Peak Watch

Deflation, Reflation and Our Oil Future

The only function of economic forecasting is to make astrology look respectable.
    — John Kenneth Galbraith

I suspect that most of those concerned about a peak, plateau and decline in the global oil supply assumed that such events would eventually cause a reeling economy like the one we have now. But something else happened instead—the depression came first.

When will a faltering oil supply and high energy prices next have an impact on global economies as they did in 2007 and the first half of 2008? The answer depends entirely on whether the severe global recession lingers—Nouriel Roubini calls it stag-deflation—for some years or starts to ease as early as 2010. 

How do these poor economic conditions bear on the oil question? The easy rule-of-thumb goes like this:

When there is positive inflation and the global economy (aggregate demand & output) grows, so does oil consumption. When deflation rules and the global economy shrinks, so does oil consumption.

Figure 1 — Relationship between real GDP and oil demand growth. From my Trouble With Oil Down The Road (taken from the IEA)

I have written a long essay Depression or Recovery—What's In the Cards? to examine the past, present and possible future state of the economy. That article serves as an essential companion piece to this column. I examine long-term indebtedness in the United States, deflation versus (positive) inflation, where things stand now, and the past, present and future measures being taken by the Federal Government and Federal Reserve to extricate us from the mess.

My analysis attempts to show that the deep roots of the economic crisis result from a 30-year private credit bubble. This situation will not be undone in a few months, a few quarters or even a few years. If you do not agree that our economy is structurally unsound, and that repairing it will take some time, you will probably not accept my view of the timing of renewed problems with the global oil supply.

My basic thesis runs as follows: if the United States and the other OECD countries experience a long (2-3 years) period of deflation, global oil demand will plummet and prices will remain low throughout the downturn. Afterwords, inflation will drive borrowing and spending, so aggregate demand and output will increase during the bounce. Renewed GDP growth will drive up oil demand. Some years into the recovery, and depending on its strength, oil prices will spike as geological and geopolitical constraints on supply once again come to the fore.

The sooner a recovery begins, the lower demand destruction during the recession will be. Oil prices will thus spike sooner as demand once again bumps against the ceiling on supply, a limit that remains invisible until demand bounces back. It's all a matter of timing. It's easy to see that in the more dire economic scenarios, it could be many years before global oil supply problems resurface.

This view acknowledges that  "decoupling" theory is all but dead. The story was that the BRIC countries (Brazil, Russia, India, China) could continue their economic growth even if the United States went into recession. The situation is more complicated than this simple theory suggested. The Eurozone, China's largest export customer, is also in recession as are Japan and Korea. The recession is truly global in scope. As a result, growth in China and India is slowing down. Russia's economy, which depended heavily on oil export revenues, is almost dead in the water. Brazil is trying to avoid a recession. Thus rapid economic growth in the BRIC economies will not support oil demand as it did in past years. Domestic oil demand growth will likely decrease in Saudi Arabia too.

This line of reasoning also suggests that mitigation of the world's oil dependency from efficiency measures or substitutes (e.g. plug-in hybrids or biofuels in transportation) will be virtually nil during the downturn and the early years of the recovery. A combination of low oil prices that discourage implementation of substitutes along with insufficient time for research, commercial development and significant market penetration of new technologies supports this assumption.

Ka-Poom Theory — An Example

itulip's Eric Janszen provides a road map called Ka-Poom theory to guide us as we consider our muddled economic future (Figure 2). I am citing it for illustrative purposes only. Although the theory may not be correct in all its details, especially as concerns the duration and severity of the current downturn, it likely broadly reflects what the next decade will look like. There is a period of deflation (or disinflation) like we are in now followed by inflation when the Federal government and the central bank successfully reflate the economy. These issues are discussed at length in my Depression or Recovery essay.

Figure 2 — Ka-Poom Theory from Eric Janszen (itulip.com@2006). Annotated to reflect the current recession (in gray). Note that the start of the current downturn (December, 2007) was predicted in 2006 following the reflation that began in 2003 after the collapse of the stock market (Tech) bubble

Ka-Poom theory is explained in a more recent article—

...the Ka-Poom model explains how, following the collapse of the credit bubble, the US economy will experience a short (six month to one year) period of deflation that we call disinflation, such as we are experiencing today, followed by a major inflation induced by monetary [via the Federal Reserve] and fiscal [via the Federal Government] policy and the actions of US trade partners in response to that inflation.

...The difficult part is forecasting what comes after the disinflation phase. Does the Fed sit back and do nothing while the debt deflation runs out of control? Does the Fed have a choice, or does it become impotent, overwhelmed by the rate of debt defaults and money destruction?

