ECONOMIC ASPECTS

Contents:  The Issues, Why no Price Signal?, Oil Supply has little impact on GDP, Increasing Price Accesses More Oil, The European 2000 Fuel Protests, References

The Issues

For many years now the geologists have been warning that conventional oil production will start to decline once about 1000 Gb have been used, (see Past Forecasts). In the 1970’s this 1000 Gb threshold was a safe three decades into future, now it is close. Throughout this period, the economists have derided this position, and explained that the geologists just do not understand economics. 1

The general arguments of the economists are:

  -  It is impossible for there to be any near-term risk of oil resource limits; if there were, the market would have warned us via rising prices. 2  Put another way: the market will give adequate warning. 3

  -  Oil supply difficulties will not be of much significance anyway, oil is a much lesser part of the global GDP than back in the 1980’s. 4

  -  When the limit of current reserves eventually approaches, the resulting higher prices will solve the problem: increasing reserves through increased exploration, and by bringing on new field extensions, fields, technologies, and sources of supply (tar sands, gas-to-liquids, shales, etc.) that are currently uneconomic. 5

    These arguments are discussed below. (top)

Why no Price Signal?

The economists ask: Why, if oil resource limits are imminent, has there been no price signal? The answer to this question is five-fold:

(i).  Commodity prices are intrinsically volatile.

    Oil, to some degree, behaves like other commodities, where price is set by very small differences between supply and demand. Demand is a strong function of global economic activity, itself partly determined by oil price. Supply reflects a host of competing production trends. It is therefore hard, perhaps impossible, to forecast changes in supply and demand in the detail required to identify the small amounts of over/under supply that drive the short-term price. In this regard, oil price forecasting is as difficult as for other commodities, such as metals, foodstuffs (wheat, coffee), or ‘commodity’ chemicals (e.g., ammonia, sulphuric acid.)

    Such intrinsic price volatility is aggravated in the case of oil by very poor information (e.g., on real reserves), and sometimes by market over-reaction, even hysteria.

    Thus the first lesson is that for oil, with its intrinsic price volatility, it is hard to pick out the underlying price trend. Trying to communicate the message of oil’s near-term resource limits when the price fell to $10/bbl in 1999 (due in part to weak Asian demand) was a thankless task.

(ii)  The price warning of oil difficulties is likely to be short.

    The economists say that when the fundamental oil limits approach, the price signal will give adequate time for response.

    The answer to this view is, in a sense, a corollary of (i), above. Commodity prices tell a lot about the current over/under supply situation; they contain less information on the longer term. The oil supply fundamentals that drove the US peak in 1971 had been known to analysts for 15 years, but the price signal that warned of impending difficulties was only available for about three years, prices doubling from about $9 to $18/bbl in to-day’s money between early 1971 and late 1973. But this increase was not perceived to be significant, so the subsequent trebling of the price in 1973, to nearly $60/bbl in to-day’s money, came as a surprise to most.

    Underlying to-day’s situation is the fact that sunk costs, and hence the need for return, dictates a short-term requirement on pricing by producers. Since future supply is never known for sure, even a strong feeling that next year’s price will be higher is unlikely to close the spigot, at least for commercial companies or nation-states with large budget requirements, as it is to-day’s income stream that dominates.

    So the second lesson is that oil price contains mostly short-term information.

(iii).  Part of the natural ‘market-based’ price warning has occurred, but was disguised by geopolitics.

    Of course, over the longer term, commodity prices tend to average out at cost price plus some reasonable return; and this is the basis for the economists’ argument that for all minerals an approaching scarcity (hence lower grade ore, hence more expensive extraction costs) must be reflected in price.

    But many factors can push a commodity price away from the ‘cost-plus’ price for long periods. Producers may accept disastrously low prices for long periods wishing to retain market share; or just hoping things will improve; while prices well above production cost can also last, due to difficulties of market entry for new producers, hoarding in expectation of still higher prices, or geopolitics of supply.

    For oil, the latter cause of ‘price disequilibrium’ has been in operation since 1973.

    In its early days, oil was a true commodity, and its price was indeed volatile (see graph in BP’s Statistical Review), with successive shortages, and times of over-supply, sending the price on a roller-coaster. As increasing numbers of new basins came on-stream, the problem became one of chronic over-supply. It took heroic efforts before pro-rationing, backed by US Federal mandate, was finally installed. 6  The days of ruinously low prices were over, and the ‘Seven Sisters’, in conjunction with Uncle Sam, set oil on a long period of tranquil markets, with price steadily decreasing as technology and scale were brought to bear.

    The sequestration of oil company assets by host states, and the peak in US production, ended this idyllic state. The US was left with nothing to pro-ration, as US fields were running flat out, and the Seven Sisters were no longer in quiet competition, but at the mercy for much of their supplies from sellers newly aware of their position.

