Have we seen the last of cheap oil?

Updated October 30th 2005 (added section on "Retail Price Inflation and the Price of Oil")

"If the real figures were to come out there would be panic on the stock markets"
Dr Colin Campbell, Berlin, 2004

In this article, I examine the case for expecting that the price of oil will remain high for the foreseeable future.

I have also included a reprint of an earlier article entitled "OIL Price set to soar?" where I predicted that there would be a substantial increase in the price of oil, a prediction that has now essentially been fulfilled.

The Price of Oil in 2005

October 9th 2005

This chart shows the price of West Texas intermediate crude from 1970 to September 2005 (monthly). On October 7th, 2005, the US spot market price of West Texas Intermediate at Cushing, Okla., was quoted as down by $1.43 to $61.37 a barrel, and light, sweet crude for November delivery rose 48 cents to $61.84 a barrel on the New York Mercantile Exchange.

The chart shows that after a run up almost to the top of the triangle above $30 had occurred, there was a return move to a level close to the apex of the triangle to $19.33 in December 2001. Since then, oil has moved up strongly, and on this data, (which differs somewhat in price from the 1998 one, probably due to differences in benchmark crude sources) reaching a price level that has clearly exceeded the minimum "base plus apex" rule, i.e. $18 + $25-$30 = $43-$48.

The IMF's World Economic Outlook for September, 2005 now predicts an oil price of $61.75 per barrel for 2006.

Retail Price Inflation and the Price of Oil

October 30th 2005

This chart shows how the price of oil has related to retail prices. I have used British retail price index information, which includes prices for food, drink, tobacco, public transport fares, motoring, clothing and household, personal and leisure goods and services. The oil price is based on West Texas intermediate crude in dollars, the difference from other benchmarks of the same grade is not significant here. The price of oil is shown both in original dollars of the day, and adjusted for the retail price index and the £/$ exchange rate, so that the RPI-adjusted price of oil shows the real cost of oil to the UK consumer. The results shown are moving averages of quarterly data to smooth out excessive fluctuation.

The numbered reference points on the chart indicate the significant events to the oil market as tabulated below.

Datum	Year	Description
1	1972	OPEC raises prices due to falling dollar
2	1973	OPEC Yom Kippur War Oil embargo begins
3	1976	Jamaica Accords promoted floating exchange rates and replaced the role of gold with SDRs
4	1979	Iranian revolution
5	1980	Iran hostage crisis
6	1980	1980-1988 Iran-Iraq War starts
7	1983	World oil demand trough
8	1990	Iraq invades Kuwait: Short-lived oil price spike
9	1991	Operation Desert Storm, Iraq
10	1997	OPEC production increases, Asian economies weak
11	1999	World producers cut production to raise prices
12	2001	Sep. 11 economic slowdown
13	2003	Economic recovery

The most recent rise in the price of oil, which follows economic recovery and increased demand in the US after the shock of September 11 2001, occurs when inflation has been static, fluctuating around 2.5% since around 1993. Previously, inflation rates have increased together with the price of oil, a period of slowly rising inflation being evident from 1968 to 1974 before the OPEC oil embargo started. It is as if the unstated reason for the oil embargo was to raise the price of oil to compensate the producers for the loss of value of depreciated currencies. But the recent rise in oil shows no relation to inflation. Could this be indicating that the price rise is related primarily to supply versus demand, with the recent recovery in demand in the US simply adding to increasing demand in China and elsewhere? There is little current pressure on producers to raise prices on account of currency devaluation, at least no more today than since 1993. Inflation levels although apparently rising from a long-term low, are still low relative to the longer term. When the price of oil does eventually feed through to retail prices, the resultant inflation and devaluation of currencies may be expected to increase pressure on producers to maintain real returns for their oil exports, which would add further pressure for oil and retail prices to spiral upwards.

Demand for Oil is Increasing

World demand for oil is expected to increase by 54 per cent in the first 25 years of the 21st century, according to the US Energy Information Agency. That works out to an average compounded increase of 1.74% per year.