The correct answer to these crucial questions is that the Federal Reserve and the U.S. government will actively try to reflate the economy and positively have the ability to do so—on this point, Janszen and I, not to mention Ben Bernanke, Barack Obama, Larry Summers, Paul Krugman and a host of others, are in complete agreement.

Efforts to reflate the economy began when the Fed started cutting the Fed Funds target interest rate early in 2008 and continue in various ways today (e.g. the TARP, the proposed Obama stimulus plan, the expanded Fed balance sheet) as discussed in my Depression or Recovery article. All these measures have failed up to now, but if at first you don't succeed, try, try again.

You can see that something very similar to the "Ka-Poom" scenario happened in the 1930s (the green circle in Figure 3).

Figure 3 — A "Ka-Poom" event in the 1930s. Taken from Monetary Policy in a Zero-Interest-Rate Economy (Federal Reserve Bank of Dallas, May, 2003) Annotated (green circle) at itulip.com

A 2nd Great Depression is certainly the worst case scenario, but a repeat of the cascading bank failures that took place in the early 1930s has probably been averted by Fed and government intervention. Still, we need to be careful here. Nouriel Roubini's analysis indicates that the banking system is effectively insolvent and will likely not survive in anything like its present form without additional rescue packages and guarantees like those given recently to Citigroup ($300 billion) and Bank of America ($118 billion). The situation is unstable, but the caretakers are bound and determined to bail-out the banks and reflate the economy.

The Oil Supply Problem Did Not Just Disappear

This all-too-brief overview of our economic future relates to the "peak oil" issue in a very straightforward way. Oil demand and prices will remain depressed during the deflationary period (2008 Quarter III–?, the "Ka" part of the model) and then rebound as they did in recent years when inflation takes hold again (the "Poom"). In the inflationary period that preceded the current downturn from 2003–2008 Quarter II, oil demand and prices rose steadily against a backdrop of faltering supply after 2005.

The next inflationary period shown in Figure 2, when it finally kicks in, may have very similar effects to the previous one, but this is not guaranteed because we're in dire straits now. If aggregate demand and output growth in the next period turns out to be robust, which I consider unlikely, the end game may play out very differently this time around, with oil scarcity taking on a much larger role in determining our economic health than it did these last few years after the collapse of the Housing Bubble.

If all of the OECD economies stagnate for a long time, like Japan did in the 1990's and thereafter, the oil supply problem may be postponed that much longer. Oil production capacity would eventually fall to the level of demand, but who knows how long that might take? There are just too many variables to consider here—future demand levels, future production decline rates, future investment levels and oil prices, OPEC policies going forward, longer term economic growth rates in the BRIC economies, etc. Yogi Berra said it best: "It's tough to make predictions, especially about the future."

When the global economy was booming and oil demand was strong, I thought the "peak oil" situation was pretty much cut and dried. Now the waters are muddied. I am reminded of a scene in the great 1970s movie Three Days of the Condor.

In a memorable scene in one of my favorite movies, Three Days of the Condor, the spy thriller in which a low-level CIA researcher (Robert Redford) uncovers a rogue conspiracy inside the CIA, the researcher's handler (Cliff Robertson) and one of the agency's deputy directors (John Houseman) share a moment of reminiscing about the history of the intelligence business. Houseman recalls his early experience: "I go back even further than that. Ten years after The Great War, as we used to call it. Before we knew enough to number them." And Robertson asks: "You miss that kind of action, sir?" To which Houseman replies ... "No, I miss that kind of clarity."

I miss that kind of clarity and I'll bet Saudi Aramco, Lukoil, Rosneft, PDVSA, Petrobras, the NPD, Shell, BP, the NIOC and Suncor (to name a few) do too.

Recently revised EIA data show that the world crude oil supply fell year-over-year in 2006 and 2007, but started to rise over the average 2005 level in the first half of 2008, peaking in July at 74.885 million barrels per day (b/d). The latest data for September, 2008 is nearly 2 million barrels below the July level and subsequent months will likely shave more barrels off that number. World demand appears to be crashing faster than supply is falling, a deteriorating situation OPEC is trying to reverse. This imbalance has pushed the oil price off a cliff, but can not account for all of that price decrease.

I have argued that it is impossible to separate oil supply issues in the medium-term from the demand destruction caused by a contracting global economy. This view must be weighed against the strong likelihood that the crude oil supply will never again exceed its July, 2008 level. Aggregate demand and output rises & falls, but depletion never sleeps. Even in a depression, oil will still be produced at prodigious rates in struggling countries (e.g. Russia, Venezuela) and in declining countries (e.g. Mexico, Norway, the UK, and the United States). Tar sands oil from Canada will see a dramatic slowdown in the rate of production growth. All the while, cost factors will make it harder and harder to put new oil on-stream.