    Exploration had already found the new oil in Mexico, China and Russia, and the entirely new basins of Alaska and the North Sea, and the high prices encouraged these supplies on-stream. But, crucially, because of geopolitics, oil was no longer coming from just the cheapest sources. Had the ‘Seven Sisters’ still been in command, oil would have mostly flowed from the cheap Middle East, with the more expensive sources largely left until later. But this did not happen, and some of the ‘scarcity-driven’ price rise (due to pumping intrinsically more difficult oil) occurred in the 1970’s.

    The third lesson, therefore, is that part of the scarcity price signal has already occurred.

    (Subsequently, flush production from the new sources more than satisfied world demand, and OPEC’s share fell. Saudi Arabia sacrificed its own production to hold the cartel together, until finally it could accept no further reductions and the price collapse of the mid-1980’s ensued. To-day those ‘new provinces’ are getting old, either near or past their peak production, and there is little in the way of newer provinces to take their place, except for Kazakhstan, which, in reality, is a very old province indeed).

(iv). Market ignorance.

    Markets are not very knowledgeable. Were the dot.coms really worth a lot one year, and little the next; did Marconi change in intrinsic value almost overnight?

    For oil, the ignorance of the market is appalling. If Chief Economists can show so little understanding of the business; if City of London analysts think ‘replacement of proved reserves’ is significant, and if Newsweek does not understand the difference between reserves and recoverable resource, what hope is there for the punters out there? Adequate price warning requires the market to know what is happening. Otherwise the price signals do arrive, but they come like a summer storm.

(v).  The price rises since January 1999 are due, in part, to scarcity.

    Some of the ‘scarcity-driven’ price rise was taken in the 1970’s, but there is also an aspect of scarcity in recent price moves.

    Currently (Spring 2002), OPEC has several million barrels per day of potential production in hand, while the former Soviet union (FSU) may be able to up its production by perhaps 3 million barrels per day over the next 10 years or so. But most of world production outside these two regions is already in decline, making these regions the primary market setters. It was the resource limit in non-OPEC, non-FSU conventional oil that allowed the OPEC quotas of recent years to stick (despite OPEC members cheating), and which led to the price rise from $10 to $30/bbl that started in 1999.

    The latter led in turn to the European 'Fuel Protests' of 2000. Had the warnings the University of Reading passed to the UK government in 1998, of OPEC soon regaining control of the marginal barrel, been passed on to the UK Farmer and Freight lobbies, it is probable that the UK fuel protests would have been averted, or at least managed more rationally. (See
European 2000 Fuel Protests
, below.) (top)

‘Oil Supply has little impact on GDP’

The UK fuel protests had at least one beneficial effect. Up till then the UK’s Department of Trade and Industry (DTI) was convinced that oil played only a minor role in the UK economy; the UK using less oil than previously, having switched to gas. 7  In many quarters the argument still holds, that, since oil is only a small part of GDP, price rises will be of little consequence. 8

The reality is very different.

It is true that oil is now a smaller percentage of the global energy mix than in 1973 (some 40% of traded energy to-day vs. 50% in 1973); and, because oil is also currently cheaper in real terms, its proportion of the global GDP is smaller still.

But to-days’ use of oil is greater in absolute terms (some 25 Gb to-day vs. 20 Gb in 1973), so Humankind is now more dependent on oil to do the many things our burgeoning population wants and needs. And as the fuel protests showed so graphically, transportation, now largely oil-based, is the lifeblood of modern society: in the protests the doctors and nurses couldn’t reach the hospitals, the food did not get to the shops, the schools closed. Society, deprived of transportation, without adequate time to adjust, collapses.

Humankind is in the process of replacing light oil that flows at great rates from single wells with oil obtained by digging up and processing large quantities of sand coated in modest quantities of heavy, degraded oil. That is, the end of conventional oil is the end of intrinsically cheap oil. To-day the ‘cheap’ oil may be priced at $25/bbl due to market control, and the ‘expensive’ oil at $18/bbl due to prime sites, cheap local energy and sunk costs; but as the world moves progressively from real $5/bbl oil to real $25/bbl oil we all lose out. Humankind becomes the poorer, and the world’s real GDP decreases.

And if the difficult oils cannot be brought on-stream fast enough, perhaps because of technical constraints, or because doing so would breach Kyoto limits by unacceptable amounts, then we face actual shortages. Of course, demand then falls to meet supply. But this is what recession (some predict depression, and some even worse) is all about, a world economy running at a significantly lower level. Facile arguments about oil’s current low proportion of global GDP are frighteningly naïve.

