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     Feb 10, 2005
Dealing with runaway oil prices
By Andrew McKillop

Recent data from the Organization for Economic Cooperation and Development's (OECD's) International Energy Agency (IEA), the US Energy Information Administration (EIA), leading oil analysts concerning world production and inventory in key consumer countries, together with "traditional" claims by certain analysts that OPEC (Organization of the Petroleum Exporting Countries) is still able to "overproduce" is taken by some commentators as offering a prospect for oil prices sliding below the current, rising levels in the region of about 36-45 euro/barrel (US$45-55), perhaps by mid-2005.

Optimism regarding non-OPEC supply growth is, however, muted at this point, with the only major upturn to counter non-OPEC production decline by the three largest OECD producers (US, Norway and the United Kingdom) coming in the shape of Azerbaijan-Turkey pipeline deliveries from Caspian-region producers. Deliveries are slated to build to not much above, and probably less than, 2.5 million barrels/day (mbd) from spring, 2005. World demand growth remains very strong - at about 3%/year or 2.5 mbd per year - with exceptional growth being recorded not only in the emerging industrial superpowers of China and India, but also in East Europe, the US and West Asia.

World oil stocks, depending on the country and using periodic data from the IEA, EIA and oil analysts, in fact remain well below the average figures for the 2000-2003 period. Combined with recent - extreme - figures from the IEA for world oil production (well over 82 mbd), the overall reading is that world oil markets will remain tightly supplied with generally uptrending prices, right through the period to 2010.

The base for this situation is, in particular, world demand growth. This "vintage" growth has been consistently underestimated now for more than two years, not only by the oil majors and national economic forecasting institutions, but also by major oil importer country agencies, such as the IEA and EIA. These two agencies, in their periodic publications and data series, have continued to forecast slower demand growth likely to "go forward" while publishing real figures for the real world that show "vintage" growth in nearly all markets.

The base for this "surprising" growth in world oil demand, and reason why demand is growing faster than in the 1990s, is unstoppable growth of all forms of commercial energy demand by very fast-growing economies, including China, India, Brazil, Pakistan, Iran and Turkey. In addition, the type and nature of economic growth at the world level, also including the older, slower-growth OECD economies, has become more oil-intensive. This is reflected in the US (taking about 26% of world oil output) by consistent and large oil demand growth coming out of the 2001-02 recession in what has essentially been a "jobless recovery".

Weather trends have become ever stronger, even key factors in deciding price movements - again reflecting the tightly balanced, low stock context that is generated by world demand growth trends moving ever further away from the "low growth paradigm" of the early 1990s. World oil demand has moved up with higher oil prices, which themselves lead to faster economic growth through raising "real resource" prices and revenues to generally low-income exporters of non-energy minerals, metals and agro-commodities.

Another factor tending to drag oil prices higher is strong growth of natural gas demand in several world regions, while supply flattens and then shrinks. For the two largest gas consumer regions, the US and Europe, the fast emerging picture is one of serious shortfalls in regional and national gas supplies becoming "structural" pricing factors. Gas prices in the US will certainly never return to those in the "cheap oil interval" of 1986-99, when daily traded prices averaged around $2/million British thermal units (MMBTU), and oil prices held at around $18-30/barrel. The emerging gas price paradigm for US consumers is now in the $7-10/MMBTU range, equivalent in energy economic terms to oil at around $38-55/barrel.

Gas prices in Europe are "traditionally" above US and Asian prices; faster decline of European gas production (depleting at 5%-6%/year) compared with US domestic output (depletion around 2%/year) will for some time maintain or reinforce this differential. In turn, this will drive European oil prices closer to price levels in the US, negating market proximity-transport cost differentials that tend to reduce European oil prices relative to US. Gas at $10/MMBTU results in oil at 40-45 euro/barrel becoming competitive and the emergence of these price levels will push day traders to erode residual negative price differentials against oil, effectively raising its price in both markets.

