As you may know, I worked at the Energy Information Administration (EIA) for 17 1/2 years as an international energy markets analyst before leaving in March 2006. During my last few years there, I headed up a team that prepared the international oil market inputs into EIA's Short-Term Energy Outlook. As economists, it's not particularly surprising that we tended to look at world oil supply and demand balances, oil production capacity utilization rates, oil inventories, economic growth forecasts and the like. We also tended to think in terms of price and income elasticities of supply and demand.
As of March 2006, all of those metrics had been pushing up the price of oil for several years -- from about $27 per barrel in late 2003 (several months after the invasion of Iraq, I would point out) to $55 per barrel when I left EIA. Today, West Texas Intermediate crude closed at nearly $119 per barrel, more than double two years ago. Even more startling, the president of OPEC said today that oil prices could hit $200 per barrel, while other analysts predicted gasoline prices as high as $8-$10 per gallon. What on earth is going on here? Please see the "flip" for an explanation.
First, let's get out of the way a couple of factors that have been widely cited but have almost certainly NOT caused oil prices to soar from $27 per barrel in late 2003 to nearly $120 per barrel today.
*It's NOT Iraq. Let's repeat that: it is NOT Iraq. Recall that oil prices were just $27 per barrel in late 2003, after Iraqi oil output had been nearly completely disrupted by the war. Also recall that Iraqi crude oil production averaged 2.02 million barrels per day in 2002. Today, Iraqi crude oil production averages around 2.15 million barrels per day, above pre-war levels. And no, this isn't a fluke: Iraqi oil output averaged 2.01 million barrels per day in 2004, 1.88 million barrels per day in 2005, and 2.00 million barrels per day in 2006. That's right, through all the turmoil and unrest the past few years, Iraqi oil output has been...roughly flat, approximately at pre-war levels. So much for Iraqi oil supply disruptions constituting any more than an extremely minor factor in the world oil picture.
*It is not "market manipulation" or "price gouging." This explanation is rolled out, usually by politicians who frankly don't know the first thing about energy, every time there's an increase in refined oil product (particularly gasoline, but also heating oil, diesel, etc.) prices. The problem is, despite many investigations (such as this one over the years, there's no evidence that "market manipulation" is a common or widespread phenomenon.
Let me emphasize that I say this as no fan of the oil companies or of OPEC. And let me also say that OPEC is a cartel, designed by its very nature to try and manipulate oil prices. However, keep in mind that OPEC has, for the most part, tried to keep oil prices within a range -- $18-$22 per barrel was a common target during the 1990s -- with varying degrees of success.
Today, what has happened is that OPEC -- far from "manipulating" prices -- has essentially lost control of the world oil market on the "upside", so that we are now $100 per barrel above OPEC's former $20 per barrel target price. Did OPEC plan this $100-per-barrel price increase? Not to my knowledge, or to the knowledge of the people I used to work with at EIA. That's one reason, by the way, why everyone's been so surprised and failed to forecast this degree of a price increase -- because it wasn't planned or "manipulated."
As far as gasoline is concerned, the price has more than tripled, from about $1 per gallon in 2003 to nearly $4 per gallon now. During that same period, crude oil prices have gone from around $31 per barrel to $120 per barrel -- a quadrupling. The point is, gasoline prices have essentially tracked oil prices, if anything lagging a bit. That's exactly as one would expect, and obviously not what would be the case if there were "market manipulation" by oil companies (or anyone else).
So, if it's not Iraq or "market manipulation," then what are the causes of $120 per barrel (and possibly a lot higher in coming years) oil?
1. Demand. Since 1998, when oil prices bottomed out near $10 per barrel, world oil demand has jumped nearly 13 million barrels per day, from 74 million barrels per day then to nearly 87 million barrels per day now. China and "Other Asia" accounted for around 6 million barrels per day of that increase, while "Other Non-OECD" account for about 4 million barrels per day. That's 10 out of 13 million barrels per day accounted for right there, outside the OECD, where oil demand has been up just 5% or so since 1998. It doesn't take a Nobel Prize winning economist to figure this one out. In fact, it's just Econ 101, as my extremely basic supply and demand graph illustrates. When demand rises, ceteris parabis, prices tend to rise.
