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Saturday
Lagniappe

Oil: No Supply Side Answer to the Coming Crisis

U.S. Energy Consumption by Fuel (1980-2030) (quadrillion Btu)

By Andrew McKillop

Ultraliberal notions

One hangover from the ultraliberal 1980s is the myth of ‘supply side solutions'. For oil, the key target is to keep prices low as long as possible because "High oil prices hurt growth". In practice, giving this myth some substance needs a sharp fall in economic growth and energy demand destruction. After this, the myth goes on, oil prices will recover slower than economic growth allowing a window of opportunity for building another fragile asset bubble. The key element therefore is demand destruction because supply growth is slow, underlining that so-called 'supply side solutions' are in fact demand-linked and demand-constrained. Without a certain period of destroyed demand, supply side responses cannot work. Entry to the present and most severe economic recession since the 1929-31 run-up to the Great Depression and its late 1970s harbinger, the 1979-83 recession, led to serious demand destruction for oil. Both also caused plenty of collateral damage right across the economy. Worse however is the fact that the coming opportunity window for generating another asset bubble will surely be shorter than in the 1980s, 1990s, or the post-911 asset bubble of 2002-2007.

 

The 1979-83 recession caused the first and only 3-year consecutive fall in world oil demand since World War 2. Recession in 2008-2009 is already producing impressive cuts in world oil demand, but from a much higher base. Comparing the 1979-83 period with today, the differences are huge. Global oil demand was running at around 64 Mbd (million barrels/day) in 1980, compared with 88 Mbd in mid-2008 and 85.5 Mbd in March 2009. The growth of average demand through this long period was about 7 Billion barrels-a-year. This is reflected by total drawdown of global oil reserves in the long period 1980-2008, about 275 Bn barrels. This is well above the remaining official oil reserves of Saudi Arabia – themselves likely exaggerated by 40%.

 Taking other major exporters, we can note that world oil extraction in 1980-2008 was more than 3 times remaining Iraqi reserves, over 3 times Kuwaiti reserves, nearly 3 times Iranian reserves – and so on. Therefore we can say, with no risk of being contradicted, that the chance of another long classic and conventional economic growth period following the present energy demand destroying recession is absolute zero.

Supply side solutions did not run out of rhetoric or wishful thinking – but they did run out of oil.

Other big differences

The intense recession of the 1979-83 Reagan-Thatcher heyday was brought on by swingeing interest rate hikes, massive business failures and spiraling joblessness for millions of persons. Today we have the second two, but certainly not the first ! Any 'vigorous and courageous' increase in interest rates, today, will collapse the entire global economy – that is sure. In the early 1980s falling oil demand was an unsurprising spinoff from this ‘fiscal rigour' or latter-day monetarism, but today's context is more complex and contrarian. Near zero base rates set by the US Fed, BoJ, BoE and ECB, and incredibly massive Keynesian-type deficit spending by governments around the world, including China and Russia, should in theory be generating a flurry of growth, but is not yet doing so.

Even worse for the outlook, cheap oil is surely not going to operate for a long lost decade, as it did through 1986-99. To be sure we could forecast 13 weeks of oil prices below about 50 - 55 US $ per barrel on the WTI future from March 2009, but 13 months is already off limits. 13 years is outside of all possibility. This underlines one simple fact: supply side solutions for oil are now finished. Energy transition is the coming No Alternative - and a lot more sure than Neoliberal "no alternatives" such as financial derivatives creation and trading. No longer can cheap oil be locked-in by slow rates of economic growth, de-industrialisation and outplacement, and low wage kleenex jobs.

In reality, increased oil supply in the 1980s and 1990s was due to the final burst of major world oil discoveries, in the 1950s and 1960s. Other supply and demand factors also depressed oil prices, including "quota fighting" among OPEC states, technology and industrial change, geopolitical pressures in the Mid East and central Asia, the arrival of big new supplies of cheap natural gas, increasing export supply of very cheap coal, deindustrialisation and lower energy intensity of the economy in the 'mature postindustrial' OECD countries, and so on.