It is not inconceivable that lack of investment and low oil prices during a prolonged depression will do irreparable harm to the oil & gas industry outside of the Persian Gulf in a world where marginal production costs for new oil (e.g. in the Brazilian ultra-deepwater) are very high indeed. A distressed oil industry will have even more difficulty raising production to meet renewed demand than it would have under normal economic circumstances.

I will defend my view that world oil production peaked in July, 2008 in next week's column. For now, our desperate economic situation probably entails that no one will notice that we're past peak for many years to come. It is an absurd but dangerous situation which lies down the road. Just when you've solved one disaster, you've got another one. Welcome to the 21st century.

Contact the author at [email protected]

What About the Poor?

It would be nice if the poor were to get even half of the money that is spent in studying them.
    — Bill Vaughan, American journalist and author

Today's front month oil contract stands at about $77/barrel. Such prices have not dampened demand in China, where demand growth is running at 11%, or in the United States, where finished motor gasoline consumption reached 9.71 million barrels per day in the week ending July 13, 2007. The volatile but rising oil price since 1999 is the primary signal of a growing supply and demand imbalance in a market with little spare capacity. This indication of scarcity now only inconveniences the wealthy, whose past income growth still allows mostly pain-free purchases. But what about the poor?

A note on a forthcoming ESMAP study, How are Developing Countries Coping with Higher Oil Prices?, describes "policy alternatives adopted by developing countries in response to the increases in world oil prices since the end of 2003." Before looking at the results, let's look at some emerging stories in the developing world to get a feel for what's going on.

• Liquid Fuel Shortages — Nepal hit by deadliest fuel crisis:

  After days of acute fuel shortage, the Kathmandu valley was Tuesday hit with its worst crisis in history as the state-owned petroleum importer and distributor reached the lowest level of fuel stocks and stopped supplies to gas stations.

  "Kathmandu valley now has just 300 kilolitres of petroleum," said Bishwanath Goyal, managing director of Nepal Oil Corporation (NOC). "This is the minimum mandatory stock we have to keep. We can't sell any of it" ...

  Signs saying "No diesel", "No petrol" hung at the entrances of petrol pumps.

  Also see Kenya: Acute Gas Crisis Hits Towns, where "an acute shortage of liquefied petroleum (cooking) gas (LPG) has hit major towns countrywide" and a "survey yesterday showed that some dealers had not received fresh supplies for the past three months."

• Fuel Switching and Efficiency — Thailand boosting palm oil production for alternative fuel:
  

  In a bid to boost consumption of alternative fuel by motorists in Thailand, the Ministry of Agriculture and Cooperatives has drawn up a plan to develop and enlarge the palm oil growing area between 2008 and 2012, a senior ministry official said Sunday...

  The decision to grow more palm oil is aimed at catering to the rising demand for fuel in the future as well as to increase the potential of the industry, said Theera Wongsamut, deputy permanent secretary for Agriculture and Cooperatives.

  The Thai government is encouraging motorists to switch to using alternative energy as local oil prices have jumped sharply, causing the country to apply significant amounts of foreign currency for imported oil.

  Also see Namibia: Free Lights to Counter Power Shortages, where the "national power utility ... NamPower announced that it had budgeted N$14 million for the purchase of compact fluorescent lights (CFLs) to be distributed for free to Namibians in a move intended to counter power shortages widely expected in the southern African region."

• Passing Costs Through — Malaysia has no plans to cut fuel prices:

  Malaysia, which heavily subsidizes fuel prices, sharply raised prices of gasoline, diesel and liquefied petroleum gas in February last year by as much as 23 percent after global crude oil prices shot up to US$70 a barrel.

  Despite the subsidy slash, Malaysia's fuel prices remain among the lowest in Southeast Asia. But the price hike prompted a series of public protests, with demonstrators saying it was unnecessary as Malaysia is a net oil exporter.

  Also see the Philippines, where P0.50 per liter fuel hike surprises motorists. "As if the threat of power and water shortages were not enough, motorists got another whammy Saturday as three major fuel firms raised prices of their fuel products by 50 centavos per liter. QTV-11 television reported Saturday that the 50-centavo hike covered gasoline, diesel and kerosene... It said the oil firms justified the price hike, saying world prices of crude oil had gone up from $65.80 per barrel to $71 per barrel."

The sporadic, almost anecdotal, nature of such stories in the press hides the systematic reduction of oil consumption in the developing world. The poorer countries get priced out of the market, or can not obtain the fuels they require when supplies are tight. The western press rarely covers the issue. Stories that touch on the problem, such as Toiling in the Dark: Africa's Power Crisis (New York Times,  July 29, 2007), surface and are then forgotten. Web searches often turn up reports from 2005, when oil prices first hit $70/barrel. Press accounts from the developing world are hard to find. These stories tend to report on local events, and assume some knowledge of local conditions. Some commentators in peak oil circles have labeled these events with the unorthodox (for economists) term "demand destruction", but the phenomena is poorly documented..