Oil prices and world growth
Since late summer, 2003 and for about four months into 2004, US economic growth was likely running at close to its record post-war rate of about 7.5%, last achieved for a whole-year (12 month) period in 1984. At the time, expressed in dollars of 2003, yearly average oil prices were in the region of $52- 65/barrel. In 2004, through June-September, as oil prices moved up to and beyond $50/barrel, the OECD and International Monetary Fund (IMF) consistently revised economic growth estimates for Europe, Africa and Latin America. The IMF estimated that world economic growth in 2004 would be at least 4.5%, the highest in over 10 years. World merchandise trade growth in late 2004 was at about 15%/year, the highest in over 15 years. These real-world, real-economy data provide a direct challenge for those who regularly claim that "high oil prices hurt economic growth".

As in 1984, faster economic growth in 2003-2004 is in no way hindered by higher oil prices, and in fact is likely accelerated by higher oil and energy prices spinning off higher prices for non-oil raw materials, agro-commodities and other "real resources", and raising the purchasing power of generally low-income exporter countries of "real resources". In addition, higher oil and other "real resource" prices - these resources quoted and traded in US dollars - automatically levers up world liquidity, which then buoys and reinforces world solvent demand. At the same time, the emerging industrial superpowers of China and India have such generally low economy-wide oil and energy-intensity (around 1/8th to 1/15th per capita oil-intensity of the US and EU countries) that they are easily able to absorb much higher oil and energy prices without strain to their balance of payments.

Over the past 39 years, the oil price impact on world oil demand trends has been complex and variable. In the chart and Table 1 below, I compare year-peak oil prices in constant 2003 dollars and average demand together with demand trends on a three-year base.



TABLE 1

World per capita average oil demand and oil price trends
1965-2004

Year

World population

Year average
 (millions)

Average daily oil
demand
 

 (Mbd
'all
liquids')

Billion barrels consumed per year

Change on previous 3-year value
 (percent)

World per capita average (bcy) Barrels/
capita/
year

Year
peak oil price in 2003
US$ per barrel
(light volume crudes)

1965

3310

31.23

11.39

+17.2%

3.65

$9/bbl

1968

3520

39.04

14.25

+25.1%

4.05

$9/bbl

1971

3750

51.76

18.89

+32.6%

5.04

$15/bbl

1974

3980

59.39

21.68

+14.8%

5.44

$56/bbl

1977

4200

63.66

23.23

+7.2%

5.53

$39/bbl

1980

4410

64.14

23.41

+0.7%

5.31

$82/bbl

1983

4650

58.05

21.18

-9.6%

4.56

$59/bbl

1986

4890

61.76

22.54

+6.4%

4.60

$32/bbl

1989

5150

65.88

24.04

+6.6%

4.67

$32/bbl

1992

5400

66.95

24.43

+1.6%

4.52

$29/bbl

1995

5610

69.88

25.51

+4.4%

4.54

$25/bbl

1998

5870

72.92

26.62

+4.3%

4.51

$18/bbl

2001

6130

75.99

27.74

+ 4.2%

4.53

$31/bbl

2004

~6400

~82

~29.75

+7.6%

~4.67

$~55/bbl

Data sources:
 
Population data - UN Population Information Network (year
average or June population estimate);
World daily average oil demand each
year: BP Statistical Review of World Energy, various editions;
Peak annual oil
price (2 month basis) for volume traded light crudes, world demand and price
deflator 1965-2001, and price forecast for 2004 are by the author.

The oft-repeated but unproven claim that high oil prices hurt economic growth also lacks proof of its logical corollary, ie "low oil prices favor economic growth". The fast fall in economic growth rates in all OECD countries following the "liberation" of Kuwait in 1991 was accompanied (in fact driven) by fast falling oil and energy prices. In any case, cheap oil in 1991 led to no spontaneous upsurge or recovery in US or other OECD country economic growth. The huge oil price falls of 1985-86 did not lead to faster economic growth in any major OECD country through 1986-88 either.

Conversely, the "Baghdad Bounce" so often predicted by business and finance "experts" for the US and world economy in the run-up to the US and UK invasion of Iraq in 2003 was most certainly upward - for oil prices. Economic growth rates, already at high levels in South and East Asia, were either unaffected, or marginally increased by the economic context in which oil prices bounced upward and continued bouncing upward as Iraq descended into chaos. From early 2004, with continuing and strong growth of the oil price, the "trickle down" effect of higher oil, gas and "real resource" prices began to take effect. Since early 2004, economic growth rates in most world regions, including Europe, Africa and Latin America, have been repeatedly re-estimated upward by the European Commission, OECD and IMF. In addition, and for about 4 months from late 2003, even the erratic US economy showed some signs of "vintage" economic growth before falling back to lower and more hesitant trend rates of about 3.75% to 4.5% in mid-2004.

