Actually, the oil business is turning into a sunset industry. New technologies are discovering new vast reserves faster than can be consumed. As for old and plugged fields, they can now be brought back to production with new recovery techniques squeezing more oil that heretofore remains unrecoverable.
Capitalism leaves in its wake a history of broken constraints. In the case of oil, there are two ways in which oil supply constraints can be smashed. Both involve the use of new technologies. One will enhance the prospect of discovering new fields and recovering more oil from the fields, including those that have been long abandoned. The other, part of the final technology wave, will make oil obsolete and redundant.
On the surface, although oil prices appear as the product of supply and demand, things are not that straight forward. Looking back at the history of oil prices since October 1973, when OPEC started flexing its muscles, oil prices have usually been a product of the interplay between global liquidity and the follies of the oil producers. On the way up and down, they move in tandem, continually reinforcing each other. The wild swings in oil prices are the inevitable outcome of the commodity nature of oil. It doesn't take much to tip the scales in favour of either the consumers or producers; the marginal price sets the price for the entire market since the market is not segmented. Worse, both supply and demand are not that elastic over the short term.
In the immediate term, even without factoring the new technologies, the outlook for oil prices is downward. Because bringing new oil fields to production takes time, anywhere from 7 to 10 years, these fields, the planning of which began in 2003 when oil prices inched upwards, will start producing by 2010. Foreign Affairs Nov/Dec 2009, disclosed that Saudi's production capacity would rise from 9.5 million barrels a day in 2002 to 12.5 mbd in 2010, with an extra 1.0 mbd on standby. By then, total OPEC production capacity will grow to 37 mbd, giving a spare capacity of 6 to 7 mbd over current production level. All this is happening in the face of a massive global economic slowdown.
Twice in the past, as narrated by Foreign Affairs Mar/Apr 2002, Saudi used its spare capacity to discipline wayward oil rivals. In 1985/86, Saudi intentionally engineered a price war to regain its market share from interlopers. More than ten years later, in 1998, again it purposely added another 1.0 mbd to its production to punish Venezuela for displacing it as the prime supplier to the US. But the authors of that piece ignored the events leading to the two price collapses that had taken place a few years earlier. The chart shown here from The Economist is enlightening.Prior to the Arab Israeli War in 1973, the oil spare capacity had been on a secular fall while production - and, by inference, consumption - had been rising, Surely, such opposing trends would have signalled a price increase in the near future. On the other side of the globe, another war had been draining the US of substantial funds that by August 1971, Nixon had to de-peg the US dollar from the gold standard. Free from its leash, the total debt level (money supply) in the US leaped. The 1973-74 oil shock, wrongly attributed by many to the Arab oil embargo, wouldn't have been a shock had the policymakers been aware of the rapidly declining spare capacity as well as the depreciating value of the US dollars. The sudden jump in oil prices from US$3 a barrel to US$12 was an otherwise predictable event. In the 1967 Arab Israeli War, the Arab countries also imposed an embargo but it came to nought. Why? Because spare capacity was still high; even the US then was a net oil exporter.
However at US$12-US$14, there was no much incentive to develop new oil fields. Oil spare capacity was still hovering around 5 percent of production. It needed the Iranian revolution and the subsequent Iran-Iraq war to secure a production fall of more than 3 mbd and thus jolted the prices to US$38 a barrel by end 1979. At this new price, consumption dropped through energy efficiency measures but not in an appreciable manner. More momentous was the spike in spare capacity as all producers ramped it up to capitalise on the high prices. Gradually, the prices dropped to US$26 by 1985. Saudi, being the swing producer had to cut production from 10 mbd to less than 4 mbd in order to stabilise prices. Seeing that others were profiting at its expense, it suddenly surged production to 5 mbd in early 1986. Within a year, prices slumped by more than 50 percent, dropping to as low as US$11.
Spare capacity dropped steadily all the way to 1990. Because of the long lead time in the development of crude oil production, spare capacity cannot jump or slump suddenly. Not however actual oil production . When Iraq sparked the first Gulf War by invading Kuwait on 02 Aug 1990, oil prices bounced back to US$38 but this was shortlived as Saudi jacked up production from 5 mbd to 8 mbd to appease the coalition countries which expelled the Iraqis.