So much for generalities; what about the detail of the economists’ specific contention that a price rise will not be significant? As long as the oil price stays within a moderate range, this is true. Following the 1973 shock, the oil price was about $40/bbl in to-day’s money. This halted growth, but did not push the world into major recession. That only happened following the second shock, when the oil price, in the first half of the 1980’s, averaged around $60/bbl in to-day’s money. So as long as the world sees no shortage of oil, and the price stays below, say, $40/bbl, the impact will not be too great. 9

But shortage is shortage, and the succession of production peaks (non-OPEC conventional oil, all-world conventional oil, and ‘all hydrocarbons’) will move the world into very dangerous and totally uncharted economic waters. As the peaks roll by, bland assurances that oil ‘does not matter much’ will look foolish indeed. (top)

‘Increasing price accesses more oil’

A strong defence by economists is that price will solve the supply problem. 10

Higher price clearly does curb demand, and bring on more supplies, but in the latter case, the question is: By how much?

This is a numerical question, and is partly addressed in the University of Reading publication: Perspectives on the Future of Oil, Energy Exploration and Exploitation, Vol. 18, Nos. 2 & 3, pp 147-206, 2000; and the ODAC publication: Global oil and gas depletion: an overview. Energy Policy,Vol. 30, No. 3, February 2002 pp 189-205.

The availability of a mineral is often seen as a pyramid; a small resource of cheap mineral at the pyramid’s apex, and ever-larger resources of more expensive (typically, lower concentration) mineral as one descends within the pyramid.

As explained earlier, such a view is essentially correct for all the hydrocarbon resources combined (but where extraction technologies for some of these are not available, or at negative net energy cost). But it is decidedly not true for conventional oil, where the latter is defined by extraction technology. For conventional oil, there is no large base to the pyramid waiting to be tapped at marginal increase in cost. The oil-water contact defines what fields exist; the size distribution in basins dictates that only the large fields (almost all already discovered) contain significant oil; while the physics of oil entrapment in reservoirs, coupled with the technology specified, determine the proportion of oil-in-place that can be extracted. The ‘resources pyramid’ analogy is not correct for conventional oil.

In this respect, it is worth recalling that the job of oil exploration geologists, like Ivanhoe, Laherrère, Campbell, and Hardman, is not just to identify a probable location of oil, but also to make a detailed financial case to persuade their Boards to drill. The latter decision depends critically on the cost of wells, and on the perceived future price of oil. All of these people have lived through times of both plummeting and soaring prices, so know in their bones that price can change the economic amount of oil in a reservoir, sending it to zero in a difficult reservoir when the global oil price is low, raising the amount when the oil price rises, or the engineers dream up a better extraction technology. So these geologists have an intimate feel, that their economist critics deny them, of what price and technology can do. The oil geologists’ experience leads them to conclude that the impact of price on the date of peak, though real, will not be large, primarily because most of the world’s oil is in large, known fields. (top)

The European 2000 Fuel Protests

Because it was an early manifestation of the coming resource limits, it is worth saying a few words about the European fuel protest of 2000.

Following a period of disastrously low oil price, when commercial companies were producing some their barrels below full cost, and national oil companies were putting far too little into their countries’ exchequers, OPEC decided to be rigorous about quota reductions. At that time, much of the financial community saw OPEC as a ‘non-cartel’, as an organisation where political differences, and a tendency to over-run quotas, would always prevent effective co-operation. Few seemed to realise that OPEC, like virtually all other commodity cartels, finds it difficult to stay together in an over-supplied market (like the late 1980’s, and much of the 1990’s), and easy to stay together when product is tight. Talking to the financial community about OPEC back then was like mentioning the Suffragettes: OPEC was universally seen as an organisation once important, but currently with little relevance.

So when OPEC decided on significant quota reductions, most of the financial community thought little of it, and the best current view was that the oil price would head further downwards, to $5/bbl, not up. 11

But reality intervened. The amount of non-OPEC oil available to compensate for the OPEC cuts was small, with nearly all non-OPEC, non-FSU oil production either in decline, or reaching plateau. Though the OPEC producers cheated on quotas quite substantially, as was expected, supply tightened, and the price rose roughly threefold to about $30/bbl.

Fishermen in France were the first to complain, seeing the cost of business hit; the views spread across Europe, including to UK farmers (who use low-tax fuel on-farm, so feel the price rise in full), and freight hauliers who could see rival companies on the continent using lower taxed diesel. Not a word in the entire debate mentioned resource limits, and in a re-run of the 1970’s, attention focussed instead on oil company profits (a foretaste of problems yet to come) and OPEC’s behaviour, but mainly, at least here in the UK, on the government tax take.

The latter is illustrated in the Figure below.