2. Supply. Since 2003, as world oil consumption has increased 7 million barrels per day, non-OPEC oil production has increased just 2 million barrels per day. As a result, OPEC has been forced to use up pretty much all of its excess production capacity, leaving it with close to zero today (there's debate about whether Saudi Arabia really maintains 1-2 million barrels per day in "spare" -- I'm highly skeptical, as are people like Matt Simmons). Today, as the New York Times explains:
Some regions are simply running out of reserves. Norway's production has slumped by 25 percent since its peak in 2001. In Britain, oil production has plummeted 43 percent in eight years. The North Sea is now considered a dying oil basin. Alaska's giant field at Prudhoe Bay has declined 65 percent since its peak 20 years ago.In many other places, the problems are not located below ground, as energy executives like to put it, but above ground. Higher petroleum taxes and more costly licensing agreements, scarce manpower and swelling costs, as well as political wrangling and violence, are making it much harder to raise production.
"It's a crunch," said J. Robinson West, chairman of PFC Energy, an energy consulting firm in Washington. "The world is not running out of oil, but rather it's running out of oil production capacity."
Another way to put this is that we are now facing as "vertical" supply curve, as illustrated in my graph. Given a vertical or near-vertical supply curve, any increase in oil demand will cause a sharp increase in oil prices. And that's exactly what we're seeing today.
Why is the supply curve vertical or near-vertical? There are numerous factors, including "sharply higher drilling costs and nationalistic policies that restrict foreign investments" in the oil sectors of many countries. Also, whether or not the world is actually at "peak oil" or not (and depending on how you define "peak oil"), the fact is that we simply haven't been finding new "North Seas" over the past 20-30 years. Instead, non-OPEC countries "seem stuck at about 50 million barrels of oil a day, or 60 percent of the world's oil supplies, with few prospects for growth."
That kicks the ball back to OPEC once again, but what can Saudi Arabia and other OPEC members do about the situation (even if they want to, which is dubious)? Not much. As the New York Times explains:
... Saudi Arabia, the world's top oil exporter, signaled last week that it might have trouble increasing its production.Saudi Arabia, the de facto leader of OPEC, signaled it would freeze any further expansion after next year. That dims the long-range outlook for OPEC supplies, though in the near term, Saudi Arabia is expected to loom larger in the market as it completes a $50 billion plan to increase its capacity to 12.5 million barrels a day. Yet that leaves it well short of the 15 million barrels that most experts expected the kingdom to produce in the long run.
The cartel's 13 members say they plan to spend $150 billion to expand capacity by 5 million barrels a day by 2012, according to estimates by OPEC. But that falls short of most projections, which say OPEC will need to pump 60 million barrels a day by 2030, up from around 36 million barrels a day today, to meet the expected growth in demand.
In sum: sharply increased world oil demand combined with a vertical or near-vertical world oil supply curve translates into sharply higher oil prices.
3. Non-fundamental factors.
These factors, not related to "fundamentals" of supply and demand, have tended to get overblown by the popular press (and by popular imagination), but a depreciated dollar -- given that oil is priced in dollars for the most part -- certainly tends to put upward pressure on the dollar price of crude.
Thus, for oil exporting countries to maintain their same purchasing power and revenues for a given level of oil exports, they need to charge a higher dollar price. This is particularly important for countries like Saudi Arabia, faced with exploding populations of restless young people, chronic unemployment (and underemployment), political unrest, threats from extremist groups like Al Qaeda, and regional instability. In short, Saudi revenue needs are a lot higher today than they were 10, 20, 30 years ago. And so we see a country that used to be considered a price "dove" is now seemingly quite hawkish, willing to accept (and/or unable to do anything about even if it wanted to) oil prices $100 per barrel higher than the "fair" price it was talking about just 5 or 6 years ago.