In the 1986-99 period there was only one bottom line to oil prices – they were low and trending lower. Any oil analyst only had to say ‘Opec overproduction' and maybe add ‘Sunset commodities' to explain why the whole real resource sector was bargain basement, while entirely virtual financial services generated big profits. As late as March 1999 the cheerleader of neoliberal punk economics, the ‘Economist' magazine, could peek into its New Economy crystal ball and announce a future price trend for oil of ‘ probably not much above 5 US dollars-per-barrel ''.

200-dollar oil

Through late 2007/early 2008 analysts, forecasters and commentators fell over themselves to tell the press and media that after 150-dollar oil the world would have to pay US $ 200-a-barrel "sometime soon". One of these forecasters was none other than Dmitri Medvedev, then Gazprom chief. By end-year 2008 the price outlook was more like 35-dollar oil, but the price bottom was near.

Finding out how long it will take for oil prices to bounce back to the US $ 75 to 100 range is of course a key question, but it can be answered ! By late 2010 and perhaps before, there will likely be perceptible physical shortage on world oil markets: the main controlling variable is nothing to do with supply, but demand. Whenever the present global recession shakes into a sickly and inflation-riddled imitation of economic recovery, oil prices will already be at US $ 75-per-barrel. This semi-recovery of global economic growth and much higher oil prices could occur by early 2010, but as noted above it could be sooner. After we arrive at this price level structural supply shortage can quickly lead to very high prices being attained.

 The basic cause is structural high demand coupled with flagging supply growth. To be sure the "Asian decoupling theory" has taken serious flak in 2008-2009 to date, specially concerning trade and investment, but one of the few ways to lever up global economic growth is rising growth, investment and consumption outside the 'postindustrial' OECD countries, especially in the emerging new industrial superpowers of China, India, Brazil, Pakistan, Turkey and Iran (with a combined population close to 2.8 Billion compard to just over 1 Bn for the OECD group). Recession in these countries means a fall in economic growth from near-double digit annual percentage rates, to around 4% - 6% annual. Any hike in world economic growth trends, even small, will inevitably result in world oil demand breaking out of its current free fall – which we can note in percent terms is running well behind the percent rate of global oil demand contraction during the 1979-83 recession.

Part of this difference (about 2.7% reduction in 2008-2009, but about 3.6% annual in 1980-82) is due to a higher base for global oil demand, today, but another is structural. One easy example is the world car fleet, more than doubled to around 925 million units in 2009 from the 1980 score. Similar growth has operated for other oil-hungry parts of the global economy including airline fleets and maritime bulk cargo fleets, the agriculture and food production sector, urban development and public works.

On the supply side, for oil, things are serious and getting worse. Even in recession, geological depletion of global oil reserves and ageing of sometimes already very old production infrastructures do not take a holiday, surprising as this may seem to some economic 'experts'. The world oil and gas industry, due to many years of non-renewal and low investment in the 1980S and 1990s cheap oil period is heavily exposed to accelerated ageing which can only be corrected, or slowed in its impacts, by massive spending. Without higher oil prices, this is impossible. By at latest 2010, depletion will tilt the supply/demand balance to overall loss of world supply, not covered by NGLs, syncrude, gas and oil conversion and even less so by biofuels – supplying about 0.6 Bn barrels oil equivalent, annual. This tilt, or the end of the 'undulating plateau' of world supply which has lasted since 2005-2006, where depleting conventional oil is just covered by unconventional, is even possible in late 2009.

No ‘price elastic' response to demand growth

 Through 1999-2007 world oil demand growth progressively ratcheted up, sometimes attaining (in 2004) rates as high as 3.2%-per-year. Rising prices had little or no impact on demand growth, specially in the "decoupled Asia" growth economies. This totally contradicts cozy liberal notions of ‘price elastic adjustment', or ‘inevitable' oil demand destruction when prices rise, despite even faster growth of world natural gas and coal burning. Put another way, without cheaper gas and very cheap coal, oil demand growth would likely have been even higher.

