What happens next?
Posted on Sunday, May 25th, 2008

First published in the Independent on Sunday, 25 May 2008

Never mind speculation, forget the weak dollar. To understand the soaring oil price you need only glance at figures from the US government which show that global oil production has been essentially stagnant – at just under 86 million barrels per day – since early 2005. Despite soaring demand, production outside OPEC has been persistently disappointing as international oil companies struggle to maintain production from ageing fields, while OPEC has been unwilling or unable to raise its output. The result is $135 per barrel – for now. To many this suggests that global oil production has already reached its geological limits, or ‘peak oil’.

If supply is constrained, then the variable that will control the price is demand. Since the economy seems to be moving rapidly into recession, conventional thinking would suggest that falling demand for oil should soon bring the price down again. But few traders are betting on that, because oil market dynamics have changed.

In the OECD countries oil demand has in fact been falling for the last two years – but without moderating the price of crude. That’s because of booming demand from countries such as China, Russia and the OPEC producers, where fuel is deeply subsidized and consumers shielded from the soaring price. For the first time it seems that steeply rising fuel prices can co-exist with recession in the West. There are three ways this new situation could play out:

Oil price collapse.

This could happen if fuel subsidies were suddenly scrapped in developing countries and among the OPEC producers, so dousing demand. Cost pressures have forced Malaysia, Indonesia and Taiwan to cut energy subsidies, but China – with $1.7 trillion in foreign exchange reserves – is hardly strapped for cash. OPEC producers are under no pressure to abolish subsidies; as the oil price rises they get richer. Prospect: very unlikely.

The price could also collapse if peace breaks out in Iraq, the long disputed oil law is agreed, and the international oil companies get to work on the biggest collection of untapped supergiant oil fields in the world – which was clearly the intention behind the invasion. Prospect: vanishingly unlikely.

Oil price stabilizes or moderates.

If the combined effects of the oil price and credit crunch plunge the West into a deep recession, this might cut oil our consumption enough to offset growth in the developing world and OPEC and soften the oil price. Or if the recession engulfs the developing countries and trims demand there too. Prospect: unlikely in the short term.

Oil price charges to $200.

If production stays flat and demand in big producer countries continues to boom, export capacity will soon start to be cannibalized. Analysts CIBC predict that exports from OPEC, Russia and Mexico will fall by 2.5 mb/d in the next 5 years, and this will push oil to $200 by 2012. Prospect: highly likely.

Any hint of further problems on the supply side will supercharge the oil price rise. In recent months Russian oil output has gone into decline, Saudi Arabia has shelved all plans to expand production capacity past 2009, and advisors to the Nigerian government predicted that the country’s oil and gas output will fall by 30% by 2015. Any more news like this and the trip to $200 oil could be nauseatingly quick. Prospect: likely.

British government’s forecast

Despite all this the British government’s considered opinion is that oil will cost just $65 per barrel in 2010 and $70 in 2020. This is the government’s ‘central forecast’, but a return to these prices is highly unlikely without an economic slump. Absurd. But then Gordon Brown apparently understands so little about the world oil market he thinks it a “scandal” that OPEC controls 40% of the world’s oil. It’s the geology, Gordon.

4 Comments on “What happens next?”

Tony Troughton-Smith Says:
May 25th, 2008 at 10:59 pm

I’ve been doing some judicious driving lately. By simply (but religiously) keeping my maximum speed down to 50mph(80kph) where I could otherwise do 70(112), and by being very gentle on the accelerator, I have found I improve my consumption by between 20% and 40%! Some of this may be due to the fact I’m driving a Prius, which has a fairly high-tech fuel management system, but I still think any car will deliver an improvement at least as good as the lower of these figures.
During the last oil ‘crisis’ back in the 1970s the US government (and others, I have been told) legislated to reduce the maximum speed limit to 55mph purely for this reason – to save precious fuel. From the driver’s point of view of course, it also reduces the cost per trip by the same percentage. And in terms of CO2, the environment is saved that proportion of additional greenhouse gas.
So why aren’t our governments rushing through similar laws this time? Why isn’t anyone even talking about it?
I’ve registered two URLs – and, with the intention of getting the ball rolling, explaining this idea and maybe selling some bumper stickers (useful to explain to the driver behind you!). But I’m not a web developer, and never got around to learning html. Anyone want to lend a hand with the site, or suggest avenues to promote a move to reduce our top speeds, such as NGOs or bodies who might be prepared to back it?
I’d welcome any ideas, observations or opinions – even negative ones (but don’t bother to point out that time is money and longer journey times will cost us – this is obvious, but I think the savings in fuel and environmental costs now outweigh the – very slight – increase in travel time.

