global oil demand, viz. only just over one quarter of the world’s increased oil use in the past 10 years.

   The oil industries of non-OECD countries already account for some 95% of world reserves, from which their state-owned or state controlled companies produce over 65% of total world output. Thus, even the remaining five largest multi-national oil corporations increasingly appear to be unable to secure significant new exploration and production rights, except as minority partners in state-run systems. This rapid progress towards state’s control of oil supply is now unlikely to be reversed, as all the ten large oil consuming nations of the developing world, together with many of the smaller oil-using countries, view self-sufficiency as a prime objective and feel assured of this only in the context of their nationally owned and operated companies.

   In these potentially worsening circumstances for the oil majors, the fact that they have in recent years pursued policies which have hardly endeared them to the countries in which expanding demands for energy are of the essence, is not helpful for their survival. The companies are seen as responsible for high prices, leading to high profits, from which extortionate remuneration is paid to their executives and shares are ‘bought-back’ so as to enhance the companies’ status in the stock-markets. Meanwhile, they make too little investment in new upstream operations as they cannot count on securing their required 20% plus rate of return on such investments.

   Thus, as with those ‘majors’ that have already failed to survive, so those remaining may now well be playing out their last few years in countries outside the OECD. In this context a Chinese bid for Exxon and/or Chevron and/or a Russian bid for Shell and/or BP, backed by funds provided by the wealthy member countries of OPEC, seem likely to be only a matter of time. With the ‘majors’ gone, however, there will necessarily be heightened concern in the main OECD countries for their future security of oil and gas supplies. In this context one can reasonably forecast a revival and/or the resuscitation of state-owned oil and gas industries in the developed world. Indeed, this development is already indicated in the three currently booming and expanding state oil companies in OECD countries (viz. Statoil of Norway, AGIP of Italy and ÖMV of Austria). They could thus soon have new bedfellows; for example, a new British National Oil Corporation, a revived Petro-Canada and a de-privatised Total in France/Belgium.

   Above and beyond all these developments, we should now seriously anticipate the creation of a UN International Energy Organisation designed to deal with the world’s 21st century energy matters. Such an organisation would necessarily include central roles for Russia – with its massive hydrocarbons’ resources – and for China – with its inevitable continuing increases in oil and gas demand and its plethora of oil and gas sector agreements in more than thirty overseas countries. There will also be a major input from the now more-powerful-than-ever Organisation of Petroleum Exporting Countries, given its members’ interests in tomorrow’s much expanded and ordered global oil markets. In this global context one can, however, also anticipate the early demise of the International Energy Agency, given its failure in recent years to take any action whatsoever to stabilise energy markets.

   Meanwhile, the world’s continuing regionalised gas markets are massively expanding. In Europe the current obsession for liberalisation will inevitably be abandoned, as external gas producers and suppliers to the growing market wisely insist on long-term contracts to ensure security of demand in the context of the importing European nations’ search for security of supply. The EU’s current commitment to fully liberalised gas markets, in general; and, in particular, the UK’s hopelessly failed experiment with “perfect competition” for securing infrastructural developments and low pricing, seem unlikely to survive for many years beyond the present decade.

   Taken from “An insight into the likely future evolution of the global oil industry” July 2007

   Peter Odell is Professor Emeritus of International Energy Studies, Erasmus University, Rotterdam

   Posted by: Peter Odell | May 16th, 2008 at 3:45 pm | Report this comment
   

4. Kjell Aleklett: “Global supplies of crude oil will peak as early as 2010 and then start to decline, ushering in an era of soaring energy prices and economic upheaval – or so said an international group of petroleum specialists meeting Friday”. This quote was a result of the first meeting of the Association for the Study of Peak Oil and Gas (ASPO) in May 2002 in Uppsala, Sweden. In response to press inquiries ASPO claimed: “The world oil depletion curve is based on all available information on oil reserves and estimates of the amounts yet-to-find, and indicates that world oil production will reach a peak (87 million barrels per day) around 2010 and decline thereafter.”

   Remarkably, this forecast seems today to still be on target. At the 2007 ASPO conference former US Secretary of Energy James Schlesinger said:”…and therefore to the peakists I say, you can declare victory. You are no longer the beleaguered small minority of voices crying in the wilderness. You are now the mainstream. You must learn to take yes for an answer and be gracious in victory.”

   But the concept of peak oil relates to the fact that oil is a finite resource and that at some point, world oil production will reach a maximum and go into decline. Because oil is a life-blood of economies worldwide, the decline of world oil production is certain to result in severe negative consequences, particularly for oil importers.

   The world can be divided into those countries that import oil and those countries that are oil exporters. Current daily export volumes are around 50 million barrels per day, Mbpd, with the rest of the 85 Mbpd produced every day consumed by the oil producing nations. The top five oil importers are USA, Japan, China, Germany and South Korea, who rely on exports from the top five exporters of oil, Saudi Arabia, Russia, Norway, Nigeria and Venezuela.

   The US Energy Information Administration (EIA) forecasts that the US will need an additional 7 Mbpd by 2030. By that time production within the US will have declined by around 2 Mbpd, requiring an increase in imports of 9 Mbpd. Production within China appears to be near a maximum now and will also decline in the near future. With a strong increase in consumption, China will want to increase imports by the same order as the US. Summing import expectations from all of the importing countries an increase in import demand of the order of 30 million barrels per day seems to be required by 2030, but that cannot happen if world oil production soon peaks and then goes into decline.

