Sunday, June 19, 2005
High oil prices are here to stay
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

While the world’s leaders and finance ministers have been concerning themselves with issues such as African poverty, other matters have not disappeared from the agenda. Last weekend in London, the Group of Seven finance ministers expressed their “significant concern” about high oil prices, warning they were hampering economic growth.

On cue, the Organisation of Petroleum Exporting Countries (Opec) said on Wednesday it was raising production quotas by 500,000 barrels a day to 28m from July 1. That is unlikely, however, to produce an early drop in prices, which hit a record of $58.45 a barrel in New York on Friday. Opec, having abandoned its old $22-$28-a-barrel target range now seems relaxed about these higher prices. Demand for oil is strong and supply is limited.

Anyone who writes about oil soon comes across M King Hubbert, the geologist who, in a 1956 paper, Nuclear Energy and the Fossil Fuels, predicted that oil production in America would peak in about 1970. It did, and it earned him a huge following, not least among those who think we are now close to a Hubbert peak for the world as a whole.

A new book, Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy, by Matthew Simmons, argues that production in Saudi Arabia, the world’s largest producer, is at or close to a peak. It cites the fact that 90% of its oil comes from seven giant fields, all of which are mature and increasingly in need of water injection to keep pressure high underground.

“Saudi production . . . is likely to go into decline in the very foreseeable future,” Simmons writes. “There is only a small probability that Saudi Arabia will ever deliver the quantities of petroleum that are assigned to it in all the major forecasts of world oil production and consumption.”

If he is right, now might be the time to start panicking. For, far from today’s high prices representing the top, we could be on track to exceed the modern record: $82 a barrel in today’s prices in 1980, or even get near to $100, the equivalent of which was reached in the 1860s, the height of the Pennsylvanian oil boom.

As it happens, both of Britain’s oil giants have been examining the outlook and, while some would argue that it is in their interests to present a rosy scenario, they also bring a lot of inside knowledge. Lord Browne, BP’s chief executive, recently told the House of Lords that the era of $20-a-barrel oil was over and for. the immediate future, prices would remain above $40.

After that, however, he looked forward to a period, perhaps three to four years hence, in which higher output would come from the Caspian, Angola and from expanded capacity in some of the Opec states. “Over the longer term, the abundance of resources, interfuel competition, and the potential to employ more energy-efficient technology suggest that prices much above $35 are not sustainable for very long periods,” he said.

That is a long way from the Hubbert peak view, and BP, launching its annual Statistical Review of World Energy, has put flesh on it. Last year we had the biggest absolute rise in world energy demand on record, and the biggest increase in greenhouse-gas emissions.

China, with a 15% surge in demand, was a big factor but so were other countries, mainly those outside the older industrial economies. Even excluding China, energy demand rose 4.6% in non-OECD countries, against 1.6% in the OECD.

Will energy demand go on growing at this rate? Not according to Peter Davies, BP’s chief economist. The softening of world economic growth will take the edge off the demand for oil, which will increase at a slower rate than last year.

Even China’s rate of consumption growth is slowing, from 23.5% in 2002 to 15% last year. But demand is still growing, and the reason prices are above $50 a barrel is that there is little spare capacity. Davies said that for the past 12 to 18 months the industry had been operating on spare production capacity of about a million barrels a day, a third of the normal margin.

What about energy supplies? The rise in demand has caught energy producers by surprise. Oil output is in decline in Britain’s part of the North Sea, Norway, America and Australia. But it is rising in Russia and its former satellite states, in China, in Africa (Chad, Sudan, Angola, Equatorial Guinea) and in Canada. It has the potential to rise in Iraq and in other Opec countries. The deep waters of the Atlantic also offer possibilities. But these things will take time, which is why capacity will remain tight for a while. Most of the world’s proven reserves are in the Middle East.

Shell, which has had its fair share of problems with proven oil reserves, has also been looking forward. This month the company published its global scenarios for 2025. Shell says the energy outlook will be determined by what it describes as the combination of three discontinuities. Energy demand will become linked again to economic growth because of the dominance of high-energy-using emerging economies such as China and India. Carbon will become a commodity in its own right, it says, because of concern over emissions. Energy security will become a key concern.

What does this add up to? It is unlikely to mean low prices. Even if prices above $35 a barrel have not been sustainable in the past, as BP’s Browne points out, they may be in the future.

There may, however, be a couple of interesting mechanisms at work over the next few years. One is the normal one whereby high prices encourage exploration in marginal, high-cost areas. In the medium term, in other words, production does respond to higher prices.

The other interesting possibility is that high energy prices will in themselves change the future balance of economic power. The breakneck expansion of China and India, and of emerging economies, could be held back by their appetite for energy in an era of high prices.

Advanced economies that have reduced the ratio of energy usage to growth because of energy efficiency and the decline in heavy industries, are in a better position to cope. Perhaps the relentless rise of China is not so pre-ordained after all.

PS: Two central bankers appeared to play hardball on interest rates last week. Jean-Claude Trichet, the European Central Bank president, stamped on suggestions that rates in euroland could soon come down.

Our own Mervyn King, who in his speech at Salts Mill, in Saltaire, near Bradford, revealed that he had spent some of his boyhood in Yorkshire, also seemed to bat away suggestions that the Bank of England would be cutting interest rates soon. There were, he said, both downside and upside risks to inflation, including 13% annualised growth in the broad (M4) measure of the money supply in the first quarter. There will have been whoops of delight from the nation’s remaining monetarists at that.

But to me King’s speech seemed pretty neutral, as was a subsequent interview he gave to the Bradford Telegraph & Argus. The statistics, meanwhile, are shifting. Last week’s labour-market figures were soft: claimant unemployment has risen for four successive months. The new inflation measure is running at 1.9%, close to its 2% target, but the old one is some way below it. The housing market is comatose and retail sales are particularly weak.