Alexei Kokin Says:
May 30th, 2008 at 2:56 pm

I cannot agree that fuel (other than natural gas) is “heavily subsidized” in Russia. Speaking of high-octane gasoline, there is an export duty that should lower the domestic price. However, it is offset by an excise tax of similar magnitude. Plus, there is an 18% VAT charge. As a result, drivers in major Russian cities are paying about the same per gallon amount as Americans. As I am writing this, premium gasoline is sold at about RUB 23 per liter in Moscow, or USD 3.7 per gallon.

For diesel, the excise tax is much lower so there is an effective subsidy of about 15% so it costs about RUB 20 or USD 3.2 at the pump. US diesel is between USD 4.5 and 5.0 per gallon. Yet compared with the pump price “before tax” in the UK (about USD 1 per liter as reported here: — Russian diesel is only 10%-15% cheaper. I do not think this qualifies as a heavy subsidy.

Shaun Chamberlin Says:
June 1st, 2008 at 4:56 pm

While I agree with your overall position David, I would suggest a refinement to your points on China and OPEC’s domestic fuel subsidies. While I agree they’re not going to run out of money with which to continue these subsidies, they might run out of will.

If they continue to maintain artificially low domestic fuel prices and keep domestic demand rising then, as you explain, the world oil price will keep on going up. But through that they risk hurting their foreign markets so much that they themselves begin to suffer via reduced demand for their exports (oil in the case of OPEC, almost everything else in the case of China)

It is not necessarily in OPEC’s selfish interests for the world oil price to be absolutely as high as possible, and not only because it might stimulate diversification. They can’t just take all the money in the world – they do still require a functioning world economy, as does China.

This should *at some level* provide a motivation for them to limit those domestic fuel subsidies, limiting their own domestic growth in the process.

Marcus Malkmus Says:
August 25th, 2008 at 11:49 pm

Just a few thoughts about changes in driving habits and oil consumption.
Even with the best effort the change in oil consumption per mile driven is going to be a relatively small (<50%) proportion of the oil used for the trip. Since one can only slow down so much in an ICE car until fuel per mile goes up again there is a linear cap on the savings. If you add to this the rapid increase in the car fleets of countries like China and India it becomes obvious that savings of this magnitude can only delay the supply crunch by a few years at best.
One could even argue that by giving people the false impression that behavioral change makes a big difference attention is drawn away from realistic solutions. Anything that stands a chance to work will have to achieve a fundamental and scalable change in consumption patterns both in the industrialised and the industrialising world. As far as transportation is concerned this could be a (very unlikely) complete shift to next generation biofuels or more likely the introduction of purely electric cars, maybe via the intermediate step of hybrids. In this context the recent escalation of oil prices may long term be extremely beneficial as it accelerates the introduction and economic break-even point for scalable new solutions to transportation.

Another thought about driving more slowly has to do with human behaviour patterns. The introduction of technologically new and initially expensive solutions will need people in the industrialised world who are willing to spend a lot of money on the technically advanced cars. Strict low speed limits as enacted in the US in response to historic oil shortages seem to have had the effect of killing any market for advanced cars. This may in turn have the perverse effect of depriving the world of the few markets with rich and interested consumers that could support the commercialisation of initially expensive advanced green cars.

Buying a prius has a massive secondary effect of getting advanced scalable green technologies down the cost curve into mass production, low speed limits will most likely have the inverse effects of slowing down the adoption of fundamentally new cars.

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