   By 2030 it is virtually certain that there will be no more oil exporting nations than we have today. So what will likely happen to the top five exporters during the next 20 years?

   Venezuela produces heavy oil from the Oronoco belt and the Global Energy Systems group at Uppsala University, UGES, estimates a possible production increase of 2 Mbpd by 2030. This number was recently confirmed as realistic by experts in Venezuela. Conventional crude production from Venezuela will decline and consumption within the country will almost certainly increase so an optimistic forecast would be that Venezuela might increase its export by 1 Mbpd by 2030.

   Over the next 20 years Nigerian deep water production will likely increase, reach a peak, and go into decline. By 2030 there will likely be a lower export volume from Nigeria than at present.

   Norway has a serious problem with their oil industry today. They now receive so large revenues from their oil exports that they do not know what to do with it. In the future it looks like this problem will disappear as their oil production declines. A field by field analysis of Norwegian production shows that small fields are declining by 20 percent per year and their giant fields are declining somewhat more slowly. Without new significant discoveries in the coming years, exports from Norway will have dried up by 2030, and the world will have lost 3 Mbpd of exports.

   During the Soviet era of the 1980s, Russia reached a production rate of 12 Mbpd after which it dropped dramatically during the collapse of the Soviet Union. Since then, the Republic of Russia worked hard to bring production back to its current level of roughly 10 Mbpd. To keep this level of production they would need to find another “North Sea” somewhere in Russia. If not, they can expect to see no exports of oil by 2030. Because Russia will not wish to import oil from other countries, they may well reduce their exports in the near future.

   President Bush has asked King Abdulla of Saudi Arabia to increase oil production but the answer was a clear no. In recent forecasts, the International Energy Agency (IEA) had hoped for Saudi Arabia to produce 17.5 Mbpd by 2030. In a recent UGES analysis, we estimated that this level of production would require 6.6 billion barrels of possible reserves per year to be brought into production. If the development trend that we have witnessed for the last 20 years continues, production will more likely be 8 Mbpd by 2030. The consumption within Saudi is expected to increase to be 2 Mbpd by 2030, and this leaves 6 Mbpd for export.

   Some believe that “the light at the end of the tunnel” is Kazakhstan, Libya, Canada and Iraq. The first three might compensate for the decline in Norwegian production. The big hope for the future is Iraq. They have seven giant oil fields to develop and might reasonably expect output from these fields to reach 3 Mbpd. The investment required would be enormous, and a big question is who is going to provide this level of investment?

   When it comes to the future the world seems to be walking into twilight, and we need a “renewable torch” to light the path. In recent words of King Abdulla of Saudi Arabia, this is said in a different way: “The oil boom is over and will not return. All of us must get used to a different lifestyle.”

   The world will not collapse due to peak oil. We are a sturdy lot and we will find ways to mitigate this terrible problem. But it won’t be easy nor quick. But working together, making compromises, and mobilizing like never before, we will work our way through these problems and prevail, but we need to start today.

   Kjell Aleklett is professor at Uppsala University, Sweden, and President of ASPO - International.

   Posted by: Kjell Aleklett | May 19th, 2008 at 10:12 am | Report this comment
   

5. Martin Wolf: I think Desmond Lachman makes three good points. First, it is perfectly possible that the present oil prices will precipitate a severe recession. Indeed, such short run effects were certainly on my mind in writing the piece. I am assuming, however, that the world would find some way to adjust to the shock. In the longer term, we might have to do so if the more pessimistic views on oil production turn out to be true.

   Second, it is true that exports play a big role in China’s growth. As a matter of fact, however, it is untrue that the its growth is “primarily export driven”. It is primarily driven by domestic demand. While the Chinese government would welcome a slowdown, it is in a good position to keep demand up should it need to do so, even if export markets became far more closed.

   Finally, I accept that speculation may well play a role in the recent run up in prices. But the prices I talked about are spot prices, not forward prices. If the spot price is well above the short-run equilibrium price, one would expect to see a build up in inventories or a noteworthy reduction in output at the well head, relative to trend. Neither seems to be the case, on the requisite scale, though Philip Verleger suggests I might be wrong on this. I do accept Philip Verleger’s view that $60-$80 may be a better price than $135. How could I disagree with such an expert? But even the 20m barrels of Iranian heavy crude he mentions is less than 6 hours of world production.

   I thank Peter Odell for his interesting comments. He makes many points, not least his opposition to market liberalisation. I do agree with him that some sort of price stabilisation is needed in this most important of all markets. But his most significant comment is his view that the “the ultimate physical sufficiency of the world’s oil and gas resources to yield more than 50 per cent of global energy demand until the end of the third quarter of the 21st century is thus not in doubt.” This is despite what will surely be a huge in overall demand. I hope he is right. But many do not share his certainty, not least Kjell Aleklett, who is, of course, a leading “peak oil”ist. I am open to the possibility that either of these views is correct (though both cannot be). We will find out soon enough.

   Posted by: Martin Wolf | May 26th, 2008 at 5:05 pm | Report this comment
   

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