CHEAP OIL MYTHS AND ENERGY
TRANSITION
Andrew McKillop
Founder member, Asian Chapter,
Internatl Assocn of Energy Economists
Former Expert-Policy and
programming, Divn A-Policy, DGXVII-Energy, European Commission
The
US economy in late 2003, for about one trimester, attained up to 7.5% economic
growth on an annualised base, and this was hailed by administration friendly
media as ‘the highest growth for 19 years’. In 1984, the US economy attained
about 7.5% economic growth on a 12-month base, its highest-ever whole-year
postwar growth of real GDP. Expressed in dollars of 2004 corrected for
inflation and purchasing power parity, the 1984 oil price was in the range of
USD 55 - 68/barrel. Earlier in 2003, many respected economic analysts and gurus
repeatedly claimed that the invasion and military occupation of Iraq would
‘surely’ reduce oil prices and increase US economic growth. While oil prices in
fact increased, economic growth did so too. Those well publicized economists
and journalists who chant the slogans that “high oil prices hurt growth”, and
low prices ‘surely’ increase it must explain these simple and recent facts of
US economic history, or abandon their constant baying for cheap oil as the
‘passport to growth’.
We
can trace the root events that generated these slogans (and studies designed to
‘prove’ them) to the 1979-81 period, in which, through a combination of supply
cutoff and geopolitical uncertainty due to the Iranian Revolution oil prices
were bid up to well over USD 80-per-barrel (in dollars of 2004). All OECD
countries suffered fast falls in stock market indices, investment, economic
growth and employment. Inflation increased, and this was reacted to by a new
‘monetarist’ policy of extreme interest rates.
Through
1980-83, the industrialized world experienced its deepest recession since the
1930s. The interest rate ‘medecine’ was applied in OECD countries with such
ferocity that rates attained extremes we associate today with the meltdown process in Latin American and
African countries unable to achieve ‘structural adjustment’. US base rates
exceeded 22%/year in 1981, with regular or high street banks operating minimum
loan rates at 25% p.a. In other developed countries, national governments vyed
with each other to crank interest rates ever higher, in a race to cut economic
activity and slash demand for oil. The objective was to bring down oil demand
through provoking recession and mass unemployment, and cutting oil prices
because these were judged as the major, or even sole cause of the inflation fireball that ripped through
the economies of the OECD countries from late 1979 and into 1981 and 1982.
Whatever
the oil price, or any other factor at play in the economic mix, we can be sure
that extreme interest rates will cut economic growth, bankrupt enterprises and
cause massive rise of unemployment. Mainstream media and gurus of the New
Economy will surely not add that extreme interest rates will themselves maintain inflation, and limit
any rapid fall in price rises for the simple reason that more expensive money
and higher re-financing costs for existing debt are added to the list of things
that get more expensive. In addition, in the early 1980s, oil prices had no
difficulty remaining high – not for reasons of depletion of capacity shortage –
but through geopolitical uncertainty. At the time, and depending on data
source, the supply shortfall due to the Iranian Revolution was in the range of
5% or 6% (about 3.25 Million barrels/day, for a period of about 6 months). In
dollars of 2004, the peak oil price in late 1979/early 1980 attained about USD
108-per-barrel. Gold prices of the time, again in dollars of 2004, attained
over USD 1300-per-ounce. The plunge in world stock markets through 1980-82 was
attributed to oil prices, but operators were in fact and at that time suffering
a meltdown in confidence through geopolitical uncertainty and fear of
continuing, extreme interest rates. The length and severity of the stock market
panic in the overall period of 1979-82, we can note, was far greater than
following the 1973-74 oil shock, after which interest rates had not been
violently raised, but during which oil prices had risen about 300%, compared with a total of about
110% in 1979-81.
