Cheap Oil, the depletion issue and firming demand
Any reasonably unbiased reader of the Oil & Gas Journal's current (2003) series treating "the depletion issue" could quickly conclude that oil and gas depletion, as ever, is a 40-year threat, challenge or opportunity, and therefore a subject for the Keynesian long-term. Extremely large remaining and recoverable oil resources, would exist in so-far underexplored or even 'ignored' regions like the deep offshore South Atlantic region, in parts of Russia that for various reasons would have been overlooked, and of course in Iraq, of which the 'real reserves' can be almost any figure above 200 Bn barrels that the 'expert' cares to toss up. World total endowment would, according to these optimists, be at least 4000 Bn barrels, of which production to date is about 900 Bn barrels.
Much less is said about the 'producibility' of these enormous reserves, that is the rate at which world annual oil production can be increased before some 'hypothetical' maximum is attained, of perhaps 150 Mbd by about 2038 (a 2% annual average growth rate for 34 years would bring world oil demand to 156 Mbd). Even less is is said about oil prices. For the moment, most contributors to the Oil & Gas Journal's "depletion" series appear to suggest, oil market traders will pursue the 'toil' of talking down oil prices because supply tends to outstrip demand and cheap oil is so good for the economy. A host of 'expert' opinion will always be on tap to opine this is so, latterly using the approximate tripling of oil prices in 1998-1999 as a very retrospective explanation for the 2000-2002 'dotcom-telecom' equity price crash on world stock markets.
The OECD IEA in its monthly oil market assessment 'Oil Market Report' for 11 July 2003 is constrained, by facts, to record that world oil demand on an 'all liquids' base is running at an average of at least 78 Mbd in 2003. Based on data in previous issues of the same 'Oil Market Report' this yields a yearly growth rate of at least 2.25% for Summer 2003 against Summer 2002. Not only is no explanation offered for what BP Amoco calls "surprising growth" in the Introduction to the 2003 issue of its Statistical Review of World Energy, but the IEA confidently forecasts that world oil demand will only grow by 1.3% in 2003-2004, attaining 79.08 Mbd as the rate of average demand by Summer 2004. No explanation at all is offered as to why world oil demand growth will now suddenly return to the "long-term trend" growth rate, after its 'surprising' near doubling ! The IEA, in its July 2003 report then goes on to offer the perspective of nonOPEC suppliers increasing their market offer by up to 1.7 Mbd in the next 12 months, leading to OPEC suppliers losing maket share for a fifth successive year. The only explanation offered for the Baghdad Bounce in world oil prices is that OPEC has decided not to increase output, and that Iraq's oil output is only making a "slow return" towards prewar levels. The now dramatic decline of North Sea oil production, with the UK and Norway losing a total of 0.516 Mbd capacity through June 2002-June 2003, and continuing gradual loss of US production capacity (a decline of 0.285 Mbd in the same period), while US oil demand increased at a 10-year record rate of more than 0.5 Mbd, are of course not mentioned by the IEA as factors raising prices.
The work of Deffeyes, Youngquist and the ASPO group on real world oil production potentials strongly suggests net additions to world production capacity will soon fall to zero as the world arrives at its absolute peak of production. This will, through the deforming lens of the oil market, be tested in real time and its impact will be vastly increased price volatility, followed by price explosion. After this, depending on the immediate economic sequels, some form of world compact to hold oil prices in a new and much higher price band will possibly or probably be arrived at through hastily arranged 'North/South' conferences like those of the 1974-81 period.
No easy alternatives
Some economists argue the highest-ever one-year growth of the US economy in 1984 was due to equally extreme budget deficits operated by the Reagan administration with the aim of securing Reagan's re-election. The current Bush administration now seeks re-election of its leader, and is pouring on deficit financed spending but this has done little or nothing to restore or redynamise economic growth. The very recent growth upturn in the US economy, perhaps ironically, is attributed by analysts to stationing about 140 000 troops for occupying Iraq, that is very classical, labour intensive, military Keynesianism. Not coincidentally, the oil demand of foreign troops occupying Iraq is estimated at about 0.35 Mbd, effectively raising internal or domestic demand and constraining exportable surpluses by Iraq.
