Oil price set to double if production is cut off

First published in the The Independent on Sunday, 27 February 2011.

Oil prices surged to a thirty-month high this week as the turmoil in Libya cut supplies by over 1 million barrels per day, raising the chances of a global supply shock that could push the economy back into recession. Brent crude reached almost $120 per barrel, its highest level since August 2008, as international oil companies pulled out and foreign workers fled the country.

Crude prices eased, closing at $111.36 per barrel on Friday, after OPEC promised to make good any lost production. But some experts fear the cartel will struggle to mobilize extra supplies quickly enough, or that vital producers such as Saudi Arabia may themselves be engulfed by revolution. Analysts Nomura warned the oil price could double if production were cut off in Algeria as well as Libya. In Britain, retailers forecast the recent rise in crude would push fuel prices up by another 5p per litre.

The oil price has been climbing since the regional upheaval started last December, but jumped over 10% this week as production was affected for the first time. Libyan output slumped as companies including Total, Eni, Repsol, and BP withdrew, rebels seized some fields, and a Chinese installation was attacked. Analysts Barclays Capital estimate two thirds of the country’s usual 1.6 million barrels per day is now shut down, while the Italian oil company Eni estimates three quarters has been lost.

Italy is the country most exposed to the shortfall, buying almost a quarter of its oil imports from Libya, followed by France and Spain. Britain relies on Libya for less than 10% of its oil imports, and produces around 1.4 million barrels per day from the North Sea, while consuming 1.6 mb/d.

For all the alarm, Libyan production represents less than 2% of global consumption of 88.5 mb/d, and officials stressed there should be no immediate shortage of oil because of high levels of oil stocks and spare capacity.

In the OECD, the oil industry holds working stocks of about 2.7 billion barrels, and governments hold another 1.6 billion barrels of emergency supplies coordinated by the International Energy Agency, equivalent to 145 days’ imports. The IEA last released emergency stocks in 2005 after hurricane Katrina knocked out almost all US oil production in the Gulf of Mexico. Britain holds about 95 million barrels which the government says amounts to around 80 days’ final consumption. A spokeswoman for the Department of Energy and Climate Change said the government was monitoring the situation but there were no plans to release stocks.

But none of this has calmed the market, which is much more sensitive to the level of spare capacity – wells and pipelines that have already been built and can be brought on stream relatively quickly. All of the world’s 5 mb/d spare capacity is held by OPEC countries, and most of that – 3.5 mb/d – by Saudi Arabia. The world’s biggest exporter is currently producing 8.6 mb/d but is thought capable of raising that to around 12 mb/d.

The trouble is, it’s the wrong kind of oil. Libya’s crude is light and ‘sweet’ – meaning it contains little damaging sulphur – whereas Saudi’s is heavier and ‘sour’, which European refineries are not designed to process. Saudi cannot replace lost Libyan production directly, so officials are discussing a complicated swap arrangement, in which West African oil bound for Asia could be diverted to Europe and Saudi oil would take its place.

While few doubt Saudi can raise output in the short term, there are widespread concerns about its ability to continue fill the gap, particularly if the crisis spreads further. Analysts Nomura point out that if the production of a small producer such as Algeria were also shut down, OPEC’s spare capacity would be reduced to levels not seen since the first Gulf War, when the oil price soared. The analysts say their stratospheric forecast of $220 per barrel could be an underestimate because speculators are now more influential.

The world’s spare capacity could also evaporate, and worse, if Saudi Arabia itself succumbed to a popular revolt. Experts say conditions in the kingdom are ripe, with its young population, high unemployment and sizeable Shia minority in the eastern province where most of the oil is produced. The spark could be a ‘day of rage’ planned for 13 March, or a flare-up of the conflict in its tiny neighbour Bahrain. King Abdullah is evidently alive to the risk; this week he dispensed $36 billion of largesse in higher wages, unemployment and other benefits, and promised to spend $400 billion by 2014.

Analysts say a Saudi collapse is unlikely, but if it happened the impact would be dire. “If Libya was Saudi, there would be no producer of last resort”, says Chris Skrebowski of Peak Oil Consulting. “It would be like 1974 all over again and the price would go off the charts”.

Even if Saudi Arabia escapes the turmoil and the crisis is shortlived, high oil prices could further stoke inflation and extinguish the recovery. Spikes in the oil price have precipitated most recessions since WWII, and the IEA recently warned of the increasing ‘oil burden’. Steven Kopits of energy consultants Douglas Westwood calculates the US usually goes into recession when it spends more than 4% of GDP on oil, which currently equates to $86 per barrel. For the OECD as a whole the recession threshold is $130 per barrel.

But even if western economies manage to avoid a double-dip, the relief may be short-lived. According to a US diplomatic cable written in 2007 recently released by Wikileaks, Saudi’s claimed reserves may have been hugely inflated by ‘speculative resources’, and its production may struggle to exceed 12 mb/d. If so, global oil production could peak and start to fall much sooner than most governments expect.