Today,
the world’s oil supply system is faced by cumulative problems which, on the
supply side, feature reserve depletion and slow capacity growth. On the demand
side, after about 10 years of typical annual growth rates around 1.25%-1.5%,
growth has significantly increased, leading to average 3-year demand increase
rates moving towards 5% or 6%, with a potential for further increase; annual
average demand growth rates are now well above 2%. Overall, the supply/demand
system is both fragile and stretched to the limit. Several key suppliers and
their national oil companies are intensely exposed to the sequels of many years
in which oil revenues, in real purchasing power terms, retreated each and every
year. For the richer oil importer countries of the OECD group, this period –
the Cheap Oil interval of 1986-99 – was one of ‘benign neglect’ to constantly
falling commodity and oil prices. The sequels have naturally included sharply
cut exploration-development activity in the oil and gas sector, and lowered
investment by oil producer countries, neglect of installations and equipment,
reduced maintenance, and exposure for their civil societies to the stress and
tension that declining real revenues entrain. In the worst case, of national
unrest, civil war or military conflict, production and exports can rapidly
diminish or even be shut down to almost nothing. Civil unrest leading to
interrupted oil production and exports, has affected a number of producer
countries, notably Nigeria and Venezuela.
The
present context of slowed supply growth and increasing demand growth is
essentially not remediable without higher, more stable prices. The most recent,
last and largest era of major discoveries (individual fields of above 5 Bn
barrels, annual discoveries up to 40 Bn barrels total) is situated in a period
(about 1955-63) that is now very far behind the present. This has several
implications: annual capacity loss for
‘conventional’ oil through depletion will only increase, net additions to
production capacity will cost more than previous, several producers (including
large ones) are destabilized through the economic and political sequels from
long years of ‘benign neglect’, and the world demand context is characterised
by rising annual growth rates. We can estimate that supply loss through civil
unrest, strike action, embargo, etc, of even 3% of world supplies (about 2.5
Million barrels/day), if maintained over a few months, would likely trigger a
free-for-all bidding spree on the world oil market able to push oil prices well
above USD 75/barrel.
World
supply fragility at this time is increased by the unexpected and unplanned
length of time taken by the post invasion administration in Iraq to restore even
the prewar level of net exports (about 2 - 2.4 Mbd). Continuing political,
economic and social problems in several oil producer countries (including
Venezuela and Nigeria), and declining political transparency, going forward,
for the world’s two largest exporters (Russia and Saudi Arabia) completes the
outlook for an unstable, fragile and unsure supply system. Any sudden and large
rise of oil prices could entrain finance ministers of the OECD countries into a
round of interest rate hikes, despite the almost unlimited risks this would
bring for world stock markets and the world economy at this period in time.
Through
2000-2002, and into early 2003 world stock markets suffered a slow motion
meltdown, pushing index levels back to those of the mid-1990s. Since the end of
the Iraq War there has been substantial, but unconvincing recovery. Total
losses of notional ‘value’ on world stock markets through 2000-03 were around $
6 000 Billion. Attempts at explaining this as wholly or mainly due to oil price
rises since late 1998, when the most recent trough in prices was reached (about
$9.70/barrel or well below the real price in 1973) have a hollow ring. In the
present context of stock exchange operators seeking to rebuild equity strength,
the rational hope of investors is for continuing low interest rates. Any event leading rates to move sharply up will
logically result in rout on world stock markets. We can therefore, at least
temporarily, exclude moves by OECD country finance ministers to sharply raise
interest rates, and especially to double-digit
levels in the developed economies. If however this was attempted the result
would surely entrain major or even complete collapse of world stock market
indices, runaway ‘domino effect’ bankruptcy of many major corporations, mass
layoffs and unemployment, and grave problems for the financing of structural trade and budget deficits of
the US, the UK and other countries.
The
intensifying fall of the US dollar, depriving commodity exporters whose exports
are traded in dollars of real revenues at a time when many minerals and
agrocommodity prices, outside gold, oil and gas, remain at low levels, or
suffer from very high volatility, is itself a downside factor for world
economic growth, and a guarantee of future supply shortage through investors
delaying decisions to take risk in the face of volatile prices. Yet recourse to
the interest rate weapon when or if
oil prices climb through sensitive and psychological barriers, like the $40 -
$45/barrel range, could well intensify
the flight from the dollar rather than bring it rapid new strength, while the
UK pound might be shielded to some extent by its declining petromoney status, before it is almost inevitably abandoned with UK
entry to the Euro. Overall, any use of the interest rate weapon in the face of
fast-rising oil prices would likely entrain an OECD-wide recession, and further
destabilize the lengthening list of ‘emerging’ economies such as Russia with
highly unstable national currencies, severe debt, and major financial
restructuring burdens.