The problem created by high oil prices is widespread, as Africa's Energy Crisis Worsens: Viable Clean Energy Alternatives Are Imperative (Center for American Progress, July 17, 2007) makes clear.

With world crude oil prices nearing $75 a barrel, economies across Africa are grinding to a halt under the burden of soaring energy costs. The spike in world oil prices this summer will exacerbate economic problems, pounding already fragile national budgets and offsetting hard-fought gains from poverty reduction programs, international development aid, and debt relief efforts.

In Senegal’s capital city of Dakar, the cost of taxis has almost doubled since 2005 and blackouts occurred every day last summer because the state-owned utilities couldn’t afford to pay for fuel. The country relies on oil imports to power its diesel-fired generators, and while conditions relaxed somewhat over the winter, power cuts are on the rise again. As of May, the capital was facing 10-hour power cuts several times a week and the government was warning of impending, unprecedented shortages. 

Senegal is paying nearly twice what it was a few years ago to import the same amount of oil. The increased cost alone is more than seven times as much as the country is gaining through multilateral debt relief programs. The government has responded to the energy crisis by providing direct subsidies to consumers. Since the rise in world oil prices began in 2002, these subsidies have increased five-fold, creating yet another incredible burden on the national budget.

The ESMAP survey carried out by former World Bank officials polled 38 developing countries to find out what measures they were taking to cope with high oil prices (graph left, click to enlarge). Countries are divided up into (i) 16 non-oil producers (e.g. Cambodia, Senegal, Nicaragua); (ii) 13 producers who are net oil importers (e.g. Pakistan, Ghana, Thailand); and (iii) 9 net oil exporters (e.g. Argentina, Mexico, Vietnam). China and India fall into the second category, along with Brazil, who proclaimed their oil independence last year.

Of the 38 countries surveyed, 26 have suffered shortages or have resorted to rationing oil products or electricity. Developing countries are very reluctant to pass higher fuel costs on to consumers. This is a very unpopular thing to do in fragile economies where many people are just scrapping by and government budgets are tight. Net oil exporters usually try to absorb most of the price increases, but sometimes can not—see Gasoline Subsidies and Iran. (Iran is not part of ESMAP study.) Countries without oil or net importers pass some of the increased costs on, but, like Senegal, provide a cushion for consumers through subsidies. Price hikes often result in civil unrest, which happened in Indonesia in 2005. Examples abound—protests also followed a price hike in India in 2006.

To protect their citizens from higher prices, 23 developing nations have reduced fuel taxes and 20 have financed fuel subsidies from government budgets. ESMAP notes that tax breaks are especially common among the oil exporters, whose citizens can not understand why they sell oil to others but must also pay higher prices at the pump. More than half of the countries that had market pricing have now suspended it—12 nations never did have it. Various kinds of subsidies may temporarily shield consumers from real fuel costs, and leaders from being deposed, but they also take away from fiscal programs meant to provide essential social services and aid the poor. (See the Center For American Progress article on Africa, link above.)

It is sad to say, but in a world that is likely to see ever-rising oil prices, a government-funded respite from high domestic liquid fuel costs does not come with a longer term exit strategy. Such price-based policies merely postpone an inevitable crisis in which oil may eventually become altogether unaffordable in much of the developing world. The lasting effects for governments and civil societies of continued subsidies will likely be worse than the oil price shocks they are meant to remedy.

It thus makes sense that the prevailing strategy to cope with high oil prices is fuel switching. Only 12 of the countries surveyed by ESMAP have mandated or announced conservation measures or incentives to encourage efficiency, but 28 countries have "implemented or actively promoted switching to alternative sources of energy to reduce dependence on oil." Biofuels from high-yield tropical plants appear to be a perfect fit for net oil importers or non-producers. But appearances can be deceiving.

The Center for American Progress believes that the future for alternative energy is bright in tropical Africa. There is a great potential for generating electricity from wind and solar. It is hard to argue the point. The future of hydroelectric is more uncertain. In Uganda, regional droughts have cut power generation sharply. With aid from the ever-helpful World Bank, the East African country filled the breach with two diesel-fired generators!  In the long run, there is no excuse for importing oil or diesel to generate electricity where renewable alternatives might be available. If peak demands can't always be met, it's still certainly better than the alternative—permanent shortages.