The prices moved within a price band of US$15-US$23 from 1991 to 1997. Spare capacity was subdued at 5 percent. This was a period when supply and demand reached a stable accommodation. From now onwards, the oil producing countries no longer maintained spare capacity as a matter of policy. Any increase in spare capacity will be a result of a consumption slowdown. When the financial crisis hit East Asia in 1997-1998, global oil consumption for 1998 stagnated and spare capacity increased. Venezuela increased its shipments to the US to dethrone Saudi as the biggest OPEC supplier but Saudi retaliated by jacking up production by 1 mbd. Prices collapsed to US$9 by end 1998 and early 1999.
The 2000 dotcom boom pushed prices to over US$30 but they fell back to US$16 the following year with the dotcom crash. The spare capacity yo-yoed from 1998 to 2001 because of these economic crises. Beginning 2002, Greenspan and Bush participated in the biggest US credit creation that ended in 2008. Prices peaked at US$143 by June 2008 but dropped to US$34 by winter. Spare capacity was dangerously low. Obama's public stimulus (the biggest in US history), Bernanke's money printing and Chinese easy credit revived the prices to US$80 by late 2009. These not only benefit oil exporters but also countries, such as Australia, Brazil and Indonesia that depend on other extracted commodities including coal. Their economic growth is by no means a reflection of their management of the economy.
As the world approaches 2010, these band-aid measures will start to wear off. And spare capacity for OPEC itself will exceed 10 percent. In 2008-2009, two years in a row oil consumption fell, the first time since 1982-1983. In 2010, it's likely to fall unless the US institute another trillion dollar budget deficit. The outlook for oil certainly looks very gloomy.
Will oil production drop in order to prevent price collapse? Possible but highly unlikely. The producers are caught in a trap of their own doing. Almost all the major exporters have populace that is dangerously dependent on oil largesse through government jobs and spending. This is a fixed cost that cannot be crimped without severely exposing the governments to social instability and political upheaval. As prices drop, they will rev up production to keep revenue steady. Soon, this vicious circle feeds on itself until the country itself succumbs to economic and political collapse. Although oil will be cheap, it's not oil but blood that will be spilled in the streets.
Remember the Eastern European communism collapse and Soviet withdrawal from Afghanistan in 1989, and Russian financial crisis and Suharto's fall from grace in 1998. Their root causes lay in the oil price collapse. Take Indonesia. Like the other South East Asian countries, it suffered from an overvalued currency then but buffeted at the same time by low oil prices and El Nino-induced rice crop failure, the ensuing carnage was total. Even now the rupiah exchange rate tracks the oil price movement.
As an aside to the main topic, certain commentators, some of whom are economists, have attributed the present recession to the high energy costs, specifically those based on oil. Yet more ridiculous are those who blame the expected declining oil production as a leading cause for the recession. These conjectures reflect a flawed reasoning arising from confusing cause with effect.
If you recall the investment clock (see Ticking towards midnight), high commodity prices immediately precede the deflationary crash. Inferring that A causes B just because A precedes B is a flawed reasoning known as post hoc (after this) reasoning. A fitting analogy is a rooster's crow at the break of dawn which in no way causes the sun to appear. Actually high commodity prices is symptomatic of massive credit creation and when this credit is later written off because the borrowers cannot repay, the whole economy collapses.
As for the declining oil production Chicken Littles, they should read Scientific American October 2009. The magazine describes the new technologies that will extract more oil from the fields. Right now, only 35-40 percent of the oil in the average field is recovered; the rest remains unrecovered. New recovery techniques using heat, chemicals and microbes allow us to go after this buried wealth. Moreover, for new fields, only one third of the world's sedimentary basins - geologic formations that may contain oil reserves - have been thoroughly explored using modern technologies.
A recent example in the natural gas reserves is instructive. Hydraulic fracturing, a new technology that injects water and chemicals at high pressure to break shale rocks that trap natural gas, has been attributed to a 35 percent jump in the US gas reserves in two years. A similar thing is happening to oil reserves. The fact is more oil is still untapped and peak oil is rather more of our psychological fear than of physical reality.
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