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By Majid al-Moneef

The current financial and economic crisis engulfing the world as well as the oil price ‘rollercoaster’, which saw it doubling in the first six months of 2008 and losing 70% of its value since then, is posing numerous challenges to the energy markets, the industry and the governments of the oil producers and consumers. The global environmental concerns such as climate change, the energy security concerns of consuming countries and the development concerns of producing countries pose longer term challenges.

Short Term Challenges

The oil price escalation of the past few years was related partially to demand and supply developments, particularly with growing energy (especially oil) consumption in the emerging economies being fueled by their economic growth. This demand growth coincided with declining spare production capacity due to the slow response of production to demand increases. The developments in the financial markets and the increasing emphasis on oil and gas (and other commodities) as asset classes and stores of value also contributed to volatility during the oil price rise. The oil price increase eventually impacted demand in the consuming countries (especially the OECD) and with the intensifying financial crisis in the second half of 2008, demand as well as prices started to fall from their unsustainable levels. While the global oil demand decline of 2.7mn b/d since 2007 (4mn b/d in the OECD) is related to the earlier oil price increases and to the slowdown of economic activity, some of this drop in demand could be recovered once the crisis ebbs.

The longer the current financial and economic crisis lasts, and the larger the downward pressure and volatility in oil prices, the higher the excess production capacity (estimated in 2009 at 6mn b/d) and the lesser will be the incentive to invest in maintaining, let alone increasing, production capacity for the anticipated longer term demand growth. This will impact the long term market stability and investment in the oil and gas value chain (exploration, development, production, refining, processing and transportation) as well as investments in renewable energy sources. This will ultimately impact the energy security concerns of consumers and the development prospects of producers as well as climate change mitigation policies.

Another concern in a case of prolonged and severe crisis is the inability of the energy industry (especially in the fields of non-conventional and renewable energy sources) to secure investment due to the credit squeeze on the one hand and the unattractiveness of some projects under the current oil price environment on the other. Although materials and services costs of projects have declined from their peak levels of the first half of 2008, estimates of the oil price required to make new oil supplies outside the Middle East viable range between $28 and $114 per barrel as shown in the table below (based on estimated costs of second quarter 2008).

Minimum WTI Oil Price To Justify Investment In New Projects

Source: CERA.
Note: assuming 15% internal rate of return.

As a consequence of the crisis it is estimated that over $110bn of planned investment has been cancelled or delayed in recent months, the majority of which in Canadian oil sands projects, and some 2-3mn b/d of planned oil production capacity worldwide has been put off. Cambridge Energy Research Associates (CERA) projects that roughly 7.6mn b/d out of a total potential 14.5mn b/d between 2009 and 2014 is at risk due to the oil price collapse.

Although economic growth in the oil producing countries is projected to slow due to the impact of the crisis, the period of high oil prices in the past few years provided some governments and their national oil companies (NOCs) with foreign exchange reserves to weather the crisis and continue, albeit at slower rate, investment in maintaining and augmenting oil and gas production capacities. The international oil industry on the other hand (especially the large integrated IOCs) benefited from the period of high oil prices and are better positioned to withstand the period of lower prices. However, their ability to channel investment to the upstream and downstream depends on their cost structure of their projects and their oil price assumption and outlook. Smaller companies, however, who traditionally rely on borrowed capital for project finance, may face financing and other difficulties if the current oil price and credit situation persist.

For the oil consuming governments, the impact and responses also differ depending on their political and economic circumstances. While the period of high oil prices initiated debate especially in the US and the EU on energy issues such as efficiency, development of alternatives and energy dependence, the severity of the financial crisis and the subsequent oil price decline might have sidelined the speed of response to such energy issues. It remains to be seen whether the energy policies or measures taken in response to the short lived high oil price episode should continue, or a new policy framework be developed to respond to the underlying economic challenges and the longer term energy issues.

Long Term Challenges

The 2008 World Energy Outlook of the IEA projects an annual global energy demand growth of 1.6% through 2008, with oil and gas growing by an annual average 1.0% from around 86mn b/d today to 106mn b/d in 2030 and gas by an annual average 1.8% from around 3 trillion cu ms/year today to 4.4 tcm/y in 2030. Despite the drive towards biofuels and other renewables, oil is projected to account for 85% of the demand growth of the transportation fuels through 2030.