The Center's optimism extends to biofuels. Author Rebecca Schultz tells us:

Biofuel is another sector where the continent could rival major global producers and play a central role in meeting the soaring demand for ethanol in Europe, United States, and China. Africa’s arable lands are well-suited to a range of energy crops, especially in the tropical climate zones around the equator that enjoy optimal rains and a long growing season. Conventional feedstock crops like sugarcane, maize, and soy, as well as new oilseed crops, are already being grown and converted into biofuels.

Democratically-elected Senegalese president Abdoulaye Wade (pictured left) has announced the formation of a Green OPEC "aimed at making African countries less dependent on oil by replacing it with biofuels. This organization, dubbed 'PANPP' ('Pays Africans Non-Producteurs de Pétrole'), unites 15 non-oil producing countries on the continent ... to stimulate the exchange of knowledge, skills and technologies for the development of a biofuels industry."

The problem with large-scale biofuels production is the food versus fuel issue. Higher demand for agricultural commodities creates spiraling food costs. Consider palm oil, a biodiesel fuel crop grown primarily in Malaysia and Indonesia. More palm oil is consumed world-wide than any other vegetable oil used in cooking. This is only one of its many uses (e.g. soap, make-up).

At the end of January, 2007, the crude palm oil (CPO) price on the Malaysian Derivatives Exchange (MDEX) stood at 1899 MYR/ton, where MRY abbreviates Malaysian Ringgit. This was ≅ $543/ton. On July 25th, the price was 2521 ringgit ($736 at today's conversion rate) a ton (Bloomberg, July, 25). The graph (below, left, from LONSUM ) shows the two year price trend. Soybean oil, also used for biodiesel, has shown a similar price rise.

The reasons for higher prices are not hard to find: "Rising demand from China and India, coupled with the government's move to mandate a five percent palm-oil based biofuel blend for all diesel have sent Malaysia's crude palm oil prices soaring over the past year" (Forbes, July 30).

In the May/June 2007 issue of Foreign Affairs, C. Ford Runge and Benjamin Senauer argue that a large-scale biofuels industry will harm developing nations, not help them (How Biofuels Could Starve the Poor). The authors flatly state that "if oil prices remain high -- which is likely -- the people most vulnerable to the price hikes brought on by the biofuel boom will be those in countries that both suffer food deficits and import petroleum." Just as with palm oil, the article argues that the sky's the limit for biofuel crops that compete with food. One of their examples is casava, which is an excellent ethanol source due to its high-starch content. If the developing world turns to biofuels to replace oil, it seems like a case of "damned if you do, damned if you don't."

In the poorest parts of sub-Saharan Africa, Asia, and Latin America, where cassava is a staple, its price is expected to increase by 33 percent by 2010 and 135 percent by 2020...

The production of cassava-based ethanol may pose an especially grave threat to the food security of the world's poor. Cassava, a tropical potato-like tuber also known as manioc, provides one-third of the caloric needs of the population in sub-Saharan Africa and is the primary staple for over 200 million of Africa's poorest people. In many tropical countries, it is the food people turn to when they cannot afford anything else. It also serves as an important reserve when other crops fail because it can grow in poor soils and dry conditions and can be left in the ground to be harvested as needed.

A large-scale "Green OPEC" biofuels industry may never work out for Africa's developing countries, but more power to him if Senegal's president Wade can make it work. Much smaller scale biofuel production that minimizes competition with food remains a hopeful possibility as a substitute for oil. There are also promising crops like jatropha, which "thrives in arid areas and can be grown on desert and marginal lands without taking land out of cultivation for food production and without requiring expensive inputs like fertilizers and water" (Center for American Progress).

A cynic might say that the poor have always suffered at the hands of the rich, and there's no reason to believe that will stop now. The predicament in the developing world brought about by the oil price shocks ultimately results from overwhelming, wasteful demand for oil in places like the United States, and increasingly, China. Peak oil is an issue for most developing countries only insofar as they are suffering even more now than they already were. This is one of the many reasons why there's no ASPO-Uganda. It's becoming long past peak for the poor, so let's hope they can reorganize their local economies to replace something most of them never had much of to begin with—oil & gas products.

Contact the author at [email protected]

A Paradigm Shift

by Dave Cohen

Mr. McGuire: I want to say one word to you [about your future]. Just one word.
Benjamin: Yes, sir.
Mr. McGuire: Are you listening?
Benjamin: Yes, I am.
Mr. McGuire: Plastics.
     — from the movie The Graduate

In a recent personal communication sent to ASPO-USA, former Saudi Arabian exploration and production head Sadad Al-Husseini made the following statement.

There has been a paradigm shift in the energy world whereby oil producers are no longer inclined to rapidly exhaust their resource for the sake of accelerating the misuse of a precious and finite commodity. This sentiment prevails inside and outside of OPEC countries but has yet to be appreciated among the major energy consuming countries of the world. 

