Articles

Why the oil price slump is bad news
Posted on Sunday, October 26th, 2008

First published in The Independent on Sunday, 26 October 2008

Once again Gordon Brown has energy policy all wrong. Even before OPEC announced an output cut of 1.5 million barrels per day, the prime minister had denounced the move as “absolutely scandalous”, fearing it would force the oil price higher just as the world slides into recession.

He needn’t have worried, since the cost of crude continued to fall on Friday to $64 per barrel. But what Mr Brown fails to grasp is that the recent collapse is as damaging in its way as the previous spike, and that had OPEC managed to boost the oil price it would have done us all a favour.

A falling oil price has real short term benefits. Petrol has dropped below £1 per litre for the first time in almost a year; domestic heat and power bills should eventually follow; food prices and inflation should also ease, giving the monetary authorities greater freedom to cut interest rates.

But these benefits may prove fleeting because the collapsing oil price is bad for supply in the medium term. The cost of building new oil production capacity has soared in recent years, and many planned projects that were viable just a couple of months ago are uneconomic today. Christophe de Margerie, chief executive of Total, recently warned that if the oil price settles at $60, “a lot of new projects would be delayed”.

Others put the investment bar much higher, and that means the oil supply could soon fall short of demand – depending on the severity of the recession – forcing the oil price sharply upwards once more. A recent research note from Barclays Capital argues that if oil prices stay below $90, large amounts of expected oil production capacity will not be built, and “the world faces a serious supply side crunch as little as two years away”.

The oil price collapse threatens not only the oil supply, but also renewable energy projects, because their viability is judged against the cost of electricity produced from natural gas, which is itself determined by oil. So wind farms face yet another hurdle, just as Ed Miliband, the Secretary of State at the recently created Department of Energy and Climate Change, has raised Britain’s commitment to cut emissions to 80% by 2050.

Like low oil prices, high oil prices are a mixed blessing. On the one hand they spur conservation: America is now consuming almost a million barrels per day less than a year ago. On the other, they cause recessions: oil price spikes have precipitated every major downturn since WWII. What’s needed, then, is a ‘Goldilocks’ oil price – say $100 per barrel – high enough to sustain capacity and moderate consumption, but not so high that the economy tanks.

But don’t hold your breath. OPEC, for all its fearsome reputation, has never had the discipline to keep oil prices high for long. Even if the cartel cuts enough officially to compensate for falling demand, its members always cheat on their quotas. What is more certain is that whenever the economy revives, OPEC will again struggle to raise output – the cause of the recent spike to $147.

Non-OPEC oil production is widely expected to peak around 2010, and the cartel is likely to reach its geological limits soon after. We are condemned to a sickening rollercoaster of oil price spikes and economic slumps until we finally rid ourselves of our dependence on petroleum.

Gordon Brown has just shelled out £500 billion to bail out some dodgy bankers. Surely we can afford whatever it takes to get off the black stuff?



2 Comments on “Why the oil price slump is bad news”

Peter Dawe Says:
October 26th, 2008 at 5:38 pm

Is there somewhere we ordinary people can plot the elasticity of demand and supply curves of oil in the short, medium and long term?

The up spike was based on no upward supply elasticity in the face of elastic upward demand. The down spike is the short term down elastic demand due to recession.

BUT, is demand really going down? a few less journeys, few few less new things in the west, but what if China India etc use the freed capacity to service their local market. They do not have balance of trade problems, nor government deficit problems. They can even enjoy lower commodity prices for a while.

Looking long term, if they raise their consumption faster, their momentum could mean devastating competition for resources once (if) the west get their act together again.

BTW, up to a few weeks ago I was the most pessimistic person in my circle about the future of western civilisation. In the last 3 weeks, there has been at least one person MORE pessimistic than me! Even to the point of stocking up on enough rice, pasta beans and cooking oil for 3 months!



Hugh Sharman Says:
October 26th, 2008 at 8:34 pm

David,

You are quite right. If you visit http://www.theoildrum.com/node/4676 and view the charts, I think we might conclude that non-OPEC liquids extraction has already “peaked”. If (big IF) OPEC cuts back 1.5 million bopd, then it will be interesting to see whether “peak” already occured in 2006 or whether this has happened during 2008.

With the latest downward price shock, so much expensive capacity will close and so many new “big project” investments will be cancelled or delayed that it is hard to see how the depletion effect can be balanced by new big projects coming on line.





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