In real terms oil prices are still comfortably 60% below their level of 19 years ago. Real limiting factors on faster economic growth in most OECD countries do not include higher priced oil and gas, and do include the sequels of a long period in which economic growth has decined on a regular base, high levels of personal debt, fears of job losses, terrorism, climate change and other worries in what are essentially consumption saturated economies. There are ever fewer possible strategies for restoring conventional economic growth. Lower interest rates at this time, and apart from symbolic playacting with quarter-point cuts, can be discarded as any kind of rational, or even possible strategy for the simple reason that US, European and Japanese base rates are at historic lows. Most OECD countries, in 2003, have their lowest, or close to their lowest nominal (but not real) interest rates for 50 years! Further cuts in US interest rates, to base rates of zero percent per year, as suggested by Federal Reserve governor Ben Bernanke, would most surely increase the slow but certain movement away from the dollar. In crisis conditions, for example after stock exchange collapse, this perhaps could turn into classic flight.Gold prices could move up to extreme levels, oil prices in USD would likely grow strongly, but the only sure economic results for the USA would be sharply higher US inflation, and sharply lower US economic growth. Only restored economic growth in the US economy, in final analysis, can underpin the US dollar.
Higher oil prices restore world economic growth
Higher oil prices operate to stimulate first the world economy, outside the OECD countries, and then lead to increased growth inside the OECD. This is through the income or revenue effect on oil exporter countries, and then on metals, minerals and agrocommodity exporter countries, most of them Low Income (GNP per capita below $400/year). Almost all such countries have very high marginal propensity to consume. That is any increase in revenues, due to prices of their export products increasing in line with the oil price, is very rapidly spent, on purchasing manufactured goods and services of all kinds. In the 1973-81 period, in which oil price rises before inflation were of 405%, the New Industrial Countries of that period - notably Taiwan, South Korea and Singapore - experienced very large and rapid increases in demand for their exports. These three countries increased their oil imports in under 8 years through the 1973-81 period, and despite the 405% price rise, by 60% to 80% in volume terms.
This macroeconomic mechanism of higher revenues for fast spending poorer countries quickly levering up world economic growth (the very simplest type of Keynesianism, but at the global level) is easily triggered by rising oil and real resource prices, and flatly contradicts the arguments by authorized 'experts' who opine that higher oil prices 'hurt poorer countries the most'. Higher revenue earnings for many low income oil exporter countries, and also for the special case of Saudi Arabia may be the only short-term way to stop these countries falling into civil strife, insurrection or ethnic war.
No immediate and instant recession can occur with oil at $50 or $60 per barrel. Vastly higher oil prices than that would be needed to abort the worldwide mechanism of higher oil, energy and real resource prices driving faster economic growth. Conversely, low oil and energy prices entraining low real resources prices, combined with rising population numbers surely aggravate the 'cycle of poverty' in low income commodity exporter countries. Deprived of sufficient revenues, such countries have become 'basket case' indebted countries, subjected to draconian conditions by the Club of Paris, World Bank and IMF for debt refinancing and restructuring. Constant ethnic and civil war in Africa provides the best and most real example of what happens to countries subjected to so called 'structural adjustment'. When or if this concerns oil exporter countries there can be no surprise if this reduces or eliminates exports by the affected countries which, after the 'price taker' stage fall into the bottomless pit of basket case low performer economies. When they fall from that into civil and ethnic war their capacity to supply oil also takes a hit.
Today's New Industrial countries (NICs) include China, India, Pakistan and Brazil. All have either big or immense internal or domestic markets, and large potentials for military Keynesian spending, that is safeguarding national economic growth through deficit financed and labor intensive modernization and expansion of their military systems. The relative lack of integration of these behemoth economies in the world system, particularly India and Pakistan, also provides them with some cover or shelter from the effects of world recession, when or if the OECD countries tilt to all-out recession. Conversely, whenever any increase in world solvent demand for manufactured goods occurs, these countries will rapidly increase output. China is now and without question the world's leading industrial power for medium- and low-value consumer manufactured goods and will soon become the world's single biggest industrial economy. Under almost any hypothesis, therefore, fossil energy demand - particularly oil - will increase in China and India, and in the other large population NICs. Demand growth can only run at rates close to, or above their rate of economic growth.