 This is energy economic reality. The real world is also facing another reality: runaway climate change. Unlike peak oil, this somber challenge to simple human survival – not just to economic growth ! – is now recognized as serious, concerning everybody, and needing both legislative and economic, fiscal and other responses. Around two-thirds of global climate changing gas emissions are due to burning fossil fuels, making the link very clear. Currently however, we only have the 'mechanism' of financial-driven global economic recession, today, or economic recession driven by swingeing interest rates hikes, in the 1980s, as the ways we could ensure that oil and other fossil fuel demand falls. What could be more fine tuned than that ?

In other words, rather soon, we have to find non market mechanisms and processes, including legislative and regulatory leverage, to ensure an orderly and permanent annual reduction in world oil demand at least equal to expected net loss of supply as we come out of and off the 'undulating plateau'. This is likely to be about 4% per year, perhaps more. This is equivalent to losing more than current total oil demand of either Germany or South Korea, every year.

Fantasy solutions – supply side miracles

Perhaps not surprisingly this kind of harsh real world outlook generates fantasy solutions. Stoic defenders of cheap oil in a real world context of levered-up demand, but only weak and hesitant growth of supply, such as the International Energy Agency (IEA) and the dwindling coterie of quotable energy ‘experts' and oil analysts, claim that world oil production could be ramped up to 115 or 120 Mbd by 2020-2025, belatedly taking account of underlying growth trends since the late 1990s. In other words, based on a current daily demand average around 86 Mbd, world oil production should be increased 35 Mbd in about 15 years. The simplest challenge to this laughable fantasy is to ask if anything like this has ever been done before, to which the definitive answer is no. The next challenge is to add the net additions to world production capacity needed to satisfy this fantasy, about 2.33 Mbd per year, to annual losses of capacity, running at about 3 Mbd per year. This returns a bottom line of a yearly need to find, prove and produce over 5 Mbd. Comparing this with actual results in the real world during the last 10 or 20 or 30 years returns one-only answer: it cant be done.

Completely ignoring depletion losses to world production capacity, more than three « new Saudi Arabias » must be found, proven, developed and placed into reliable supply in less than 15 years. Surprising or not, this calculation (around 36 Mbd of new capacity needed by about 2020) has been published in the ExxonMobil in-house journal ‘The Lamp' under the name of ExxonMobil Exploration Company's CEO, Jon Thompson.

Only three of the oil major corporations (BP, ExxonMobil and Shell) have production capacities above 2 Mbd, and declared annual discoveries of the 10-largest oil corporations through 2002-2008 rarely surpassed 6 Bn barrels, often less. World oil demand in recession hit 2009 will be around 30 Bn barrels, after more than 31 Bn barrels in 2008.

The ‘supply gap' in the next 15 years can be put another way. Relative to the Iraq prize for G W Bush strategists including Paul Wolfowitz, this war "having nothing to do with oil", additional capacity needed by around 2020-2025, supposing the growth economy is resuscitated, would be about twenty « New Iraqs ». That is, based on Iraq's current production and export capacity. Not only did Iraq not have vast stocks of WMDs, we were told by General Co-lin Powell long after the war was declared, but Iraq also does not have vast reserves of light sweet crude waiting to be produced, or plundered. Iraq's role in relation to the coming oil crunch is in fact tiny and insignificant.

Demand side reality

One part of the puzzle is consistent underesimation of world oil demand growth, at least until well after 2000. The IEA's so-called ‘long-term trend rate' of around 1.25% to 1.4%-per-year which held from the mid-1980s until about 1995 was finally revised up closer to the underlying and basic rate well above 2% a year generated by global economic growth since the late 1990s. This is reflected by belated 'corrections' of IEA estimates, as shown below, from 2002, forecasting growth of up to 42 Mbd in demand through 2002-2022.