It is easy to identify non-cheap oil as a cause of this "bounce" or "rebound" of world and regional economic growth trends outside the US, and not the cause of hesitance and fragility in the special case of the US economy. In end-2003 and in the first 9 months of 2004, there were no signs, anyplace in the world, of fast-falling economic growth rates. This is claimed to be "despite high prices" by the vast majority of institutions and "experts", but it is also easy to turn this argument around.

Real world oil demand
According to data published by the IEA, world oil production in January 2004 was running at over 81 mbd. By mid- to late-summer 2004, IEA estimates indicated world oil demand running around 81.75-82.5 mbd. The same IEA source (the "Oil Market" bulletins) indicates in previous issues that average daily demand for 2002 was well below 76.5 mbd (in the range of 76.1-76.4 mbd).

Growth on a 24-month basis (2002-2004) is therefore up to 7%, and for the 36-month period (2001-2004), growth of world oil demand was at least 7.5%. This is the highest rate of growth for over 25 years. We can surmise that if 2001 had not been exposed to the dotcom-telecom crash and the 9/11 terror attacks, leading to a fast fall in economic growth, world oil demand growth in 2001-2004 could easily have exceeded 9%.

This underlines a central argument for oil prices continuing their upward trend since 1999: average three-year growth rate trends held at no more than about 4%-4.5% through the 1990s, with per capita oil consumption staying flat at close to 4.5 barrels/year since the early 1980s. This has now changed quite dramatically. Demand growth rates have increased fast, raising per capita average oil demand, proving that "low-oil-demand-growth-low-oil-prices" is in no way a "fixed paradigm". This paradigm shift, we should note, is occurring in a real world situation of oil prices increasing while world oil demand continues to expand very fast - a context in which higher oil prices lever up world oil demand.

A new paradigm, of rising per capita rates, as experienced in the "high oil price" period , is more than possible. This implies a sharp accentuation of "bottlenecks" or persistent under-supply to an ever-tightening world oil market. It is noted, first, that world per capita average oil demand increased fastest through 1965-77, (table above) in spite of the first oil shock quadrupling crude oil prices. No "price elastic" reduction in per capita demand followed from the first oil shock of 1973-74 (295% increase in nominal dollar prices). The current context is therefore comparable: oil prices are rising, creating a context favorable for faster economic growth (especially outside the OECD). This reinforces world oil demand growth, which is outstripping population growth, resulting in recovery of world per capita average oil demand.

Going forward, three "new paradigms" for annual average per capita demand can be posited, as shown in the table below. All of these paradigms lead only to one conclusion: sharply higher oil prices. In addition, these potential new trend rates of per capita demand and world demand growth on a three-year base are themselves driven by a world economic context of faster economic growth arising in part from higher energy and real resource prices. Any remaining tendency for "loss of market share" by OPEC members can only disappear with the type of vintage growth in world oil demand that is now under way. It is also noted that the per capita average demand figures used (4.75, 5 and 5.25 barrels/capita/year) are in no way "extraordinary" numbers. In 1980, with oil prices briefly attaining $100/barrel in 2003 dollars, and a year-round peak value for a basket of lighter crudes around $80/bbl, world per capita consumption averaged about 5.3 barrels.

TABLE  2

2010 world oil demand
for two population growth scenarios and three annual average per capita demand scenarios ('Low' and
'High' population growth; 'Low', 'Medium' and 'High' annual
average per capita demand)

AVERAGE
PER
CAPITA DEMAND
Barrels/year

WORLD POPULATION 2010
Millions (year average)

HIGH         LOW

YEAR TOTAL DEMAND 2010

Billion barrels (Gby)

LOW      HIGH

YEAR AVG

DAILY

DEMAND
Mbd in 2010

 GROWTH
 FROM
 2002

 Mbd 
 growth
(8 year
 growth)

