One of the most alarming features of the current economic scene is the instability of world oil markets. The economic establishment appears to have convinced itself that the near doubling of oil prices over the past year will cause only minor disruption, and may well in any event prove short-lived as the international economy loses momentum next year.
One of the most alarming features of the current economic scene is the instability of world oil markets. The economic establishment appears to have convinced itself that the near doubling of oil prices over the past year will cause only minor disruption, and may well in any event prove short-lived as the international economy loses momentum next year. But it is much more likely that what we are witnessing represents a fundamental structural change in the balance of demand and supply in the oil markets, which may well drive oil prices still higher over the medium term, causing real economic damage.
Why is the conventional wisdom so sanguine in the face of soaring oil prices? A common claim is that there is "no shortage of oil". Oil reserves are vast - enough for decades to come. Another observation is that the past 12 months' "shock" has been much less fearsome than the oil crises of the 1970s - after inflation, the oil price is currently about half the level it reached in 1980. What is more, the economies of the developed world are less reliant on oil than they used to be, using probably one-third less oil per unit of output now than then, so the economic impact of high oil prices is much reduced. So not much to worry about, then.
But in fact there is, and the oil markets sense this. In recent months forward prices, which indicate market expectations for the future, have risen steadily. Against today's $48 per barrel, the market expects the price still to be north of $40 three years from now. For next year the average expectation is $45. Clearly, the market does not believe high oil prices are going to melt away, and an analysis of the long term factors at work suggests that, if anything, it is not sufficiently alert to the growing imbalance between demand and supply which is in prospect.
The left-hand chart shows that oil prices have been on an upward trend since the beginning of 2000. The oil price has doubled over the past year; but it has quintupled over the past five. What is going on? This oil crisis is fundamentally different from its predecessors in 1973 and 1979, which brought the world economy to a halt. Those crises were caused by deliberate action on the part of oil producers to restrict supply and force prices up in order to maximise revenues and exert political pressure on the West. This time, prices are rising in response to escalating demand, which is growing at a faster pace than in any decade since the 1960s and which over the medium term will continue to do so.
The two drivers of world demand for oil, the United States and China, have been growing exceptionally rapidly by their own standards. America is heading for GDP growth of at least 4 per cent this year, far higher than in the earlier years of this decade. China has been growing in excess of 9 per cent, increasing oil demand by at least double this rate. Other Asian countries such as India, whose growth is oil-intensive, have also been expanding rapidly, and after many years of rapid growth these countries are accounting for a growing share of world demand.
Although the US is expected to grow more slowly next year, its trend growth rate exceeds 3 per cent, so American demand for oil will continue to increase. Equally, the Chinese government is taking action to reduce overheating, but the World Bank is forecasting that China will go on expanding at about 8 per cent a year. So demand for oil will keep rising strongly. And the key point is that there does not seem to be any early prospect of an increase in supply at a similar pace.
Most of the increases in supply that have been achieved in recent years among non-Opec countries have come from the former Soviet Union (FSU), but as a result of infrastructure constraints the possibilities of further increases in Russian production are very constricted, with forecasts suggesting that production there might not rise by much more than 1 million barrels per day (bpd) altogether over the next few years. As for other non-Opec countries, although new wells are being brought on stream, the output from existing wells is declining rapidly so that the potential net increase in production is small.
The extra production to meet growing demand must come from Opec. But, as illustrated in the centre chart, Opec's spare capacity has been almost entirely used up. About one-third of the capacity which was available a couple of years ago, in Venezuela, Iraq and Indonesia, has gone. The remaining two-thirds has disappeared as production has risen towards capacity limits in response to increasing demand. According to a variety of estimates, spare capacity is down to between 500,000 and 1 million bpd. Headroom has virtually disappeared.
In the current circumstances, any increase in capacity will depend predominantly on Saudi Arabia. But it is not clear that the Saudis are convinced there is a structural problem. Moreover, major increases in supply require substantial investments in infrastructure, and Barclays Capital estimates that it would take between five and 10 years to increase Saudi production by 50 per cent, from 10 million to 15 million bpd. Since the Saudi government will not allow the international oil companies to develop its vast oil reserves, any more rapid increase in production capacity is unlikely. On top of this, Saudi Arabia produces the wrong sort of crude to meet much of world oil demand, and after a decade of cost-cutting by the oil companies there is a severe shortage of refining capacity.
All in all, producers will be extremely hard pushed to increase output by the 1 to 2 million bpd which will be demanded each year if the world's economies grow in line with their trend rates. Indeed, the bald arithmetic indicates it can't be done.
Going back to those sanguine claims, there is no shortage of oil reserves, certainly, but the point is that they cannot be accessed rapidly enough to meet growing demand without a further rise in prices. Moreover, although the oil price, in real terms, is much lower than the 1980 peak, and developed economies do use less oil, oil price rises still curtail growth. The third table shows that the $20 rise in oil prices experienced over the past year, if sustained, will cut the growth of developed economies by about 1 per cent, and of emerging economies such as India by as much as 2 per cent. And, contrary to current wisdom, this is emphatically not the end of the story. The continuing imbalance between demand and supply suggests that, through the rest of this decade, oil prices may have a lot further to rise, depressing growth as they do so. And there remains the possibility of a political upheaval in Saudi Arabia.
Policymakers need to wake up to the dangers. Or perhaps they already have. Two types of development could help bring the demand and supply for oil into better balance, heading off high prices and the consequent damage to growth. One would be an increase in taxes on oil consumption, especially in America, but under Bush and Cheney this does not look especially likely. The other would be the emergence of a major new oil producer on the scale of Saudi Arabia, willing to allow its reserves to be developed at maximum pace by international oil companies. Nothing less will do, and as it happens, one is on the horizon. A stabilised Iraq under Western influence. One could be forgiven for wondering whether the Iraq war was actually about oil.
Christopher Smallwood is Economic Adviser to Barclays plc. This is a personal view.Reuse content