Peakonomics: why the oil price slide is temporary

First published in Petroleum Review, July 2012.

Time was when the oil price slide of recent months would have been greeted with jubilation by everyone bar the oil companies and exporting countries. No longer. These days both consumers and producers have been praying for lower prices to keep the wheels from falling off the global economy. But when it came, the decline served only to highlight how much of the world was already on its rims, and the grimness of the outlook.

Saudi oil minister Ali al-Naimi may congratulate himself on good timing, having written a sharply worded article calling for lower prices just before they started to fall. But the slide – from $125 per barrel at the end of March to just under $100 in early June – had rather more to do with fears of a Chinese hard-landing and the disintegration of the eurozone. However, while the economic prospects suggest oil prices should continue to languish, upward pressures will soon reassert themselves.

Anyone who still doubts the centrality of oil depletion in driving the crude price should read a recent working paper from economists at the International Monetary Fund. Entitled The Future of Oil: Geology versus Technology, it sets out to test the idea that the ten-year rise in the oil price can be explained by geological constraints. The group found that incorporating Hubbert-style depletion analysis into their model led to “dramatically improved” forecasts of both production and price. “By far the most important reason is that geology doesn’t want to release that much more oil unless you really press the price button”, said Michael Kumhof, one of the authors. As a consequence, the paper forecasts real oil prices will soar to $180 by 2020.

There’s not much to surprise a peak oiler here perhaps, nor many in the City; Barclays Capital has forecast $185 per barrel in 2020 for some time. But the paper is significant, being the first mainstream economics model to demonstrate the overwhelming influence of oil depletion over oil prices, and effectively debunk the shibboleth that rising prices will solve peak oil as many economists have long insisted.

It also suggests the so-called shale oil revolution is unlikely to be the ‘game-changer’ its supporters claim. While the paper makes no mention of specific technologies, the model does capture the impact of shale oil, says Kumhof, and the message is far from bullish. Resorting to shale – and other non-conventionals such as the tarsands – simply demonstrates the desperate measures required to maintain any kind of supply growth, because conventional oil is declining so fast. “We have to do these really expensive and environmentally messy things just in order to stand still or grow a little bit”, he says, “it doesn’t mean the picture is all rosy”. The IMF team expects oil production to grow at no more than 0.9% per year for the next decade, way below the historical average of 1.5%-2%.

While producing oil gets harder, there is also increasing competition over who gets to consume it. It is well known that oil demand growth is strongest among the developing economies such as China and India; less widely recognized is that the oil supply is fast approaching a zero sum game. Analysis by Steven Kopits of the energy consultancy Douglas Westwood shows that non-OECD oil consumption has risen around 4.8 million barrels per day since 2008, while OECD consumption has fallen by almost exactly the same amount. “China is bidding away the OECD oil supply” says Mr Kopits, “and recessions are the mechanism by which that oil is being transferred from weaker economies to faster growing economies”.

Not only are developing countries consuming more, so are the producers themselves. A recent report from Chatham House has analysed the impact of soaring oil demand in Saudi Arabia – where petrol costs just $0.16 per litre – on its ability to export. On current trends, says the report, Saudi will be a net importer of oil by 2038 – although in practice its economy would collapse long before.

The problem is not restricted to Saudi Arabia. US geologist Jeffrey Brown has developed a model called Export Land, to illustrate how quickly exports can disappear if squeezed between rising domestic demand and falling production. Brown applied the technique to 33 oil exporting countries accounting for 99% of global net exports, and found their net exports fell from 46 mb/d in 2005 to 43 mb/d in 2010. At the same time, China and India increased their net imports from 5 mb/d to 7.5 mb/d. If both trends continue at their current rate, concludes Brown, ‘Chindia’ will consume 100% of global net exports by 2030 – just 18 years from now.

Slower oil production combined with intensifying competition among consumers may soon produce oil prices so high they kill all prospect of sustained economic growth. The outlook is for repeated oil price spikes alternating with deep recessions, regardless of when global output actually peaks. Welcome to the last oil shock.