Low      4.75

6900

6800

32.3

32.8

88.5-89.8

~ 12.5 Mbd

Medium   5

6900

6800

33.8

34.5

92.5-94.5

~ 17 Mbd

High    5.25

6900

6800

35.4

36.2

97-99.2

~ 21 Mbd


Population growth forecast for 'Low' projection assumes UN forecasts of slowed
annual rates of growth for the 2020-2030 period are attained by 2004-2010.
'High' population projection utilizes current trend of world demographic growth
(85-90 Million/year).
World average per capita oil demand figures: 'High' case
does not exceed 1980 average (5.3 bcy)

Emerging and "structural" under-supply
There can be plenty of discussion as to what "structural" under-supply would mean with world oil output likely to start trending down soon, from its peak that may be well below 90-92 mbd (according to geologists and analysts such as Younquist, Deffeyes and the ASPO group). The key word for analyzing price-demand relationships and the much-predicted but slow emerging "gas bridge to the future" is "soon". This paper sets out to suggest that under almost any circumstance and any hypothesis, there will be a widening supply gap driven - not opposed - by rising prices. The above scenarios (Table 2) are very far from adventurous or unrealistic. Barring major catastrophe, the population projections for 2010 are likely to come about, leaving only the average per capita or demographic demand as the factor with most margin for error. Here, we can develop the supporting rationales for a likely increase in world average per capita demand, as summarized below:

Non-implementation of Kyoto Treaty - Other than the EU, Japan and Canada, there is little likelihood of ratification and implementation by major oil consumer and importer countries, including the US, China, India and other emerging industrial countries. In the countries of possible or probable implementation, average per capita or "demographic" oil demand is broadly in the range of 12 (Europe, Japan) to 18 barrels/capita/year (Canada). Reductions of more than 10%-15% from these very high demand rates are unlikely within a period of less than 5 or 10 years from the start date of implementing Treaty obligations (2008-12), without strong coercion and intense economic recession, and thus have little or no impact on 2010 forecasts.

Fast growth of oil demand by new industrial powers - both gas and oil demand growth by China, India and other fast emerging industrial economies is in the range of 6%-15%+ per year (5%-9%/year for oil and 12%-18%/year for gas). Fast growing private car fleets and development of the consumer societies in these countries can follow the pattern set through 1975-90 by the Asian Tigers, leading to tripled or quadrupled per capita oil consumption within 10-15 years, almost at any oil price. Current per capita oil demand in China and India is in the range of 1.3 - 1.8 barrels/capita/year.

Impact of higher oil prices - as shown in Table 1, much higher oil prices in the period 1973-80 led to no sharp fall in per capita demand. The range of demographic demand rates used in Table 2 (4.75, 5 and 5.25 bcy) are all below the actual figures for 1975-80. The only potential for actual fall of world oil demand is through intense economic recession triggered by massive rises in interest rates in OECD countries.

As shown in Table 2, the forecasts presented here indicate a minimum increase of about 12.5 mbd for the eight-year period of 2002 through 2010. In fact, the higher cases, with eight-year demand growth above 14 mbd, are probably more likely in the absence of self-induced and intense economic recession or extremely strong "oil-saving" measures in the OECD countries. Rapid cuts of oil demand in OECD countries will only be available through physical rationing and related technical measures, or through indiscriminate use of the interest rate weapon to provoke economic recession: in both cases the political and media rationale will be "oil shock". This analysis is supported by a review of previous actual growths of world oil output, oil prices, and energy policy responses over eight-year periods from 1971 to 2004.

Supply growth shortfall
The only eight-year periods shown in Table 1 in which oil output capacity was increased by more than 12 mbd were all in the distant past - well before 1980. In other words, for the last 25 years, there has been no eight-year period with net increases in capacity more than 12 mbd. From the end of the "high output growth" period, which ended by 1980, and for about 5 years during 1978-83, world exploration-development activity achieved its highest-ever rates of spending and activity, measured by drilling and proving work. These have never been achieved again. Current trends for exploration-development are very far below this, and to date have shown little positive response to rising oil prices.