Saudi Arabia's production declined 8% in 2006. This is a fact which requires interpretation, and there are two opposed views: they can't or they won't raise exports. Matt Simmons has doubts about current Saudi capacity, most prominently raised in his book Twilight in the Desert. At The Oil Drum, Stuart Staniford's analysis appears to buttress Simmons' position, but is hampered by a lack of current production data from Ghawar, which the Kingdom will not reveal. The "won't" position has gotten scant attention in the peak oil community. Al-Husseini's statement points to a fundamental reorganization of the world's future oil supply. Downstream investments in the Persian Gulf states lends support to his view that these producers will exert greater and greater control over their fossil fuel resources in the future.

The paradigm shift reflects the historical trend toward resource nationalism. IHS Energy's Pete Stark summarizes the change.

Considering that governments and NOCs control more than 80% of the world’s remaining oil reserves, are expanding and upgrading refineries and infrastructure, and are developing gas resources, the effect [of the shift] is considerable. But that has not always been the case. In the past, when oil prices were low, investments in exploration dropped, and governments were eager to create incentives to attract investments—including reducing tax rates and state participation, or providing royalty relief.

All that changed in 2003 when oil prices began to soar....

The core issue for the large consumer nations is how quickly¹ resource holders will produce oil & gas to meet their burgeoning demand. The IEA and other OEDC representatives constantly call on OPEC — with ever greater acrimony and desperation —  to increase production (graphic below, left). The key question, as energy economist Ferdinand Banks notes at EnergyPulse, is why should they?

On this topic I think it best to pay attention to something that Matthew Simmons of Simmons & Company – a Houston-based investment firm specializing in oil – once said: "Too many people are looking at OPEC through the rear-view mirror. There’s a resolve in their eyes never to go back to the days of cheap oil." Not just in OPEC’s eyes but in their investment policies, which make it clear that they feel that it is in their best interests to refrain from bringing too much additional oil to market. This is a good place to ask one of my favorite questions: would you if you were in their place? Accordingly, the optimal  development strategy for a country like Saudi Arabia is to pay more attention to the refining of oil, and the production of petrochemicals.

A paradigm shift means that OPEC nations are determined to never see the low prices of the late 1990's ever again. The Call on OPEC? (published here, May 2, 2007) calls attention to the obvious fact that the OPEC nations will always act in their best economic interests. This conclusion would seem self-evident, except that the IEA apparently has not absorbed the lesson, as Al-Husseini says. Further to the point, there is no OPEC desired price band at the moment. It was also argued, based on some reasonable assumptions, that at the current OPEC Basket Price — $67.90 on June 18th — Kuwait, Saudi Arabia and other OPEC states are making as much money leaving some of their oil in the ground as they would if they were producing it, which would only lower the price.

This conclusion runs counter to James Hamilton's reasonable assertion, made in June, 2006, that Saudi production did not fit "the classic story of a monopolist cutting back production in order to raise the price." However, Hamilton also says "while I believe the Saudis are quite capable of letting output drift down in order to try to defend a price floor, wherever such a floor might be, it's not $70 a barrel." A year later, on June 15, 2007, the Brent price is $71.84, and has hovered around the $70/barrel mark for the past month, rising from low $50s since the beginning of the year. There is little evidence that current price level has stifled world oil demand, although that demand has been redistributed from the poor to the wealthy. (See Africa and Central America.) The desired price today is whatever OPEC thinks the market will bear, not the fair price of $60/barrel back in 2006. This is a dangerous game because the downward demand pressures on consumer economies created by even higher prices (about $80/barrel) could be severe.

Oil consumers expect Middle Eastern nations to invest heavily in upstream activities to keep the oil flowing. In fact, major investments are being made, in the downstream refining and petrochemical sectors. The numbers are staggering, as compared with upstream investments, according to Ali Al-Naimi.

Based on the outlook of growing demand for their oil and gas, by 2011 the countries of the Middle East will invest some $94 billion in their oil and gas upstream sectors, more than half of which will go to expand oil production capacity. This is in addition to more than $240 billion of investment in the mid and downstream oil and gas chains and petrochemicals...

Of the $70 billion Saudi Arabia is investing by 2012, only $18 billion is for upstream expansions. Nancy Yamaguchi's Middle East petroleum sector: growing in all directions (Petromin, March 2007) provides an overview of refinery expansions in the Middle East (graphic, left).  Saudi Arabia has ambitious plans to create more refining capacity, including the Jubail and Yanpu export facilities.