Meanwhile, as the International Herald Tribune writes, "A falling dollar tends to buoy oil prices in part because consumers using stronger currencies, like the euro or yen, can afford to pay more per barrel."
Another non-fundamental factor is the flow of investment money -- pension funds, hedge funds, etc. -- into commodities like oil. This is caused, in part, by concerns over inflation and also as a strategy to hedge against it. We see it not just in oil, but also in gold, silver, and other commodities. How much impact have these investment flow had on the price of oil? Hard to say, as this analysis explains:
Absent systematic, longitudinal data, it's difficult to form a conclusion regarding the issue of investment/hedge fund sector's ability to "distort" prices. That said, the alarming increase in both oil earlier this year and gasoline this month -- when sector fundamentals suggest the price should be falling -- provides observational support to the theory that some investment players in search of return are boosting prices. At the very least, it certainly provides fodder for additional study.
Still, even if investment and hedge fund activities have boosted oil prices by $10, $20, or even $30 per barrel, they don't come close to explaining a $100-per-barrel price increase since 2002.
Final question: why aren't high prices causing a surge in supply and a reduction in demand? A few thoughts. First, the short-term price elasticity of demand for oil is very small. In other words, people don't change their habits quickly (they are locked into commuting patterns, a suburban/exurban lifestyle, etc.).
Second, although gasoline prices are relatively high compared to the past few years in the United States, they still make up a relatively small percentage of the overall cost of owning and operating a vehicle, let alone of family income. And U.S. gasoline prices are also far lower than prices in most of the developed world, such as in Britain where they're currently paying around $10 per gallon.
Meanwhile, the income elasticity of demand is swamping the short-term price elasticity for oil demand worldwide. In other words, as incomes rise and people reach a certain threshold level, they reach a "tipping point" where they can afford a car. Well, hundreds of millions of people are now reaching that "tipping point" in India and China, and that means increasingly Western consumption patterns - including buying cars, SUVs, etc.
Where will this all lead? I remember doing a calculation at EIA about 15 years ago, just for fun, to see what would happen if China started to consume oil at our per capita rate. The answer? Let's just say we all sat around laughing incredulously -- "yeah right, hahahahahahaha!" -- because the answer was so absurd. In short, if China consumed oil at U.S. per capita rates (around 0.07 barrels per person per day), Chinese oil consumption would increase roughly 10-fold to reach something like 85 million barrels per day, approximately equal to total world oil consumption today. Obviously, this is ridiculous, yet it is exactly where we're heading right now. And it's not just China, it's also India and other "developing" countries.
Can the world produce enough oil (or any other resource, for that matter) to bring over 2 billion Indians and Chinese to western consumption levels? This answer's easy: no. Did I mention "no?" But, to the extent that the oil supply curve remains roughly vertical and oil demand continues to surge (barring a severe worldwide economic downturn which "destroys" demand), it is very likely that oil prices will continue to rise. The only question is, how fast and how high?
In view of your backgound, what do you think about drilling offshore (not just in US but other places as well)? Are there significant potential oil/gas reserves there?
I read that the Chinese are going to drill of the east coast of the US. What a bite, if true.
1. World demand is growing much faster than supply
2. New discoveries are needed in part to keep up with natural decline rates at existing fields.
3. It's very expensive to drill in deep water far offshore, and the availability of equipment and personnel can become a serious issue.
4. There are, of course, environmental issues as well, not so much in the drilling itself but in the continued use of fossil fuels and the impact on global climate.
5. Most conventional crude oil reserves continue to be found in some of the most politically problematic places in the world, particularly the Middle East. Non-conventional oil reserves, such as Canadian oil sands, are enormous, but they pose their own set of technical and environmental challenges.