Current
world oil output of about 78.5 Mbd on a year-average base (IEA figures give a
January 2004 peak at 82 Mbd) includes that by 24 producer countries whose
output is well beyond peak, and falling, with some in decline at over
4%-per-year. Production capacity loss is especially sustained for the 3-largest
OECD producers, the USA, Norway and UK at about 0.9 Mbd/year. Estimates by the
CEO of ExxonMobil Exploration in September 2003 give annual world capacity
loss, for all producers, in the region of 3 – 3.3 Mbd per year. Annual demand
increase on a worldwide base is forecast by many influential sources (like the
US EIA and OECD IEA) as likely to be above or close to 1.6 Mbd. In much less
than 6 years, at that rate of demand growth, a “new Saudi Arabia” is required
to satisfy the increase in world demand. Taking account of depletion, this
horizon is reduced to around 2 years. No “new Saudi Arabias” will be
discovered, proven, developed and produced at this rate. As the special case of
Iraq shows, major producers can almost overnight collapse, with restoration of
production able to cover national or domestic demand taking many months through
2003. Oil exploration-development, still at a low level for a mix of reasons
(including declining prospectivity or success rates), has resulted in an
inevitable fall in annual discoveries, that are at best one-third to one-fifth
of annual consumption on a worldwide base. Underlying this trend is the simple
fact of physical depletion of the world’s geological reserves of oil, as we
move towards Peak Oil, or the absolute peak of production that can be achieved.
This is probably below 90 Mbd, with a sharply increasing proportion of ‘non
conventional’ oil, as easier produced ‘conventional’ oil declines. The
expansion of nuclear electric power, at one time believed to shield against
rising oil prices through producing far-from-cheap electrical energy, is almost
everywhere stalled, with the number of reactors in service actually declining
(from 443 to 441) in the last 2 years.
No
genius is needed to decide what these and other facts strongly imply for oil
prices. Using interest rate hikes to provoke a so-called ‘soft landing’ or
controlled fall in economic activity, leading to a fall in oil demand and a
fall of oil prices if producers do not cut back their export offer as demand
shrinks, is a dangerous weapon at this time. World population growth continues
at around 80-90 Million persons per year and the world economy has structurally
changed, to higher energy intensity since the period of 1985-95. By consequence
oil markets will likely never again be “awash with oil”. The oil-lean service
economies of the aging OECD countries have massively de-industrialized and
outsourced their manufacturing activity, first to the Asian Tigers, and now to
China, Brazil and India. This change has itself set a high floor to any
worldwide falls in oil demand when or if the OECD bloc decided, through
inflation fear, to engage a round of interest rate hikes, believing this could
master the challenge of ‘runaway oil prices’.
Economic
policymakers should understand that if, or rather when oil prices attain
$40-$50/barrel in dollars of 2004, and are maintained in that range, global
economic adjustment to higher prices can restore and stabilize economic growth,
worldwide. The revenue impact of increased oil and energy prices, entraining
higher earnings for exporters of energy-intense commodities, can rapidly
improve the prospects for growth in the straight majority of the world’s
economies. With or without inflation, higher oil prices that are not resisted
by slugging interest rate hikes can ease and speed structural reform and
financial adjustment in many, sorely pressed primary commodity exporter
economies. In the recent (1986-99) context of unstable and low real oil prices,
and the present context of runaway trade and federal budget deficits of the US
economy, and crumbling consumer confidence in most OECD countries due to fears
of job losses, terrorism, climate change and other worries in what are
essentially consumption saturated
economies, few other strategies for restoring conventional economic growth in
fact exist.
