The rising trend of falling supply

These days the news is full of dire warnings about another financial meltdown emanating from the sovereign debt crisis in Europe. Professor Nouriel Roubini, who was catapulted to international fame after correctly predicting the 2008 financial crash, said Europe was sliding into a “double-dip” recession, if not depression, and a break-up of the eurozone was increasingly likely.

So, in the face of this downside economic risk, why does the price of oil remain stuck above $100 a barrel? What are the short, medium- and long-term prospects for oil prices? And, most importantly, what do the underlying currents imply for future economic prosperity?

To answer these questions we need to interrogate the “usual suspects”: the insatiable Chinese dragon, supply fundamentals, the Opec (Organisation of Petroleum-Exporting Countries) cartel, the geopolitical risk factor and assorted speculators.

Before starting the inquisition, some historical context is useful. Between 1986 and 2003 the oil price traded in a remarkably stable and narrow range, averaging about $20 a barrel. From 2003 it rose steadily for several years and then spiked dramatically to reach an all-time nominal peak of $147 a barrel in July 2008. When the world sank into recession after the global financial crisis later that year, demand for oil fell rapidly and the oil price plunged to about $40 a barrel. Since then the price has ratcheted up again and has traded in triple figures for the whole of this year.

The resilience of the oil price reflects first and foremost the tightness between the global supply and demand for oil. Despite oil consumption having apparently peaked a few years ago in the industrialised countries, demand for oil products continues to grow apace in emerging economies. China leads the pack, expanding its oil consumption by almost 10% a year. Last year 13-million new cars were sold in China, topping America vehicle sales for the first time. And it seems that whenever the oil price falls, China taps into its vast foreign-exchange reserves—more than $3-trillion and counting—to stockpile crude for its strategic petroleum reserve.

Meanwhile, oil producers seem unable to meet demand as they used to do. A number of independent oil analysts have been warning for years that oil production could reach its all-time peak early in the 21st century. Now even the International Energy Agency agrees that conventional crude oil output likely peaked in 2006. The data indicates that world liquid-fuel production has been essentially stagnant for the past six years, aside from an increase in biofuel output that has, in turn, boosted food prices.

Global spare oil capacity is now minimal, which means the slightest market disturbance can trigger big price fluctuations. Furthermore, most new oil sources outside a few Persian Gulf states—many of which are in deep water—have marginal production costs of about $80 a barrel. Canada’s tar sands have marginal costs of about $90 to $100 a barrel.

Another perennial suspect is Opec countries: most of them can no longer “afford” for the price to drop below $100 because they are dependent on high oil revenues to maintain government spending and social stability.

Speculators no doubt played a part in amplifying the wild price gyrations from 2007 to 2009, but without fundamental price drivers they would have nothing to bet on.

Our final suspect is geopolitical risk. Certainly, the conflict in Libya this year played a significant role by taking about 1.2-million barrels a day of world oil exports offline. And tension persists throughout the Middle East region, centred now on Syria and Iran.

So, all in all, there are many forces keeping the oil price in three digits. Meanwhile, there seems to be a ceiling for oil prices at about $120; above this level it destroys demand.
Forecasting oil prices with any great precision is notoriously difficult. Nonetheless, we can be reasonably confident about certain trends.

In the next year or two the oil price kite will continue to be buffeted by the winds of financial turmoil and an increasingly tight demand-supply balance. If the world economy continues to grow, spare oil capacity will essentially disappear next year. But if Europe falls into a financial-economic abyss, the oil price could drop markedly, although probably not for very long.

For the remainder of this decade the greatest likelihood is that oil prices will continue their volatile swings, but around a rising trend driven by falling supply. Beyond that, the trajectory for oil prices will depend largely on how governments and societies respond to diminishing oil supplies. If they attempt to continue business as usual and compete for a shrinking pool of the black liquid, it will become increasingly unaffordable and engender economic chaos.

If, on the other hand, there is a concerted mobilisation to reduce oil dependency through conservation and efficiency, investing in alternative energy supplies and electrifying transport systems, then eventually the oil-price train could run out of steam.

Indeed, the economic fortunes of the world hinge on which of these scenarios comes to pass. The window of opportunity for launching a crash programme to mitigate the impending decline in oil production and accelerate a transition to a sustainable global economy is rapidly closing.

So fasten your seat belt and tighten your economic belt: 2012 promises to be another wild ride on the oil roller coaster.

Jeremy Wakeford is an independent sustainability economist, who is completing his doctoral degree at the University of Stellenbosch. He also chairs the Association for the Study of Peak Oil South Africa, a non-profit organisation dedicated to raising awareness of global oil depletion and its implications

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