It’s Getting Hot In Here

The price of oil has been increasing rapidly since 2002, going from ~$25/barrel to its current flirtations with a record $80/barrel. Prices are skyrocketing largely because global demand is rising quickly, led by China’s unprecedented growth that shows no signs of slowing as it hit 11.9% in the 2nd quarter of 2007. The discussion regarding oil is often centered on when we will run out or when production will decline. But I would like to reframe the issue into three important questions that we need to answer even if there is no decline for decades:

1. Can global oil production physically keep up with demand?
2. Can it politically keep up with demand?
3. If not, then what?

1. In this context of higher prices, economists would expect competitive producers to take advantage of the current price premium and ratchet up their supply. But over the past few years the competitive non-OPEC producers have been largely unable to increase their output as reported by the International Energy Agency (IEA) in mid-July. A plateau has been reached ~50 million barrels per day (mbd) because producers such as the UK, Norway, and Mexico are unable to maintain current production levels so that additional supplies by Russia, Brazil and Azerbaijan only offset those losses and hold non-OPEC supply mostly constant. The IEA predicts tighter supply through the next five years as 2.2% per year demand increases have to be met by OPEC producers.

Thus continued demand growth will put our oil price future in the hands of OPEC. The “call on OPEC” for additional supply is estimated to be ~2.5 mbd on top of their current ~30 mbd production by the 4th quarter of this year. The IEA June report mentions that such a situation would include a substantial drawdown of OECD crude oil stocks (which are high now partly because last winter was so mild) and erase existing spare capacity, similar to the situation in 2004 which spurred a ~30% price increase. Such a price increase repeated would bring us $100/barrel oil and $4/gallon gasoline, though demand may be more elastic this year since the price is higher, causing poor and middle income people to drive less and preventing as large of a price increase.

Over the next few years, whether OPEC can increase its production almost 10 more mbd as the IEA predicts consumers to demand is a difficult question to answer. And that is the first important question, as the determinant of price is the balance between demand and supply. So, even if production were to be able to increase 2% per year for decades, if the global economy wanted 2.2% growth per year then there would be a shortage and the price would continue its upward trend. Since many OPEC nations such as Saudi Arabia and Kuwait keep their oil reserves and related information as state secrets, we can only guess what their capabilities are.

Some geologists and energy analysts question whether OPEC would be able to increase production in the next few years. Matthew Simmons wrote a compelling book in 2005, “Twilight in the Desert,” questioning Saudi Arabia’s ability to increase output due to its mature oil fields such as the world’s biggest super-giant, Ghawar, which has been producing oil since the early 1950s. Simmons and others point to declining production in the US, UK, Norway, Egypt, Mexico, and dozens of other countries as a glimpse of OPEC in the near future.

The US Energy Information Agency (EIA) forecasts have comforted the oil-consuming public that price mechanisms will ensure plenty of oil production for decades into the future, including unconventional oils such as Canada’s tar sands and Venezuela’s heavy oil. But such projects take years to tap and may mostly replace production from older declining fields rather than add significant new capacity. And while EIA forecasts probably make geological sense, they may not sufficiently factor in limits to production that are political – such as Iraq’s lower production totals since the US invasion in 2003 and Nigeria’s decreases caused by people who feel they have not received benefits from the oil pumped out of the delta in which they live. And of course weather can play a role too as hurricane Katrina did back in 2005. Oil production reality is made up of a mix of technical possibility, weather, and political circumstance.

If the politics and geology/technology allow OPEC to accelerate their production, we may not see prices much beyond $100/barrel oil in the next few years, but it leads us to the next question.

2. Would OPEC want to keep up with demand? It would be in the interest of the cartel, acting as a monopolist supplier, to let the price of oil increase from its current inelastic range by withholding additional production to hover in elastic territory. That elastic territory may be $85/barrel or $120/barrel – I don’t know. But one would definitely expect further price increases. Some say that OPEC would not want to risk large price increases because they would risk causing a global recession and lower oil demand. But the economy has handled a tripling of the price of oil these past five years – the case could be made that further increases could be adapted to in stride as well.

3. If $100+/barrel oil is in our near future, then mobility for billions of the poor and middle-income would suffer. The annual global expenditure on oil would increase $1 trillion and prices of the other fossil fuels, natural gas and coal, would increase due to their increased attractiveness relative to oil. As oil currently provides the largest share of global energy, at ~38%, its competition would jockey for market share – including renewables.

An Opportunity

While such price spikes would decrease the short-term welfare for many, it would also provide an opportunity for us to transition toward a sustainable energy future. The biggest impact would be on transportation, which is 90+% dependent on oil. This may create opportunities for cellulosic ethanol to become a viable alternative that allows us to power our travel on switchgrass and biomass waste, helping us to reduce greenhouse gas emissions and improve air quality. But it may also provide a huge boost for coal-to-liquid (CTL) fuels that emit twice the GHGs of gasoline and it may make it profitable to cut down much of the remaining tropical forests for biofuel farms. Another scenario could lead to more electric vehicles that could be run either on clean renewables such as wind and solar or polluting coal. To prevent a potential high price oil future from hurting our efforts of emissions reduction, public health and biodiversity stewardship, we must put incentives in place to prevent such threats as soon as possible.

The methods that can save the most money are fuel efficiency such as hybrid technology and lighter vehicles. But they also include infrastructure development such as bikable and walkable routes from homes to work and increased transit options as well as behavior changes like carpooling and increased telecommuting. And if we include CTL due to coal’s abundance and lower cost, we need guarantees that any CTL projects would include carbon capture and storage. A federal renewable portfolio standard and higher fuel economy standards, as the House is considering to integrate into the Energy Bill this summer, as well as the passage of a comprehensive GHG emissions reduction bill could help to steer momentum in the right direction.

A peak or plateau in global oil production may not be just around the corner, but it clearly seems like a good time for us to plan what we want our economy and society to look like in the likely event of a high price oil future.