UK Fuel prices 1980-1999

        [FIGURE 12:]  UK Petrol Prices: Fuel Cost, and Taxe
               
Data in pence/litre, real 1990 prices.
Upper lines: prices at the pumps; Lower lines; excluding taxes and duty.
         Source: Booklet, UK Energy in Brief, DTI/National Statistics.

As this Figure shows, the UK government increased tax and duties on fuel as the underlying cost of fuel price fell dramatically from about 1985. These tax and duty increases (partly reflecting the ‘fuel price escalator’, put in place for CO2 reasons) were very large. They rose from about 100% of the basic cost of fuel in the 1980s to over 300% by the end of the 1990s. Consumers largely did not notice these tax hikes, as the pump prices changed relatively little. But once the OPEC quotas bit, and the government did not revoke the taxes, conditions were in place for the fuel protests.

The next time prices rise, the same culprits (OPEC, oil companies – they need to be beware of windfall taxes), and government will all again be blamed in error. What is required instead is a better understanding of the hydrocarbon resource base, and its capacity to deliver. (top)

References

1.  Numerous references. A key example was a meeting held at the IEA in 1997 to discuss the question of global oil resources. Speakers included Campbell and Laherrère, Odell, Adelman and Lynch. Campbell and Laherrère made the quantitative case based on Petroconsultants’ data. Odell said ‘now let’s look at some real data’, and used the 1980’s gains in proved reserves to argue for a world ‘running into oil’; Adelman said the oil resources were “unknown and unknowable”, but effectively infinite, so price could always turn resources into reserves; Lynch listed many failed forecasts from the past. At day’s end, the rapporteur, an American economist, summed up by saying ‘We’ve heard the geologists’ Chicken-Little views before; on-balance I go with the economists.’ [Chicken Little in the story cried: ‘The sky is falling!’] Incidentally, one fellow present, on hearing of the accuracy of Hubbert’s 1956 prediction for the US oil peak said: ‘Well, somebody had to guess it right’.

2.  See, e.g., P. Davies’ ‘Balanced View’ article, or W. Schollnberger’s submission to the European parliament. (both op cit.)

3.  This is a widely held view, for example the UK House of Lords Select Committee report (Feb., 2002, op. cit., p18) has: “ .. we accept .. that at some stage this century oil production will start declining. However, we go along with the majority view to the extent that we do not believe that this presents an immediate security issue of itself.  … we should receive adequate warning of any shortage of oil through the normal mechanisms of the market – higher prices .. .”

4.  Many references, see, e.g., Refs. 7 & 8, below.

5.  The peak in conventional oil production is the beginning of the decline of availability of cheap oil. More expensive oil is there a’ plenty. The question is: at what rate can the more expensive oil be brought on-stream?

6.  D. Yergin. The Prize, Simon & Schuster.

7.  Discussion between the DTI and the ‘Oil Group’ at the University of Reading (including David Fleming). The DTI listened to geological resources argument, but made no comment, saying they had little knowledge in that area. Where they felt on solid ground was in strongly denying Reading’s assertion that oil supply was important. (One of the DTI economists present has since joined the Treasury, the other gone to the antipodes.)

8.  For example, Newsweek, April 8th – 15th, 2002, p34, has: “The United States is also increasingly immune to oil shocks. In 1980, when prices shot up due to the Iran-Iraq war, the United States spent 8 percent of GDP on oil, and the shock produced a deep recession. In 1999, prices spiked by a similar magnitude, but the United States had cut oil costs to 3 percent of GDP, and many economists believe it’s no accident that the recession was surprisingly mild.”

9.  See, e.g., papers by Professor Oswald of the UK, and from Los Alamos(?) of the US, correlating past recessions with energy prices, driven by oil prices. (But we are surprised at not having read of more tangible linkages than correlation. Access to company internal reporting must be able to tie changes in ‘primary energy user’ companies activity to external energy costs; and this could be analysed for indicative companies in selected sectors, with additional analysis for ‘downstream’ companies dependent on the primary companies, in order to make the energy-price/recession mechanism explicit. More fundamental work would also seem possible, tracking the effect of increased energy costs in terms of reductions in Humankind’s ‘energy slaves’, and hence global loss of productivity, hence real GDP loss.)

10.  This refers to increases in supply, but the economists also look at demand, e.g., Newsweek, April 8th – 15th, 2002, p34 has: ‘ “You know, it’s hard to have a supply crisis to-day”, says Adam Sieminski, a strategist for Deutshce Bank. The energy market works: if prices are allowed to go up, demand goes down. Crisis averted.’

11.  The Economist, cover article: ‘Drowning in Oil’, 1999(?). Oil company CEO’s were quoted as seeing $5/bl well on the cards.
(top)

Updated: 18/May/2002