A very interesting and unemotive assessment into the future of oil. Oil prices are not going to fall much, ever By Nick Louth
April 22 2008
As the price of oil climbs to $117 a barrel and petrol at the pump reaches 110p a litre, motorists are wondering how long this latest spike is going to last. Is it just another of those temporary jumps in the cost of fuel that we saw in the 1970s and 1980s or is this a new reality which will last for good?
The answer is that it is likely to stay. While market prices may or may not continue shooting into the stratosphere over the next few months, they are certainly incapable of falling back down to the levels of $60-$70 a barrel seen even a year ago.
The reason is that oil supply is increasingly constrained by extraction costs while demand, fanned by the growth of huge emerging economies like China and India, is remorseless. The International Energy Agency forecasts that in 2008, the world will need an extra 1.3 million barrels a day (bpd), but only 800,000 extra bpd will be supplied.
The supply side
I'm not actually talking about oil running out. This isn't directly an argument in favour of the "Peak Oil" theory, the idea that we will in the next few years began an irrevocable fall in oil output.
Peak oil may be true, but is harder to prove. What is happening right now is more to do with the cost of accessing oil and bringing it to market, not whether it's available under the ground.
There are a number of trends working in parallel to constrain supply:
- The easiest and cheapest to access oil fields are running out
- New fields are still being discovered, but tend to be smaller and less accessible, and so more expensive than they fields they replace
- There is a dramatic shortage of drilling rigs, pipeline suppliers, and skilled staff to meet the surge in exploration required. That has raised costs
- There is a new assertiveness among oil producing nations which has crimped supply, limited the profits and thus discouraged investment in new fields by western oil firms
The easy oil is running out
According to China's academic energy economist Xiaojie Xu, the 14 largest oil fields in the world, which together account for a fifth of global output, are all showing declining production. These old fields, where the cost of producing each extra barrel of oil is just a few dollars, are having to be replaced by new fields more expensive fields.
The cost of developing new fields can be astronomical. A massive new field recently discovered in the South Atlantic off Brazil may contain 8 billion barrels of oil and gas. The bad news is that to reach it means getting rigs aimed at an ocean bed 7,000 feet down, then drilling a further 17,000 feet through sand, rock, and a massive salt layer. That's a total of 4.5 miles.
It's never been done before, and it will cost, big-time.
Petrobras, the firm which discovered it, expects to spend $50-$100 billion over the next five years just to get at the oil. It just wouldn't be worthwhile if oil prices went back to the levels seen in 2005.
Political muscle emerges
Then there is politics, of a kind that frequently emerges when oil prices rise. Venezuela, for example, is sitting on billions of barrels of oil in heavy tar sands in its Orinoco fields, not so very far away from energy-hungry Texas. Yet oil majors are reluctant to invest given the uncertain climate surrounding the anti-US government of Hugo Chavez, which has nationalised a number of foreign operations. Instead they are turning to Canada, which also has tar sands, but of a trickier and heavier type. These will cost still more to process.
In Russia, the world's second largest oil producer, a different kind of politics is in operation. In the last two years both
Shell and
BP have been short-changed on what they considered were legally-binding terms for some of the biggest reserves in the country.
Russian turmoil spooks markets
Russia's own oil firms have been in turmoil too. In-fighting between the government and some of the billionaire oligarchs who controlled the domestic industry has combined with a big jump in taxes to make exploration in Russia a much less enthralling prospect than it was a decade ago.
Investment fund Prosperity Capital has calculated that even at prices of $110 a barrel, production companies in west Siberia, the main oil producing region, are only left with $10 after operating costs, taxes and export duties.
With such slim incentives it is no wonder that Russian oil output is now officially expected to peak this year and decline thereafter. This news last week shocked the market, which had expected further rises in output in coming years, and helped contribute to the recent price surge.
Is $90 now the floor?
In the past, oil producing nations in the OPEC cartel have responded to temporary shortfalls in the oil market by opening the taps to make up the difference. However, faced with what looks like a long-lasting deficit they have decided to be less accommodating. Meeting on Monday in Rome, OPEC blamed speculators for the tight market, while the Venezuelan oil minister Rafael Ramirez predicted that prices "would not fall below $90".
King Abdullah of Saudi Arabia summed up the new conservation attitude, one which perhaps Britain should have followed with North Sea oil, when he said "I keep no secret form you that when there are some new [oil] finds, I said: 'No, leave it in the ground, with grace from God our children need it.'"
Don't look to Iraq either
One of the great hopes was for recovery in production in Iraq, and the opening up of new exploration areas in the west and north of the country. Still, with output already back up to 2.3 million bpd, above the level which preceded the US-led invasion of 2003, the best gains already look in the bag.
So if supply cannot adjust enough, how about demand? Demand though is affected by both price and wealth effects.
The wealth effect
Increasing wealth means that for every British commuter who opts to go green and start using a bicycle instead of his car, 100 or more third world consumers are ditching their bicycles as soon as they can afford a car. In a decade's time, China's car demand is expected to overtake that of the US.
The idea of elasticity
The rising price of oil has made relatively little dent in this demand. The demand for oil is what economists call relatively inelastic in that it takes a big jump in prices to cut demand.
There are obvious reasons for this. Oil is the lifeblood of the global economy. Not only is it largely irreplaceable in transport, but chemicals, plastics, fertilisers, and textiles are made of it. Much of the price of food, heating, cooking and lighting depends upon it.
For decades we have taken cheap oil for granted and public transport has withered so much that many of us now simply have no alternative but to drive. The entire shape of cities, particularly in North America, is predicated on oil so cheap that no services or facilities, not even a newsagent or convenience store, need be within walking distance of the suburbs where most people live. A worst-case new reality wouldn't just mean junking the SUVs but tearing up the newer cities.
There is a positive slant to all this though. While governments dither over climate change and fail to set agreements to reverse carbon emissions, the market place is helping it do its job. Ever-higher fuel costs, especially if sustained over decades, will spur the technology to save fuel, make us choose smaller cars and greener homes, and curb our holiday flights.
For now, though, the price looks like going on up.
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