One cause is the "wait and see" attitudes by most major oil corporations, who have moved "down the barrel" to refined products marketing and non-energy activities. Their aversion to exploration and development is reinforced by now entirely irrational "reference oil prices" for long-term planning - of below $25/bbl (Italy's ENI claims that $16/bbl is a "rational" long-term reference oil price). In a context of very high exploration costs, and constantly falling field size of actual discoveries, there is only limited response to the emerging context set by oil prices well above $45/bbl. World discoveries in 2003 as published by the 10-largest oil corporations were below 3.5 billion barrels (world consumption is currently about 29.8 billion barrels/year). Most major oil corporations claim that exploration efforts will not increase until they obtain "easy access" to prospective areas in the territories held by the OPEC, especially in the Middle East.

World demand growth is running at 2.25-2.5 mbd per year. The relation between oil prices, world economic growth and per capita or "demographic" oil demand is dynamic: with a return to prices comparable to those of the "high price period" (broadly above $55 per barrel in current dollars), per capita demand can easily re-attain 5 bcy. At 5 bcy, world oil demand will quickly exceed 89 mbd, with annual increments of at least 2.25-2.5 mbd (as current). Even if there is a fallback to lower annual growth rates of around 1.6%, these will still generate annual demand increments of at least 1.75 mbd (around 14 mbd in eight years).

Overall, it is difficult on the demand side to forecast world oil demand growth through 2002-2010 as being less than 14 mbd, barring worldwide economic recession through the use of the interest rate weapon, and physical rationing in the OECD countries as a response to runaway oil prices. This demand increment will be very difficult to supply. Taking historical average or likely and reasonable growth trends for export surplus - "offer capacity" - over comparable eight-year periods, we find these range through 8-9.5 mbd since about 1975. In other words, no previous recent eight-year period has achieved growth of net supply offer, after depletion losses, of much better than about 60% of the approximate 14 mbd growth of world demand that is forecast here as the likely minimum growth of world oil demand in the near-term period of 2002-2010.

Taking the likely minimum or low-medium figure (14 mbd in eight years), this is close to 50% of OPEC's total real export capacity in 2004. Current price rises, apart from the "geopolitical uncertainty premium", are in fact and in reality driven by the incapacity of either OPEC or non-OPEC suppliers to significantly raise export capacity. Oil demand growth through the 12 months in the 3rd Quarter 2003 to 3rd Quarter 2004 was well above 2.25 mbd (annual growth rate of about 3%).

World oil import demand is increasing faster than world oil demand (about 4% for imports and 3% for world consumption) for the simple reason that the vast majority of oil producers are experiencing either stagnant or declining production, and world oil consumption is growing. This includes the domestic oil consumption of the producer countries, reducing their net export or supply offer. Overall, the only non-OPEC oil producers with an export surplus of more than 1.75 mbd are Russia, Norway and Mexico. They, and almost all other non-OPEC producers (with or without export surpluses) have either relatively or absolutely small reserve bases and high or very high production/reserve (P/R) ratios. This includes the UK, Syria, Denmark, Gabon, Ecuador, Argentina, Colombia, Egypt, Oman, Romania and other producers with either stagnant or falling production and rising domestic consumption.

Only Russia in the non-OPEC exporter group has a significant potential for increasing its net exports or supply offer through 2010. Inside OPEC, only the three Middle East producers of Saudi Arabia, Kuwait and UAE, and just possibly Venezuela have any major potential for increasing export offer well above their current export capacities. In volume terms, for the OPEC group, only Saudi Arabia has significant short-term potential for increased exports, but is highly unlikely capable of raising exports by more than 3 mbd through to 2010.

The non-Middle East OPEC members - Nigeria, Venezuela, and Indonesia - are likely unable to expand export offer at all through to 2010, especially Indonesia. By 2010-12, Iran may become a net importer of crude. Indonesia will almost certainly cease to be an exporter of either crude or products by 2006 or even 2005. The bottom line to this is fast emerging supply shortfall to a backdrop of fast-increasing dependence on Russia and Saudi Arabia - or in fact the only choice - transition to lower energy, conservation and renewables-oriented economy and society restructuring strategies. Planning for energy transition will be vital and urgent by 2008. Given the laissez faire or new economy doctrine in current political and business leaderships, it is unlikely that serious planning will occur, giving way to crisis by default.