 

Since around 2005 the main, sometimes only official culprit for this levered-up basic growth trend running at around 2 Mbd-per-year is: China. Unexpectedly or not, this country is now the world's industrial powerhouse, but only uses about 2.5 barrels-per-year per person (compared with 25 for the USA, and 14.3 on average for all OECD countries, 2007). The simple explanation is China's much lower but growing per capita income, and lots of coal. China's massive coal burn supplies around 17 Mbd in oil equivalent terms, and allows China to beat even the USA in total greenhouse gas emission.

Fingering China as the unique culprit, a swath of finance journal leader writers can hope out loud that China's rulers decide to ease off the gas pedal but not the coal shovel, and even slow down the country's economic growth (Chinese economic growth also being held as the main driver for surging non-oil commodity prices), but this entirely ignores the other two-thirds of current oil demand growth at the aggregate world level. This is a simple function of economic growth within the current structure of the global economy. Changing this will not be possible without highly organised and purposive programming based on solid and rational investment strategies, mobilizing large and reliable sources of financing and backed by legislation.

Today we have an Obama administration, and other G-20 leaders underlining their solemn engagement, and indulging in extremely massive public borrowing to save the world car industry, the world airline industry, homebuilding and urban construction, and so on, with the sole target of restoring absolutely conventional economic growth !

No way out but energy transition

With an ironclad determination to deny real and very close limits on global oil supply, and the need to at least cap coal and natural gas burning, leaderships of most countries are pursuing a "global growth strategy". This can only move the world closer to the very opposite of ‘sustainable' anything except international conflict, the clash of civilizations, and runaway climate change. Oil shortage made worse by refusing to restructure the economy towards low (or at least lower) oil intensity can only raise prices, then raise them again, if and when there is any recovery of the economy. The potential for another oil war in the Middle East, seeking heightened export performance or the defense of 'vital national interests' of the big oil importer countries will likely remain high.

As the Iraq tragedy shows, the end result of pre-emptive invasion of oil producer countries is long-lasting war, both civil, international, and North-South. After this stage in global destabilization due to oil hunger, we could move the ulitmate stage, of rivalry between themselves by the nuclear armed, oil import dependent superpowers for diminishing oil production capacities. The only way out are clear and courageous decisions, and engagements to limit then decrease oil and gas demand, on a long-term, universal and rapidly progressive base.

Energy transition will need international cooperation and negotiation to set binding, long-term programmes for reducing fossil energy intensity (measured in barrels and barrel equivalent per head of population). This could be compared to the much modified and weakened engagements set by the Kyoto Treaty and process, which in a near-term future will surely include both the USA and China, the world's two biggest GHG emitter countries.

For energy transition, firstly oil transition and quite rapidly gas transition, the lengthy timeframe set by the Kyoto process for greenhouse gas emissions reduction is not available. Under current real world conditions world oil supply will almost certainly fail to match demand within 2 years. The lead time to this sure and certain Oil Shock is very short, underlying the only possible solution: energy transition for reduced oil-intensity and natural gas-intensity in the OECD countries will need to start in the very short term. Coordinated and simultaneous worldwide development of renewable and alternate low carbon energy supply is equally urgent, targeting perhaps 25 Mbd of oil equivalent supply by 2025. Only the present economic slump buys a little more time.

 

 

 



Andrew McKillop is an energy economist and consultant. He has held posts in national, international and supranational (Euro Commission) energy, and energy policy divisions and agencies. He is the  editor of 'The Final Energy Crisis', Pluto Books; and co author with
Salah al-Shaikhly of  'Oil Crisis and Economic Adjustment', Pinter Publishing. He is a frequent contributor to Petroleumworld and several other energy related sites and groups. Petroleumworld does not necessarily share these views. Copyright Andrew McKillop, 2009

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