Sunday, June 01, 2008

Why are Oil Prices So High?

Why are oil prices so high? This is the question being asked with increasing frequency in many countries around the world. Some would have you believe that the blame should be placed on "greedy oil companies", "Arabs", "speculators" or "OPEC".

While speculation is happening with investors and hedge funds looking to commodities for returns that are not being seen in the stock or property markets, there are underlying fundamental reasons which mean prices are likely to stay high.

Last November the International Energy Agency released its annual World Energy Outlook report. Traditionally the agency has projected energy supply based on projected demand.

The agency has projected that India and China will lead the increase in energy demand making 45% of total growth. Oil imports for these two countries combined will grow to 19.1m barrels a day by 2030 compared to 5.4m barrels a day in 2006.

Demand for oil will grow to 116m barrels a day by 2030, an increase of 37% on 2006 oil usage. In this report back in November the International Energy Agency warned the price of a barrel of oil could rise to $159 by 2030 due to high growth in demand. This estimate now looks very conservative.

The reality is there have been some fundamental changes.

Before if the United States went into recession, this would lower demand for oil and prices fell. Now with China, India and other rapidly developing nations demanding ever increasing quantities of oil a recession in America is unlikely to lead to falling oil prices like it did in the past. Were per capita oil use in China and India to reach the same level as in the United States, this would fully deplete the world's remaining proven oil reserves in just 15 years and prospective resources, in 26 years.

The other fundamental change is that there is little excess production capacity. While Saudi Arabia would like the world to think it could increase production if it deemed it "beneficial" to the stability of the market, this is just an illusion of control. The reality of the OPEC cartel is that while sticking to production quotas may have benefited the group as a whole, individual countries have always "cheated" consistently and repeatedly exceeded their production quotas. In the past this has lead to significant downward pressure on prices.

This time the signs are that the world is at or near its maximum oil production capacity. Does this mean Peak Oil has arrived? In my opinion - not yet.

New production will continue to come online in the coming years which is likely to raise worldwide maximum oil production. So we haven't reached peak production... yet.

What we may be experiencing is what Robert Rapier calls Peak Oil Lite, with the early effects of Peak Oil arriving. Demand is rising faster than supply. In its July 2007 report the International Energy Agency predicts OPEC spare capacity will decline to minimal levels by 2012. The lack of spare capacity means, that price volatility increases with price spikes occurring in the event of supply disruption.

So what we are likely to experience prior to Peak Oil is Peak Export. According to Eugene Linden in BusinessWeek when it comes to oil our biggest concern should be the amount of "global oil available for export".

According to the Export Land Model developed by Jeffrey Brown - exports decline faster than production declines, the rate at which exports decline accelerates over time and only a small percentage of a producing country's production is exported following peak production.

According to a report in last week's Wall Street Journal, fresh information from the US Department of Energy shows the quantity of petroleum products shipped by the top exporting countries in 2007 fell 2.5% last, while prices increased 57%.

Net exports from major producers Mexico, Norway and Venezuela have fallen in every year since 2005.

With the rise in prices individual producing countries in OPEC had every incentive to "cheat" and yet exports fell. The influx of wealth into the Middle East has led to a boom in domestic demand. It seems that Middle Easterners aspire to the same gas guzzlers and energy rich lifestyles as Americans. Soaring profits from high-price crude have fuelled a boom in oil demand in Saudi Arabia and across the Middle East, leaving less oil for export. In 2007 the output of the region's six largest oil exporters - Saudi Arabia, United Arab Emirates, Iran, Kuwait, Iraq and Qatar - fell by 544,000 barrels a day. During the same period domestic demand increased by 318,000 barrels a day, leading to a decrease in net exports of 862,000 barrels a day.

A recent report from CIBC World Markets also indicates that as much as 40% of Saudi Arabia's expected production increases will be offset by rising internal demand by 2010, and Iranian exports will decline by more than 50% for similar reasons.

Indonesia recently withdrew from OPEC as it has gone from being a net exporter of oil, to a net importer of oil.

The Wall Street Journal report comments that the fall in oil exports "defies traditional market logic." Perhaps that should be blind faith that OPEC nations can turn on the taps if prices rise "too high". It seems even oil traders are unsure what is driving prices as according to one market analyst quoted by BBC News "we really don't know what the fundamentals are doing at any point in time." Much of the information on fundamental factors in the oil market is not public or freely available.

In simple terms demand is outstripping supply and prices are rising. This is how the market is supposed to work.

Other fossil fuel prices tend to follow oil. IEA's latest World Energy Outlook forecasts coal is set to rocket in demand, increasing by 73% from 2005 to 2030. This means coal's share in global energy demand will rise from 3% to 28%. It is predicted by 2015 America will go from being a net coal exporter to a net coal importer. Coal is the most carbon intensive way of generating electricity and this report predicts that rather than becoming a smaller part of the energy mix, coal is predicted to play a much bigger role.

With a presidential election this year in the United States and gas prices at record levels, oil and energy in general is set to be a key issue. There is the opportunity to have a serious debate about energy - a fundamental part of our lives which has been taken for granted for far too long. However the responses from the presidential candidates so far have not been encouraging.

In 2002 McCain declared that ethanol is a "giveaway to special interests in corn-growing states as the expense of the rest of the country." In 2003 he put out a press release saying "Ethanol does nothing to reduce fuel consumption, nothing to increase our energy independence, nothing to improve air quality." He went on to describe it as "highway robbery." Hillary Clinton signed a letter saying that there is "no sound public policy reason for mandating the use of ethanol".

McCain, Clinton and Obama all seem to have drunk the ethanol Kool Aid and seen the bright white light that has converted them to E85. In 2008 none of these presidential candidates seems to have anything negative to say about ethanol.

In 2006 Barack Obama along with four Republican and one Democrat senator introduced the Coal-To-Liquid Fuel Promotion Act.

There have also been accusations made against "Big Oil", "OPEC" (including by British Prime Minister Gordon Brown) and suggestions that a "gas tax holiday" or "windfall tax" would fix everything. It's always easier to find a scapegoat.

One bandaid being suggested from some quarters, is to open up drilling in the United States in areas which are currently off limit. This would give access to 19 billion barrels of oil enough to meet US needs for approximately two-and-a-half-years or world demand for just over 7 months at current rates of consumption.

To quote the head of the International Energy Agency:
"All countries must take vigorous, immediate and collective action to curb runaway energy demand.

The next ten years will be crucial for all countries... We need to act now to bring about a radical shift in investment in favor of cleaner, more efficient and more secure energy technologies."

Further Reading:
The Ethanol Scam in "Gusher of Lies"

You can read more on what the energy policies of McCain, Clinton and Obama should be in this Open Letter to the Next President.

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