The Middle East push into petrochemicals rivals the refining investments. Saudi Aramco has a joint venture with  Japan’s Sumitomo Chemical to build a complex at Rabigh. The  Gulf Cooperation Council (GCC) nations spent almost $70 billion in 2006, with Saudi Arabia leading the way at $44 billion (Gulf News).

The Persian Gulf states are expanding downstream capacity to meet rising internal consumption of refined products (see Yamaguchi), but that's only a small part of the story. Due to their substantial comparative advantage, refining and petrochemicals is where the money is. Oil and condensate can be provided for refining at below market costs. Saudi Arabia can refine its own heavy, sour (sulfur-laden) crude. Cheaply produced naphtha or natural gas or gas liquids can be used as a petrochemical feedstock for olefins (e.g. ethylene). From the Gulf News (link above) --

Investment in petrochemical facilities is driven by availability of cheap feedstock and the region's proximity to large markets of Asia such as China and India.

More than 30 million tonnes per year of ethylene capacity will be added in the Middle East by 2012-13, according to London-based Chemical Week.

The new capacity is also likely to put pressure on global petrochemical markets. Steam crackers coming onstream from 2008 in Kuwait, Qatar and Saudi Arabia will cause an imbalance in worldwide supply and demand, lowering petrochemical plant operating rates and leading to a softening in prices, it quoted industry analysts as saying....

General Electric has already capitulated, selling its petrochemicals division to Saudi Basic Industries for $11.6 billion. The Kingdom's future is plastics.

Saudi Arabia is expanding their refining nameplate capacity to 3.6 million barrels per day. It is hard to reconcile such large capital expenditures in a context where the Saudis have diminished expectations about their future oil production. They will not want that expensive capacity sitting idle, nor the petrochemical industry upon which it depends. The Persian Gulf countries are planning for a future where global oil spare capacity stays tight and refining margins remain high. They will increasingly export gasoline and ethylene, not crude oil.

Ferdinand Banks argues² that "OPEC is in the driver's seat." The paradigm shift strategy optimizes production rates over time, protecting the longevity of the resources while keeping prices high. Banks believes OPEC's best position is one in which non-OPEC supply price elasticities are falling just as OPEC controls a greater and greater market share. This seems to be what is happening. Angola, one of most successful non-OPEC producers, joined the cartel this year, a move which raised their market share about 2.5% all at once. Meanwhile, non-OPEC production is struggling to rise above declines. Lower downstream product costs allow sales at global market prices, a market in which OPEC can expect to exert more and more control over those prices. It looks like a license to print money. Those assets will be used to diversify the economies of the Persian Gulf oil producers.

If non-OPEC oil is on the verge of peaking, and OPEC output is going to be limited for macroeconomic reasons (Saudi Arabia, Kuwait), political reasons (Venezuela), lack of investment (Iran, Venezuela) or disruption (Iraq, Nigeria), then the near term peak of world production is all but assured. If Saudi Arabia can't manage natural declines at Ghawar at this time, and must wait a few years for additional capacity, declines there will merely speed up a liquids peak that appears inevitable in any case. Many in the peak oil community have not paid enough attention to so-called "aboveground" factors. The "paradigm shift" Al-Husseini speaks of is likely to forever change the world oil supply balance.

1. The U.S. Congress provides an amusing sideshow to the argument. They saw fit to pass a bill making it illegal for OPEC to withhold "our" oil & natural gas from the world market (NOPEC). A well-informed colleague voiced his eminently reasonable opinion that Congress is currently living in La La Land. This is not good news.

2. Bank's paper Economic Theory and OPEC is unpublished. Contact the author to arrange to see a copy.

The Call on OPEC?

By Dave Cohen

A previous column, Decline Rates and Non-OPEC Supply, investigates a likely peak (or plateau) in oil supplied by nations outside the Organzation of Petroleum Exporting Countries (OPEC) by 2010. The "call on OPEC" to satisfy growing world oil demand must inevitably increase thereafter. Will OPEC answer the call?  The people running OPEC are businessmen. They will answer the call only if there is a financial incentive to do so.

On April 16, 2007, the UAE's Mohamed Al Hamli stated that OPEC remains fully committed to providing a reliable oil supply for the consumer nations.

There should be no doubt that OPEC members are fully committed to ensure regular supplies to consumers and maintain market stability," said Mohamed Al Hamli, who also serves as UAE's energy minister.

Al Hamli told an oil conference in Dubai that the organization's commitment has been proven "time and again, during crises brought about by severe weather conditions, geopolitical tensions, or disruption of supplies caused by unrest.