Demand pull, supply pinch and oil price feedback
The absolute peak of world production may perhaps be no more than 84-87 Mbd on an all liquids base, and very far indeed from US EIA and OECD IEA prognostications of up to "115 Mbd by 2020". Maximum net production increase, after replacement of production capacity lost through depletion impacts, through the 2003-2010 period, may not be able to exceed an annual average above 1 - 1.25 Mbd. Current world demand is on an underlying growth track of about 2.25% annual, or around 1.75 Mbd increase for the next 12 months.
This situation, logically, should entrain very large or nearly unlimited increases of oil prices within a period of no more than 2 - 3 years. Whether there is military adventure in Iraq, or elsewhere, this will have little real impact on emerging and structural supply deficit on world oil markets. The role of, and scope for utilisation of 'strategic' petroleum reserves (SPR) will become also tend to become ever more symbolic since the constitution of these reserves always increases total demand and, after utilisation, the reserve must be restocked with oil at a cheaper daily market price. If price have moved higher, the additional world demand due to SPR building or restocking will increase demand pressure on prices. At the present time not only the US, but also China and India are constituting or increasing their SPR with inevitable, additional impacts on world demand. The military occupation of Iraq, we can note, is estimated to need about 0.35 Mbd for the support of troops and logistics, thus sharply increasing total domestic oil needs of Iraq.
Large oil price increases can likely result in significant falls in OECD demand, within periods extending from 3 - 6 months but this is not at all the case in nonOECD economies. Taking current world regional per capita oil consumption rates, and economic output per barrel or barrel equivalent of commercial energy, the effectively price elastic OECD North, and price inelastic NICs and LICs present almost totally different 'profiles' under oil shock conditions.
The bottom line is that relatively large and rapid falls in oil demand in the OECD North, and sustained demand increase by NICs and LICs can be expected whenever oil prices break through the current, artificially low range of no more than $30-$35/bbl in 2003 dollars. On a composite base, and depending on exactly how far oil prices rise, net world demand can likely increase when or if oil prices rise to levels extending up to $60-per-barrel or perhaps more.
Conclusions
For various economic doctrinal and economic mythical 'reasons' Cheap Oil is seen by the decisionmaking elite in the richer nations as the 'passport to economic growth'. This is a pure fantasy.
Since about 1995 'demand shock' has begun to operate in the world economy for a number of reasons, leading to considerably higher underlying growth rates of world oil demand.
Cheap oil and energy underpin the service oriented 'globalized' economy which drives the urban-industrial reference format, model and framework for economic development and social progress anyplace in the world. This in turn is a powerful motor for continued and strong demand growth for fossil energy, worldwide. Upward potential for personal consumption of fossil fuels is essentially unlimited in this context.
Physical depletion is either rejected or ignored as a price setting factor for oil and gas. Concerning oil there is mounting evidence that net additional production capacity is decreasing every year and may soon fall below the product of new capacity demand + annual lost capacity. By 2008 the world oil market may enter a situation of structural supply deficit. Before that period demand growth, and loss of capacity through accidents, stoppages or sabotage may produce recurring price 'spikes'.
In the case of conventional or classic economic growth, this will be enabled and facilitated at the world or 'composite' level by rising oil prices up to high price levels, probably above $60/barrel in today's dollars.
Also because of depletion, but in addition because of environment and climate limits, energy transition away from fossil fuels must and will happen. Price signals, in the existing economic system and framework, are needed if this is to start, and to build from the immediate near term. Existing and developing frameworks provide by the Kyoto Treaty offer some potential for adaptation and direction to the task and goals of energy transition.
Andrew McKillop
8 August 2003
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