The US Department of Energy in March 2005 predicted an increase in global oil consumption to 84.7 million barrels a day in 2005, and OPEC has estimated daily global oil demand in 2005 to be 83.6 million barrels per day, which is an increase of 1.58 million barrels from 2004, and OPEC projects a demand of 85.2 million barrels per day for 2006.

Demand for oil in China in 2005 is forecast to average 7.4 million barrels a day, which is up 12% in a year. Yet China can't get enough energy, as 24 provincial regions in China were forced to ration power supplies in 2004, and petrol shortages and rationing were experienced in Guangdong province in 2005. In 2003, China accounted for 41% of the growth in demand for world oil, and its oil imports rose 31% over 2002. In 2004 China's crude oil imports increased 35 per cent over the previous year. Oil imports to China have levelled out in 2005, but as The Economist reported on June 4th 2005, car sales in China are expected to increase by 10-20% a year for several years to come, and with cars consuming one-third of China's oil, and a chronic energy shortage, there are substantial grounds to expect continuing strong increases in oil demand in China.

The chart below shows the world's total oil production figures from 1960 up to 2004, versus world oil demand from 1970 to 2005 (demand includes petroleum products which have a greater volume than the raw input from production, and withdrawals from stockpiles). While there is no obvious peak in production yet, if you compare this chart with the previous one on oil prices, it is interesting to note the effects of the oil crisis of the 1970s, after the 1973 oil embargo and the Iranian revolution, production declines and the price increases rapidly in 1979/1980. World production declined by 15% between 1979 and 1983. Could the current price increase be signalling the peak of world oil production? Is the chart showing an increasing shortfall between demand and production since 1980?

The net difference between annual world oil reserves additions and annual consumption (see link below) shows that since about 1981, new discoveries of oil reserves (oil available for extraction), have been falling increasingly short of annual consumption, and the decline trend has been under way since the mid-1960s.
Peaking Oil Production: Sooner Rather Than Later?

The International Energy Agency said in October 2005 that it expects global demand growth to recover in 2006 after Hurricanes Katrina and Rita and that demand would expand by 2.1% in 2006, rebounding from 1.5% in 2005.

The following chart shows the rate of increase in global oil production, averaged over a 10-year moving average period, in other words the figure for 2004 is the average of the production increases for 1995 to 2004. It is clear that, during the 1970s, the rate of increase of production plummeted, and never returned to pre-oil-shock levels. Since 2000 the average rate of increase in production has been 1.6%, the rate of increase in demand has been ahead of the rate of increase in production, and the expected rate of increase in demand is 1.74% per year in the first 25 years of the 21st century, so it would appear that production growth is struggling to catch up with demand growth.

About 40% of increased demand will come from Asia. China's oil imports doubled between 1999 and 2004, and their demand is expected to continue to increase by 5 to 7% a year. India is also developing strongly, with oil consumption expected to increase by 4-7% a year.

The peak year for discoveries of significantly large oil fields globally was 1962 (1930 in the US and the mid-70s in the UK). The US Geological Survey has stated that "global discoveries of new oil peaked in 1962." According to the World Research Institute, "the amount found in new fields per year is less than 10 billion barrels and falling."

The Wall Street Journal reported in May 2004 that worldwide demand is forecast to rise by more than 50 percent in just 20 years to 121 million barrels a day. How will this demand be serviced if we have reached peak oil production? Under such circumstances, the demand will have to be curtailed by rising prices (which will go to support the extraction of remaining reserves that are uneconomic to extract at lower prices) and actual shortages.

In June 2004, when oil was $40 a barrel, Matthew Simmons of the Association for the Study of Peak Oil (ASPO) said "Oil is far too cheap at the moment... The figure I'd use is around $182 a barrel. We need to price oil realistically to control its demand. That is because global production is peaking." and Ali Bakhtiari, head of strategic planning at Iran's National Oil Company (NOIC) said "The people who will be least affected will be the super poor, who already have no access to energy, and the super rich who do not care if oil is $100 a barrel."

Dr Colin Campbell, a former executive vice president of Total-Fina, has said that "many reserve figures are highly questionable", a comment that is supported by the disappearance of reserves after Royal Dutch Shell restated its proven reserves figures five times.