The first long term challenge is related to climate change. Energy is a prerequisite for economic and social development. While it is obvious that there are no easy solutions to the transformation towards a low carbon emissions world, the consensus is that efficiency improvements and advancements in carbon capture and storage (CCS) technologies hold the key to such transformation. The fact however remains that the world will need all viable and environmentally friendly energy sources including clean fossil fuels and renewables. Until the time that alternative energy resources become viable, acceptable and have their infrastructure in place, the world will need to invest in cleaner fossil fuels to meet its growing energy needs.

The second long term energy challenge is the perception of energy security. While the cornerstone of energy security lays in the diversity of energy mix and energy supplies, it is obvious that diversity of the energy mix is a long term process which requires investment and prudent policies that use market signals to develop alternative resources. Diversity of energy supplies, however, is more problematic. OPEC countries are projected to contribute 85% of the incremental required world oil production of 20mn b/d while the Middle East, Russia and the Caspian are projected to contribute 74% of the incremental required world gas supply of 1.5 tcm/y from now through 2030.

Along with the projected oil and gas demand and supply patterns, another feature that will be reinforced is the growing energy interdependence between regions. Global oil trade is projected to grow by 34% from 41mn b/d today to 55mn b/d by 2030, while gas trade will double from around 0.5 tcm/y to 1.0 tcm/y. More than 64% of the projected global increase in oil and 34% of the global increase in gas trade will come from the Middle East (9mn b/d of oil and 170 bcm/y of gas)

It is projected that the OECD oil import dependency will increase from 55% today to 65% by 2030 and its gas import dependency from 24% to 41%, while China’s oil import dependency is forecast to increase from 35% to 75 percent and its gas import dependency from 3% percent to 48% in the same period. The Middle East, on the other hand is projected to increase its share of global oil trade from 48% to 52 % and its share of global gas trade from 17% to 32%. This energy trade patterns along with the demand pattern mentioned earlier will have implications on the issues of energy security and the safety of sea routes (Hormuz, Bab el-Mandab and Malacca Straits). They will reinforce the fact that regardless of political pronouncements to the contrary, diversity of oil and gas supplies have their geologic, geographic, technical, logistic and economic limits.

The diversity and reliability of energy sources and supplies should not be mixed with the notion of ‘import independence’ from this or that source. Pronouncements and policy initiatives in that direction send confusing signals to the public and the industry of the consuming countries as well as to the public and policymakers of the oil producing countries. One has only to consider the decades long debate on reducing dependence on imported oil (especially from the Middle East) in the US to realize the futility of such efforts.

The third long term energy challenge is related to the development drive of the emerging energy consuming/importing or producing/exporting countries. This growth in demand for the economic and social development of the former might have the environmental consequences related to CO2 emissions and climate change. Industrial countries have the obligation to facilitate the transfer of clean technologies to developing countries. Improving energy efficiency and energy pricing structures in the new rapidly growing centers of energy demand, as well as capacity building in those consuming regions, could contribute towards reconciling the development objectives of those countries with the global environmental objective.

For the oil producing/exporting countries, the projected growth of production is mostly from developing countries whose development objective for decades has had two pillars: diversify their economies and lessen dependence on oil and gas production and exports on the one hand; and lessen the impact of the internationally determined swings in the prices and production of their resources on the other. The outlook that more of their resources will be required to meet growing world demand poses different challenges to the policymakers and the energy executives of those countries. The development goal of income diversification could be impacted unless proper economic development policies are taken to leverage the leading export sector for the national economy, through identifying and developing each economy’s competitive advantage. The anticipated revenues from the increased exports could delay economic reform programs and might lead to wasteful spending unless prudent fiscal policies are enacted to optimize the utilization of export revenues for social and economic development

Cooperation Towards a Sustainable Energy System

While reforming the financial and regulatory systems and stimulating the economy to deal with the current crisis are the overriding concern of policymakers and international institutions and initiatives, longer term energy issues of sustainable development should not be overlooked. This disconnection between the longer term energy outlook and the immediate situation facing governments and the industry, needs to be reconciled. In this regard, the world needs to address issues such as the timeliness, channels and adequacy of energy investment, the role of excess oil production capacity in market stability and in the mitigation of security of supply concerns, international technology cooperation to address climate change, as well as the role of producer/consumer and industry/government cooperation to reduce price volatility and enhance energy investment flows.