There is another boogeyman that is frequently cited - environmentalists. There are those in the public that believe that we can drill our way out of this mess, and that environmentalists are holding things back by blocking drilling in one place or another. Or that environmentalists are blocking construction of new refineries. The argument shifts all of the time depending upon who the public perceives to be the bottleneck.
The public also hears these grand pronouncements that between oil shale and tar sands there is enough oil to power us for centuries. In theory anyways, as they are in no way equivalent. The public again tends to blame environmentalists for the slow pace of development, but my understanding is that it is more economic factors than anything else that prevent these from being exploited..
..total world demand (running about 30 million barrels/year)..which is wrong by 1000x -- it's 30 BILLION barrels/year. US consumption alone is roughly 7.5 billion, about 1/4 of total World consumption (and we are only about 1/20th of World population). Remaining World recoverable reserves are a debatable question, but a good working number for you to use until proven otherwise is about 1200 billion barrels. That means that consumption at current rate will exhaust reserves in about 40 years. However, we won't be able to maintain that rate, so a prudent working assumption is that supply will taper down, exhausting in about 80 years, and producing at only about 15 billion barrels/year (50% of current) after 40 years. Reduction of World production level is what Peak Oil is all about! Peak Oil is happening just about now.
Lowell said:
..Bush.. talked incessantly about drilling in ANWR and elsewhere..he can forget about that, it's not going to happen..I agree. Opinions differ on the size of the recoverable reserve in ANWR, I have seen estimates from 6 to 16 billion barrels. Suppose we feel optimistic, and take the high end of the range, say 15 billion. Then, at our current rate of 7.5 billion/year (as noted above), ANWR can support the USA for about 2 years. That's 2, not 20 years, and certainly not 200 years. And we don't know about any other unexploited US reservoirs comparable to ANWR (probably there aren't any). ANWR is the last giant.
A note of caution about ANWR: recently there was a discussion on The Oil Drum, and in the comment threads one of the well-known old-timers noted that one test well was drilled in ANWR some years ago. The results were shared among oil companies and the government, and the results were supposed to be released to the public, but they never were. Why not? Good question. One possibility is that the results were unfavorable, and it was in everybody's interest to keep playing the game, and so nothing was said.
The totality of the deep Gulf of Mexico deposits are probably not comparable in size to ANWR. The find that caused all the excitement several years ago totalled to only about one billion barrels, perhaps six weeks of US consumption.
I am skeptical about the potential for petroleum deposits off the coast of Virginia. The plain fact is that Virginia just doesn't have petroleum deposits at all, due to its geological history. (The only oil produced in Virginia is along the border with West Virginia, and appears to be in what is geologically West Virginia -- and West Virginia does have plenty of oil deposits.) On the Gulf Coast many of the offshore deposits are in strata which produce oil onshore. This simple observation causes me to offer a simple piece of logic: because interesting oil deposits are not found on land in Virginia, I suggest that it is unlikely that any will be found offshore in Virginia's continental shelf.
Any human manipulation is just the crust on the bread.
The far future of oil..... the price will increas forever, or until the demand drops. The demand will drop because.
1 alternatives that make sense will happen
2. The money that folks have will drain away.
or
3. some combo of the first two things.
Can we have a part 2 next week with your proposals for short and long term means of addressing the problem in the US?
This article (and hopefully another) are a much better value than ten dollars of gasoline -- that much is for sure.
Btw, in terms of short-term solutions what impact would:
A. freezing purchases for the strategic petroleum reserve
or
B. releasing supply from the strategic petroleum reserve
have on price pressures this summer . . .
The McCain/Clinton short-term answers of a "tax holiday" strike me as a non-starters.
Of course, we might need those reserves in the Fall when Bush decides to bomb Iran.
Prices are likely to be even higher next summer, and higher again the year after that. We could completely drain the SPR in an attempt to control short term prices, and if we did this, then we would have nothing in reserve in the event that there were a short term emergency.