On January 9, 2004, Royal Dutch/Shell announced that it was writing down its proven oil and gas reserves by 20% (3.9 billion barrels), from 19.5 billion barrels to 15.6 billion barrels. and in February 2005, Royal Dutch/Shell announced that its completed reserves reviews and internal audits led it to restate approximately 1.4 billion barrels from 14.35 billion barrels at 31 December 2003 down to 12.95 billion.

The U.S. Securities and Exchange Commission found that Shell had materially misstated its reserves replacement ratio (RRR), which is a key performance indicator in the oil and gas industry, because of "its desire to create and maintain the appearance of a strong RRR". Royal Dutch/Shell have been fined $150 million by U.S. and British regulators and have dismissed three senior executives.

Is it likely that the desire to embellish the figures is confined to a single company? Energy consultant Matthew Simmons has claimed that except for Libya, Algeria and Nigeria, the OPEC countries had tripled their reserves without providing supporting data in the 1980s. For example, after OPEC decided to allocate production quotas to its members based on the size of their reserves in 1985, Kuwait announced that it possessed 50% more oil than it had previously declared. Throughout OPEC, enough reserves suddenly appeared with the capacity to supply the world for 10 years.

When at an ASPO conference in Berlin in May 2004, Fatih Birol, chief economist of the International Energy Agency, stated that:

"If Saudi does not increase supply by 3 million barrels a day by the end of the year we will face, how can I say this, it will be very difficult. We will have difficult times. They must invest."

- one delegate laughed so hard he had to support himself on a table [Source: BBC].

In mid-2004, BP estimated that the amount of proved oil left in the world was 1.15 trillion barrels (other sources that are likely to be less energy efficient and more expensive than conventional oil, such as tar sands, are unlikely to be included in this figure).

M. King Hubbert's curve for estimating oil extraction, which he devised in 1956, has an idealised shape similar to that of a bell, or normal distribution curve, and at its peak we find the point at which 50% of the total has been extracted.

M. King Hubbert presented a paper to a 1956 meeting of the American Petroleum Institute that predicted US oil production peaking between 1965 and 1970 (US output of crude oil and natural gas reached a peak of 11.3 million barrels per day in 1970) and world production peaking in the year 1996.

The geologist Colin Campbell has estimated that about 2 to 2.2 trillion barrels of oil, including crude oil, natural gas liquids and heavy oil can ultimately be extracted, and calculated using a Hubbert model that world production will peak around 2005.

The 1980 report "Global 2000" to the President of the USA, estimated that for annual growth rates of 2 to 5%, a peak of production would have occurred between 1985 and 1995. The 2002 report "Future world oil supply", by Werner Zittel & Jörg Schindler of L-B-Systemtechnik GmbH, showed that updating the prediction using actual average growth rates gave a production peak around 2002 or 2003, and they gave their own estimate of peak production as being between 2000 and 2010.

After hurricane Katrina of 2005, Saudi Arabia (the world "swing producer" of oil) has admitted that it could not increase production to make up for the loss of oil production in the Gulf of Mexico.

"Saudi Oil Minister Ali al-Naimi said OPEC had done its utmost to satisfy the world's oil users. "I believe a reasonable consumer will appreciate very much what OPEC has done to go out of its way and to offer all the spare capacity it has, recognizing that maybe there is no demand but offering it so the consumer can feel comfortable that the supply is there."

Tuesday's OPEC deal effectively suspends quotas until the end of the year although official quota limits stay unchanged at 28 million bpd. The deal applies from October 1 for 3 months."

OPEC powerless as oil keeps climbing [Wednesday September 21, 2005]
OPEC agrees to remove all its limits on oil sales

The removal of OPEC quotas, albeit temporary, should be considered in the context of what happened previously in US oil production:

"Up until 1974, the US was the world's largest oil producer and the Texas Railroad Commission (TRC) was its OPEC. The Texas Railroad Commission had a mandate from the government to match oil supply to demand (while maintaining a security reserve for times of crisis) by regulating Texas oil wells to a percentage of their capacity. Texas oil production so dominated the industry that this worked to manage oil prices- TRC was the predecessor of OPEC, in other words. As Ken Deffeyes (Princeton geology professor and formerly a geologist with Shell who had worked with Hubbert) writes in his book, Hubbert's Peak: Hubbert's prediction was fully confirmed in the spring of 1971. The announcement was made publicly, but it was almost an encoded message. The San Francisco Chronicle contained this one-sentence item: "The Texas Railroad Commission announced a 100 percent allowable [i.e., produce full out] for next month." I went home and said, "Old Hubbert was right." "
An Echo from a Prior Peak