In the short term, once the global economy starts recovering (and there are signs of quicker recovery than had been anticipated at the onset of the crisis), leading to demand recovery, the growth in demand without the price to support new investment means great risk of another price run-up and possibly another boom-bust cycle. Even if demand does not grow rapidly, depletion rates of existing oil fields require investments on a massive scale, which the crisis-induced price does not support. The IEA projects that the cumulative oil and gas investments from 2007 through 2030 in the upstream and downstream oil and gas needed to meet the above outlook is around $6.3 trillion for oil ( $4.2 trillion downstream) and $5.45 trillion for gas.

In the existing oil market environment, there is no agreed mechanism to guarantee a floor or price ceiling. One may look at the taxation of oil products by the consumers as a means of setting a floor to oil prices with the objective of influencing oil demand growth and the development of alternatives (besides other fiscal and environmental goals). OPEC production decisions could also be viewed as a means by the producers to influence the price floor with the objective of generating adequate income and reasonable growth in demand and production. Maybe it is due to these different approaches in achieving a minimum price that the producers often criticize excessive product taxation by some consuming governments, and the IEA criticizes the production decisions of OPEC. A price ceiling is as problematic, since it requires excess production capacity to be called upon to moderate price movements.

Spare Production Capacity

Some amount of spare production capacity provides a cushion against excessive increases in price due to demand surges or supply shortfalls. The excess production capacity and its utilization in key countries in OPEC at different times have served to moderate the impact of the sudden changes in market balance and to mitigate security of supply concerns. However, there are economic and political problems associated with maintaining spare capacity. Generally, high rates of utilization of capacity are preferred by the IOCs to satisfy their shareholders or regulators. Politically there is strong pressure to use spare capacity or to reduce it due to its short term economic burden in the countries where it is located.

Historically, spare capacity existed in OPEC member countries and with NOCs as a result of the production restraint of its member countries at times of declining demand for the organization’s oil. It existed in Saudi Arabia due to its stated policy of maintaining 1.5-2mn b/d spare capacity at all times to contribute to market stability and supply security. Contrary to the critics of OPEC’s production decisions, they have lead to the existence or growth of excess capacity, which contributed not only to immediate market balance but to longer term supply security. Saudi Arabia’s spare capacity, ranging throughout the past three decades between 65-85% of OPEC’s excess capacity, has been a key to such stability and security.

Another issue related to spare capacity is that of inventories (commercial or strategic) in the consuming countries, which could be regarded as some kind of spare capacity. Strategic stocks in the OECD (held by governments or on their behalf) at 1.5bn barrels amount to 36% of total inventories by the end of 2008. Although the strategic stocks are meant to be used at times of supply emergency, there has been a debate in some IEA countries of using them for market intervention. A producer-consumer dialogue and cooperation with regards to the size and utilization of excess production capacity and the role of commercial and strategic stocks could contribute to producer flexibility and consumer security.

The long run energy outlook and government policies will be largely influenced by the global environmental concerns of climate change and related technological developments or efficiency improvements, the developments of alternative sources of energy or the introduction of acceptable ‘green’ vehicles. It is commonly agreed that a transition to a low carbon emissions future will impose costs and benefits unevenly distributed among sectors and developed as well as developing countries, depending on the emissions intensity of production and consumption. The IEA estimates that if greenhouse gas concentration is to be stabilized using a mix of policies, additional investment in energy related infrastructure and equipment of around 0.2-0.6% of world GDP is required.

Energy Security

During the period of high oil prices or rising political tensions in the main oil and gas producing regions, energy security concerns become more often associated with oil and gas import independence from a particular region. Such interpretation of energy security often leads to hasty energy and trade policies or public statements (especially in the US where energy matters are the most politicized of all industrialized countries)

The energy producer/consumer dialogue since 1991, which was institutionalized in the International Energy Forum (IEF) in 2003, has been addressing the issue of energy security from the supply and demand sides. Maintaining excess production capacity to use at times of crisis, the diversity of export routes and investments in consumer market refining and marketing assets are examples of what the producing/exporting countries can contribute to alleviating the energy supply security of the consuming/importing countries. Transparent energy markets, predictable environmental policies, better regulated financial and commodity markets and non-protectionist energy trade policies are examples of what the consumers can do to improve demand predictability and sustainability.

Majid al-Moneef is Saudi Arabia’s Governor to OPEC. Petroleumworld not necessarily share these views.

Editor's note: This commentary was originally published by Mees, on June, 15 2009, (Middle East Economic Survey VOL. LII No 24) as an edited version of a paper al-Moneef presented to the Interaction Council in Berlin in May, at an expert group meeting on energy availability and economic growth.Petroleumworld reprint this article in the interest of our readers .

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Petroleumworld News 07/12/ 08

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