Thanks for offering to contribute to RK, though, the sentiment is much appreciated. :)
Isn't this what the beginning of a peak would look like? High prices, flat or declining production? I wouldn't expect the NYT or the WSJ to just put up an article on A12 saying "Peak Oil: It's Here!"
What do you all think?
In terms of the question about whether we are at peak now, I guess I would say that it is somewhat academic to try and pinpoint it to a specific month. In all likelihood, when we reach peak there will be a plateau (much like we are in right now, actually), after which production will start to decline. But the month-on-month production figures have some variation for one reason or another - we won't really know with certainty that we have reached peak until we are a few years past, and the worldwide production has started to decrease.
Some economists say that a nationwide "gas tax holiday" would have even less impact on gas prices than a moratorium like the one passed by Illinois in 2000. "It's basic economics," said Len Burman, director of the Tax Policy Center, a nonpartisan think tank. "Gas is always in very short supply during the summer, which is why prices go up. In order to reduce the price, you would have to increase supply, but that is difficult over the short term, because the refineries cannot add capacity."According to James Hamilton, a professor of economics at the University of California at San Diego, the benefits of a temporary tax moratorium would probably go to oil companies rather than consumers. He said states that suspend gas taxes are able to respond to rising demand more efficiently than the country as a whole, because gasoline supplies can be easily transferred from one state to another.
"Prices would certainly rise to the market-clearing level," Hamilton said. "I would expect the price to go back to very close to where it was before, in which case consumers would not see any benefit."
MSP
What connection do you see between ME instability and price? I mean if the Straits of Hormuz are shut down in a pending war with Iran, a lot more than Iranian oil will go off the market.
If I were betting with oil money on GW & Company I'd double down on futures, get the oil to refinery and wait for him to totally screw up the Middle East oil patch.
Now, if there were a sustained ME oil supply disruption of any significance, we'd see a significant oil price increase. If Iranian oil production were disrupted, for instance, because of military action that threatened to spill over into the Arab-side-of-the-Gulf states, I'd guess we'd see a $30-$50 per barrel spike, at least temporarily. If the violence actually spilled over Kuwait, UAE or Saudi and threatened or disrupted oil supplies there, who knows...
Jubak had some interesting points I happened to come across on MSN:
http://articles.moneycentral.m...
It's a great article because it addresses something that's been bothering me--specifically, while the increase in demand for oil has outpaced the growth of supply, when expressed as a percentage of our gross oil consumption and adjusted for the growth in global production, things aren't quite as dire on paper as they seem when you're standing at the fuel pump. It seems like the American consumer is ready to accept the fact that gasoline prices will forever spiral upwards without dramatically adjusting his consumption.
God, but we're so stupid....
There was an interesting article about demand destruction (or the lack of it that we have seen so far) here:
Great analysis. I agree with you that market manipulation and Iraq do not explain the rise in oil prices as well as demand and the depreciating dollar, as well as other key factors you mentioned. It is true that small increased in demand cause sharp rises in cost. However, can the reverse be true? If we implement serious oil saving policies after the new Administration comes into office, can we start to drop the rise in costs, and create some stability? I am mad at Obama for repeating on Fox News his desire to lower gas prices. The desire should be to reduce dependence!
Gas and oil prices are going to continue to increase
We face a similar situation with the CO2 issue in general. Unless the ENTIRE WORLD ACTS TOGETHER any actions by individual countries will have a neglible effect.
To actually reduce consumption realistically is at least ten years off and thats assuming starting tomorrow we really make alternate sources of energy a fiscal priority.
Population and therefore demand is going to continue to increase making it hard enough to maintain current levels and very difficult to actually reduce consumption levels
China has an even worse problem. There is no way that they are going to be able to freeze their rate and continue to develop at the same time.
Thats part of the reason why I think we need a global strategy because in the end its a global problem requiring a global solution.