If Saudi Arabia, as "swing producer", is no longer able to supply unlimited increases in production to fill the gap between demand and production, then the function of price as a limiter of demand will come into full force. How long will it be before the temporary effect of loss of production in the Gulf of Mexico turns into a sustained global shortfall between production and demand, and accompanying sustained oil price increases?

Recent discoveries of oil (which usually arrive with a great deal of fanfare and expectations for the price of oil to drop), such as one in Kazakhstan with an estimated 10 billion barrels, tend to be relatively small- this amount will supply world oil consumption for only four months.

Future production rates are more likely to decrease than increase as we move into the right-hand side of the global Hubbert curve. Furthermore, the early extraction on the left of the curve was able to make use of easily-reached deposits, but as those have gone, what remains must be extracted from the remaining deposits, which are more expensive to reach.

A critical factor is that worldwide demand is rising, particularly in countries such as China and India, yet the right-hand side of the global Hubbert curve will have production declining. When consumption exceeds production, the inevitable result is that prices rise, unless the free market is done away with and subsidies and rationing are introduced.

Chris Vernon of PowerSwitch has published figures that show the production of light sweet crude has fallen by two million barrels a day since 2000, and Colin Campbell considers that it peaked in early 2004. This is the most desirable grade, as it is easiest to refine into fuel products. Only by taking into account high-sulphur oils has oil production achieved an increase since 2000, but these grades invoke higher refining costs and there are limited numbers of refineries capable of handling them.

The US has about 2 percent of the world's proven oil reserves, but consumes 25 percent of world fuel supplies. The price of oil impacts directly on the trade balance and debt burden of the country. Britain is not much better off, despite having North Sea Oil, because production levels there have been in decline since peaking in 1999. Oil production from the British sector of the North Sea fell by 13 per cent in February 2005 compared with the same month in 2004.

Princeton geologist Kenneth Deffeyes (retired) has predicted that peak oil will occur on November 24th, 2005, a date of no particular significance in the UK. However, it may be the last Thanksgiving Day for many Americans before the beginning of an economic crisis in part driven by high energy prices.

The world today has been built up on a base of nearly 100 years of cheap oil. Low interest rates have allowed people and businesses to accumulate a large debt burden, while the inflationary pressures of high and sustained energy costs and accompanying central bank interest rate rises will conspire to shut down consumer spending, destroy lenders' profits, and lead to recession. The resulting vicious spiral may well plunge the world into the second great depression.

 Recap 

 

The first sign of a sustained rise in the price of oil started when Dubai oil broke out from around the $10-$14 range around April 1999. I considered that, adding the $25 base of the triangle to the breakout level $14, this would lead to $39 oil.

I posted the following on 11 Mar 2000:

 

 

Back in 1998, the CEO of Italian oil company ENISpA was also making bold predictions of an oil price rise, as featured in a Forbes Magazine article dated 15th June 1998:

"NOT THIS YEAR, nor the next, but maybe as soon as five years hence, oil prices will start to rise, says Franco Bernab, chief executive of the Italian oil company ENISpA. Well before 2010, he believes, the world will be vulnerable to 1970s-style oil shocks. Speaking to FORBES in London in early May, he says, "There is a great deal of complacency among politicians and economists that the oil problem is over. But despite today's low prices, in the long term we will be back to a high-price scenario in the oil sector." "

Cheap oil: enjoy it while it lasts [Forbes, June 15, 1998]

References

Chart Patterns
Is the world's oil running out fast? - BBC, Monday, 7 June, 2004
Association for the Study of Peak Oil & Gas
The end of Cheap Oil - National Geographic
Future world oil supply [PDF file]
International Petroleum Information (EIA)
World Oil Market and Oil Price Chronologies (EIA)

  Oct 9th, 2005   Updated Oct 30th, 2005