An alternative perspective

13 November 2015

The Long-Run Price of Oil

Once upon a time, not very long ago, it was widely believed that oil prices could only go one way. Many energy commentators, and most European politicians, convinced themselves that supply could never keep up with demand, and hence the future was a path to $200 a barrel.

So convinced were they, that energy and climate change policy has been based on this assumption. Getting out of oil – and fossil fuels in general – was not only going to be a good environmental thing to do, but it was essential if Europe was to maintain its global competitiveness. A host of very expensive technologies got large subsidies, in the certainty that this support would be temporary, basically holding the fort until oil prices became sufficiently high.

For a while the evidence was supportive. Oil prices did go up – even at one stage getting back for a brief moment to the real level they had been in 1979, over a quarter of a century ago (in today’s money around $140 a barrel). They then hovered around $100-110 a barrel for quite a while. This became the ‘new normal’. But it turned out to be nothing of the sort, and in late 2014 the oil price collapsed.

The Commodity Super-Cycle and its Demise

What caused this commodity super- cycle and why did it collapse? The answer lies with the industrialisation of China, based as it was on a huge appetite for fossil fuels. Back in the late 1990s, China exported coal. Now it is 50 per cent of the total world trade in coal. Its oil appetite has been similarly awesome – along with a host of other commodities.

Demand marched up, but supply lagged. The low oil prices of the 1980s and 1990s had taken their toll. At these sorts of levels, it was not worth spending lots of capital on the search for new supplies. Instead, the job was cost cutting and the oil companies went for big mergers. The modern BP, Exxon and Chevron are the result, and Shell is repeating the merger approach now with the BG Group. The slow but steady price rises after the floor of less than $10 a barrel in 1999 were the inevitable result of the supply/demand imbalance.

But the economics work both ways. Ever-higher prices make ever more marginal resources attractive. Thus a technological revolution was born in the US much more powerful than advances in current generation renewables. Shale technology came quickly and massively into the marketplace. First the US gas market was transformed, and all that liquefied natural gas development in places like Qatar no longer had a market. Even the disaster at Fukushima was able to be accommodated in the gas market, so big was the US withdrawal.

But the biggest impact turned out to be shale oil. In just seven years, the US transformed itself from a declining production base, to add over three million barrels a day (‘mbd’) to a global market of less than 90 mbd, and turn itself back into the world’s largest oil and gas producer. There are no parallels in the recent history of oil.

The bubble burst because of the new US supply, and the waning of the Chinese growth miracle, which together tilted the supply/demand balance back the other way. Other powerful forces were at work too. High prices create a massive incentive to maximise production and OPEC’s discipline (to the extent there was any) collapsed. The oil producers have all been pumping hard, and they have to, because the Arab Spring showed what happens if the rapidly rising and very young populations in the Middle East are not bought off with ever higher public expenditure. By 2015, even Saudi Arabia needed $100 a barrel to balance its budget. So they were all increasing supply as prices fell.

The Collapse and its Aftermath

The proximate cause of the collapse in 2014 was a further hike in Saudi oil production. The narrative was that the Saudis would take the pain of lower prices as a way to force out US shale production, just as they had tried to force out rivals back in the early 1980s. The Saudis assumed that once the US had been hit hard, the oil price would naturally go back up, and they would be able to hold on to their market share.

But this time the music has changed. Saudi Arabia’s capacity margin is no longer a potent weapon, because shale can be turned on and off very quickly. Shale technologies are light-footed – the rigs can be put up and taken down quickly and capital spending can vary in as short a period as six months. This is the real swing production now, and what makes it even more powerful is that as the oil price has fallen, and the boom conditions moderated, costs have fallen quickly.

There are still those who think the current prices are ‘low’ and that they will rise again very quickly. Volatility cannot of course be ruled out, but high prices should not be banked on. Indeed it is even possible that they may never return – except during crisis and short sharp shocks.

In the aftermath of the price falls, a curious phenomenon has emerged: production has increased as prices have gone down. The reasons are not hard to find: the oil producers are mostly in dire financial straights. Russia is an example. Even Saudi Arabia has already depleted quite a bit of its sovereign wealth fund. They need every dollar they can get, and hence they have opened the taps even further. US shale prices have proved remarkably resilient too. Meanwhile China’s economic woes continue, and that means there is no new Chinese demand coming to the rescue.

Persisting into the Medium to Longer Term

If supply goes up and demand falters, the price falls. It is tempting to think we are just waiting for the next super-cycle. But there are several reasons for doubting this. First, the remarkable thing about oil is that for 150 years there have been very few super-cycles. Most of the time the price has been remarkably stable. Second, $50 a barrel is, by historical standards, a very high price. The marginal cost of a barrel of oil in Saudi Arabia, Iran and Iraq is less than $10 a barrel, and often below $5 a barrel. All the rest is economic rent – and that makes it vulnerable.

It turns out that there is plenty of low-cost oil to come. In theory, both Iraq and Iran can produce over 10 mbd. This is not going to happen any time soon, but it does not have to for prices to be effectively capped. Iraq has been quietly pushing up output to 4 mbd and Iran can reach this sort of number quickly as sanctions drop away. Then there is Libya – effectively out of the market now, and so it can only go one way. If Russia (with massive reserves), the US, Saudi Arabia, Iran and Iraq all one day produce 10 mbd each, that is over half the current total world demand.

But that is only the beginning. The shale revolution has yet to migrate from the US. It has yet to reap its really radical effects. The new technologies can be applied across a wide range of countries, and not only to shale deposits. The new technologies open up existing conventional reserves to higher depletion rates. Hardly any oil well has ever been depleted by 50 per cent. Adding just one or two extra per cent is a huge amount of oil.

Finally, add in the Arctic, the Mediterranean, the Black Sea, the South China Sea, the coast of East Africa, and all together it is apparent that there is a massive abundance of oil. The world’s problem is not that, as the peak oil theorists would have it, we are going to run out, but that we have more than enough to fry the planet many times over. All of this means that there is long-run downward pressure on oil prices.

New Technologies

This is assuming we actually need all this oil. But what if new technologies take over? There are two key demands for oil – transport and petrochemicals. Transport is gradually getting electrified – as is much of manufacturing. In the world of the ‘electrification-of-everything’, oil is not needed for transport. It will take time, perhaps a decade or two, to cut into global demand for oil in developing countries, but already it is no longer rising in the US or Europe.

Petrochemicals may be a harder nut to crack, but even here oil faces serious headwinds. In the US, gas (ethane) is the fuel of choice – not oil – for petrochemicals. But the really radical threat comes from new materials – like graphene. Petrochemical demand is a derived demand for things like plastics. But what if other materials can take its place? In a fast-moving world of rapid technical progress, with robotics, 3D additive manufacturing, solar film and new storage and batteries, it is far from certain that oil’s dominance is permanent.

The conclusion is radical – the oil price may never go up much again. If this is true, the great oil producers face a nightmare. For the Middle East, there will be a lot less money for a lot more very young people. For Russia, the last time this happened the Soviet Union collapsed, and then Boris Yeltsin’s government went bankrupt. There is no reason to believe it will be any prettier this time around.

Dieter Helm is an economist, specialising in utilities, infrastructure, regulation and the environment, and concentrates on the energy, water and transport sectors in Britain and Europe

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