The
writing is surely on the wall for cheap oil, for the very simple reason of
physical depletion. Large oil price rises are coming within the next few years,
whatever the current rulers of Saudi Arabia or Russia may do. Price rises may
or may not lead to a repeat of military
adventure in Iraq, or so-called ‘regime change’ in other candidate
countries such as Iran, but if there has been one lesson from the US-UK
adventure in Iraq it is that geological problems do not have military solutions. In addition, rising oil prices are not
amenable to any significant long-term control through utilization of so-called
‘strategic’ petroleum reserves, the constitution of which always increases total demand. A structure of
higher and stable prices will likely generate relatively rapid falls in oil
demand by the OECD North, where the price-elastic
function has some real scope and application. Conversely, world oil demand
cuts through reduction of OECD-North demand will soon be compensated by
increasing demand in the NICs and low-income countries. The period in question
– the number of years in which world total oil demand could be held below Peak
Oil output – may be 3 or 5 years, perhaps more, but this transition period is
one we should focus for meaningful, long-term oriented energy transition.
Greater
liquidity in the world economy, aided by higher oil, gas, gold and other real
resource prices, with relatively low interest rates can enable poorer countries
to break free from their indebtedness to the North’s financial institutions,
have real freedom of economic policy choices, and avoid development strategies
entraining total dependence on fossil fuel-based economic structures and
systems. Their experience of the Neoliberal 1980s should give them reason to
consider more autonomous or autarchic
domestic development as a better choice than pursuing the impossible strategy
of Globalization. Victims of this, like Argentina and a string of African
countries, are there to provide concrete examples of what this illusory policy
does to the economy, the environment and to the finances of weaker countries,
as well as to general human wellbeing in those countries.
Conversely,
in the OECD North and particularly the USA, oil price rises that may easily
extend upward to around $60-$70/barrel will firstly and mainly provide a ‘wake
up call’, not only for their stagnant economies, but for needed restructuring
of the economic system and cultural values. Apart from handwringing and
tubthumping, and increasingly risky military adventure, there will be little
margin of action and decreasingly few options open to political and economic
decision makers. As noted above, the ‘interest rate weapon’ at this time is
more than a double-edged sword; cranking interest rates to double-digit levels
in reaction to oil price rises driven by physical depletion is not only
unreasonable but will almost certainly bring about another 1929 crash and Great
Depression. In addition, and within about 12 months from any upcoming Oil
Shock, increased solvent world demand will trickle
up to the OECD North, in the form of increased demand for higher value
manufactured goods and sophisticated services supplied by the North.
Shrinking
growth of oil production due to geological depletion will tend to lock on oil
prices at higher levels. Soon we will no longer hear, even less believe that
the world is awash with oil. Maintained higher levels of world oil and
energy prices, and prices for energy-intensive commodities – that is real resources - will enable and
facilitate long-delayed, but inevitable structural changes of the energy
intense OECD North economies. Overall restructuring, both social and cultural,
as well as economic, can easily achieve large compression of per capita oil
demand. In the USA, currently using about 25 barrels per person/year, and
without serious harm to strictly defined human wellbeing, demand compression
could target as much as 60%-75%. In Europe, Japan and the now energy-intensive
Asian Tiger economies at least 33% cuts could easily be targeted without civil
war and famine being in any way possible or probable. Conversely, low-income
countries where per capita oil demand in rural areas can be well below 1 barrel/person
per year cannot reasonably be expected to further compress their demand, to
ease price pressures for the OECD North
Current
leaderships of the North will, this decade, learn that no amount of munitions
and ordnance can solve or defeat the geological problem of oil depletion. Some
current leaderships of the North already produce ‘landmark speeches’ about the
need to shift to renewable energy some time after 2050. In fact, even by 2025,
per capita oil use will be about 40%-50% down on today and the climate and
environment consequences of continued high rates of fossil fuel burning will be
impossible to deny. Sooner and not later, therefore, it will be understood that
there are no military solutions to geological problems of fossil energy
depletion. International cooperation, an almost forgotten term from the 1970s
and early 1980s, when oil prices attained about $100/barrel in dollars of 2004,
should rapidly be reinstated as the way forward to preparing all persons, both
in the North and South, for a future in which at least two-thirds of our
current and easily producible supplies of ‘conventional’ oil and gas will be
exhausted by about 2035.