Growth rates of world oil consumption started moving up since the 1994-96 period and have received new impetus through a combination of higher oil and gas prices, changing types of economic growth, economic cyclic changes, and the very fast economic growth of China, India and other large populations. Current trend rates of growth (long-term trend) are above 2.75%-per-year, peaking to over 3% in high-growth periods such as 2004-2006. Current oil demand growth is well above world population growth (about 1.6%/year). That is, per capita average oil demand is increasing. Oil price rises since 1998-1999, it should be stressed, have not reduced this trend, but in fact have bolstered and reinforced it.

Through a mix of factors, oil demand by the US economy - consuming about 26% of world oil production for 4.5% of world population - is showing sustained growth. Only self-imposed recession through high interest rates could change this in the short-term. While initially unrelated to world oil prices, fast-rising US natural gas prices underlain by falling domestic gas production will continue to exert a ratchet effect on oil prices in US markets. In turn, this will affect oil prices outside the US. In Europe, gas supply is exposed to rapid falls in European internal market gas production, also ratcheting up oil prices in Europe.

China, India and certain other fast-industrializing and large-population economies may triple or quadruple per capita oil demand within 10-15 years, in keeping with the trend. South Korea and Taiwan achieved a growth of 1604% and 703% respectively in their national oil consumption through 1965-78. In the case of China and India, today, their oil import demand growth will be considerably higher than their consumption growth due to falling domestic oil production. Annual growth rates of imported oil are typically at double-digit rates (for China about 27% in 2002-03). Consumption growth trends for natural gas in these markets is even stronger - Indian natural gas demand is likely to increase about 20% for 2003-04, with China's demand expected to go up by about 13.5%.

Due to the short-term prospect of "peak oil" (the maximum sustained oil production rate the world can achieve), perhaps limiting total production to around 90 mbd by 2007-2008, and featuring a fast increase in heavy oil, deep offshore oil, and "syncrude" (tarsand and bitumin base) oil output at high capital costs, prices will tend to maintain their upward movement throughout the 2004-2010 period.

Price transition before energy transition
Very large investments are needed if both OPEC and non-OPEC suppliers are to blunt the arrival of structural undersupply in world oil markets, which is likely to be imminent without much higher prices. These (higher prices) will both limit demand growth in the energy-saturated OECD countries, enable continued growth of oil demand by the New Industrial Countries and enable financing of increasingly risky, higher-cost exploration-development. Based on statements by Lee Raymond and by John Thompson (in articles published by ExxonMobil in its journal "The Lamp") spending in the oil and gas sector on a worldwide basis may need to exceed $2.7 trillion in the next 12 years.

Within this spending, oil exploration and development must also make a quantum leap. This overall development of the oil and gas sector is likely impossible without higher, and stable, prices in the range of about $45-55 or 36-42 euro/bbl for oil, and about $8.50 or 7 euro/MMBTU for natural gas. These pricing levels were surpassed through 1975-78, when OECD growth rates and oil demand growth rates averaged about 3.75%-4%. At the time, oil prices expressed in 2004 dollars were about $40-55/barrel.

Moving up to new price bands can be the focus of serious and committed international attention to the risks facing all players at this time. Runaway price rises in a free-for-all bidding process following supply loss of no more than 5% (as occurred during the 1979 fall of the Pahlavi regime in Iran) is the worst possible scenario. With military invasion and destabilization of Iraq by the US and UK, the world has effectively lost over 2 mbd of export supply, equivalent to one full year's oil demand growth.

Under any scenario, the basic need is for higher and less volatile oil and energy prices, accompanying serious and committed energy conservation, transition to renewable energy and restructuring for a low energy economy, habitat and society. This will be forced on energy consumers worldwide through increasing annual depletion losses, and slower additions of net supply - firstly for oil (around 2008) and then for natural gas (latest by 2015-2018). However, at present, energy transition is discarded as utopian and unworkable by current political decision-makers.

Andrew McKillop is founder-member of the Asian Chapter, International Association of Energy Economists. He can be reached at xtran04@yahoo.com

(Copyright Andrew McKillop 2005)



When oil peaks ... (Jan 26, '05)

Brave nightmare world (Jan 15, '05)

Black gold is king (Apr 29, '04)

Adios, cheap oil, bring on the big bucks (Apr 29, '04)

Oil's slippery slope (Aug 24, '04)

Why oil prices will stay high (Apr 8, '04)

 
 

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