I understand why King and his colleagues get frustrated. The expectation among outsiders oscillates between an imminent rise and an early cut in rates. They want to calm things for a while. We should still, however, see a small cut before the end of the year.

From The Sunday Times, June 19 2005


Comments

Lots of interest this week, including a speech from the Shell chief exec.

But this business of the oil price is very complicated. Alarm bells ought to sound when we hear there is such a thing as ‘a’ worldwide price. It says that normal competitive forces are not at play. Also, why should the price for all oil worldwide be decided by the price of marginal supply? If BP owns a platform in the N. Sea that pumps oil along a BP pipeline to a BP refinery and eventually to BP petrol stations in the UK, why should the price of UK petrol vary with the spot market price of oil in New York? And since it’s ‘our’ oil, why should the government allow this to happen?

Stepping back, there’s a lot of oil price info here: http://www.oilnergy.com/
- with graphs here: http://www.oilnergy.com/1onymex.htm

The last graph on the above page shows average annual oil prices. In 1998 the price was just over $10/barrel. Over the past twelve months it’s been $50. Has our perception of future supply really changed that much in seven years to justify a five-fold increase?

Perhaps it’s our perception of demand rather than supply. The low price in 1998 is generally associated with the Asia currency crisis and Asian recession. But the reduction in oil use in Asia in 1998 can’t have been so great as to actually create a world glut at the time. Equally, the increase of oil use in China today hasn’t actually led to a breakdown of supply. It looks as though the oil price grossly exaggerates any perceived problems in either direction of supply or demand.

So to say the high oil price is here to stay amounts to saying high economic growth worldwide is here to stay. That would be a better problem to have than a recession - but the 1998 experience shows it should only take a recession in one region, not the whole world, to reduce the oil price again.

But on the supply side, will we really run out of oil soon? Let’s look at the background. A quick Google shows that BP Amoco made 8000 staff redundant in 1998, along with 8000 from Shell. It’s less well known that similar redundancies took place among the contractor companies. (As a geophysicist I was made redundant, on my 50th birthday, along with hundreds of others in just our one contractor company).

The common factor in most of these industry-wide redundancies was that the people were aged 50 or over – i.e. it was a pensions issue.

Now I don’t remember popular street protests in 1998 at the scale of job losses caused by the $10 oil price. But my theory is that the low oil price in 1998 caused a big investment in new trucks by UK hauliers. The increased competition then contributed to the fuel protests in 2000 when the oil price went back to $25.

Meanwhile BP and Shell, having removed many of the staff that had discovered and developed all their fields from the 60s onwards, drastically cut back on exploration from 1999. They just concentrated on looking for ‘elephants’ (as daft an idea as it sounds). Only this week has Shell had a change of heart.

What’s more, crazy management behaviour (Enronism) that affected the oil industry in the late 90s resulted in an obsession with mergers and acquisitions that reduced the number of companies in the industry and sidelined technology development.

So it’s true that new finds have not been great over the last few years but that’s because the industry stopped looking hard. However the breakthroughs in 3D seismic and horizontal drilling from the early 90s haven’t been applied to all existing fields yet and there are lots of new fields that would be viable today at an oil price above $25.

Now looking at Saudi Arabia – again, it’s a story of missed opportunity. Up until 1983 the exploration analysis that found the major fields took place outside the country. Then a major exploration centre was set up in Saudi Arabia and eventually the Saudi Aramco company took over from the US oil companies in the late 80s. In practice, in spite of a large number of expat workers, by moving analysis work to Saudi Arabia the country’s oil exploration effort was deprived of the best minds in the industry. Matters have been made worse by the recent terrorist attack on expats in Khobar in 2004.

So I think there’s no real technical or physical reason to worry about a shortage of supply for a long while yet – but there are lots of are management/political issues (especially in the US).

If Gordon Brown had any sense he would give the energy industry the same close attention as the financial industry receives. The UK is in a very lucky position with oil. There’s still time to give the tax incentives and regulatory oversight to encourage the growth of small oil and contractor companies that could exploit the many remaining opportunities that still exist in the UK continental shelf. BP and Shell can take care of themselves.

Posted by: David Sandiford at June 24, 2005 07:55 AM

P.S. Now we know why Merv made his pre-emptive strike making the case for holding interest rates – to balance the release of the MPC minutes showing Charlie Bean’s vote for a cut:
http://www.bankofengland.co.uk/publications/minutes/mpc/pdf/2005/mpc0506.pdf

But a read of the Agents’ summary of business conditions in May doesn’t show any sign of panic – it’s very much ‘steady as she goes’:
http://www.bankofengland.co.uk/publications/agentssummary/agsum05june.pdf

I’m supporting Merv. Roll on the summer sales.

Posted by: David Sandiford at June 24, 2005 08:08 AM

Quote of the week from Dr. Marc Faber in his article:

Housing bubbles and resource misallocation
http://www.ameinfo.com/62979.html

"But nor to worry, we know by now that the US economy is a service economy and does not need to produce anything to prosper except printing machines to keep increasing the supply of money (most printing machines are probably imported too).

Needless to say that the quality of US services is 'the envy of the world', as Mr. Bush, Rumsfeld, Cheney & Co. might articulate and - according to the Census Bureau's Economic Census - with the fastest growth being registered not in 'mundane' businesses such as biotechnology, nanotechnology and high tech industries but in high value added and intellectually highly demanding sectors such as lawn care, childcare providers, janitorial services and nail and hair salons!"

Posted by: David Sandiford at June 25, 2005 10:19 AM