OPEC's committment comes with conditions. Al Hamli emphasized the organization's view that efforts by the Organisation for Economic Co-Operation and Development (OECD) member nations to reduce their import dependencies through subsidies for alternative fuels "discriminate" against oil, thus undermining future OPEC investment in capacity expansion. OPEC's worry about sustained oil demand may be seen as an ordinary business concern; it may also be seen as blackmail — consume oil or suffer the consequences of future shortages.

The International Energy Agency (IEA) and the Centre for Global Energy Studies (CGES) argue that shortfalls leading to an "upward price spiral" are happening now. The IEA's April Oil Market Report shows that OPEC's contribution to the world oil supply has reached it's lowest point since January, 2005 (graphic left, click to enlarge). Demand is not relenting, and the oil price is rising as OECD stocks are being depleted at a time when they traditionally rise in the weeks prior to the summer "driving season." The oil price has now reached $66/barrel, and is contributing, along with refinery problems, to unseasonably high gasoline prices in the United States. According to the EIA, American gasoline consumption is 2.3% higher than one year ago, when prices were also in the current range. Geopolitical "risk premiums" are not particularly high, and do not appear to be driving up the oil price. The best explanation for rising oil prices is restricted supply combined with growing OECD and Asian demand. Prices are not yet high enough to curb consumption.

Can OPEC raise production? The IEA's April spare production capacity numbers (graphic left, click to enlarge) indicate the OPEC-10 (excluding Iraq and Angola) is now withholding 3.55 million b/d off the market. (The EIA has a lower tally.) Nigeria should probably be removed from the list due to guerilla activity there, leaving 0.96 million b/d apart from Saudi Arabia, which accounts for 2.25 million b/d (see below). If the IEA's data is correct, it appears possible for OPEC to pump more oil and move the price closer to their stated price band target of about $55—60/barrel. 

OECD representatives have called upon OPEC to increase production when the oil price gets too high in recent years. OPEC has ignored these pleas, and there is no indication that the cartel is seeking to boost production to lower the oil price now. A simple price calculation sheds some light on OPEC's unresponsiveness. The OPEC basket price stood at $58.47/barrel at the end of February (graphic below left, click to enlarge). Kuwait produced 2.40 million b/d in March, 2007, according the IEA, but has a spare capacity of 0.24 million b/d.  At today's OPEC basket price of $63.89/barrel, and assuming a marginal production cost of $8/barrel, Kuwait makes approximately the same net profit at its March production level than it would producing at full capacity at the February closing price. Calculations yield the same result for the other OPEC nations, such as Saudi Arabia and the United Arab Emirates, who are producing below capacity. While demand remains strong and prices continue to rise, there is no financial incentive for OPEC countries to raise production.

Note on Saudi Arabia: The IEA list's the Kingdom's spare capacity as 2.25 million b/d with a maximum sustainable output of 10.8 million b/d. At an OPEC basket price of $63.89/barrel, KSA's revenue is down 1.4% compared with the end February price, assuming the Saudi's were producing at maximum capacity. This calculation is based on a spare capacity of 1.05 million b/d with a maximum production rate of 9.6 million b/d, which equals their highest output at any point in the last 3 years. The remaining 1.15 million b/d has never been produced, and some have questioned whether it exists. If the basket price continues to rise, the Kingdom will profit while producing 1.05 million fewer barrels per day. Saudi Arabia requires a separate analysis.

An elaborate game is played each year which pits OPEC against the IEA, CGES, and other Western analysts of the oil supply. Opposed forecasts of non-OPEC supply and global demand yield different estimates of the "call on OPEC." The IEA and OPEC revise these estimates each month. According to OPEC's Monthly Oil Market Report for April, both non-OPEC supply and world oil demand will increase about 1.3 million b/d in 2007 over the previous year. OPEC concludes that the demand for their crude remains at 30.3 million b/d, a decline of 0.14 million b/d from 2006.

The IEA's Oil Market Report for April (link above) forecasts non-OPEC supply growth of 1.1 million b/d in 2007 over the previous year. Revised world oil demand is projected as 85.8 million b/d in 2007, an increase of 1.5 million b/d over 2006. The "adjusted call" (including Angola) on OPEC for 2006 was 30.9 million b/d. The adjusted 2007 call is 31.5 million b/d, an increase of 0.6 million b/d. (The IEA quotes "all liquids" numbers. OPEC does not, which accounts for some of the discrepancies. See the IEA's Table 1 to see how their numbers are calculated.)

OPEC expects the call on its crude to stay about the same, while the IEA calls for a substantial increase in the cartel's production. A crucial point of comparison is the non-OPEC supply forecast — OPEC cites a larger contribution from outside the organization to justify their reduced output levels. The IEA's lower non-OPEC appraisal accounts, in part, for their higher expectation of OPEC's oil production. CGES provides a starker point of comparison. The Centre notes that forecasts that underestimate non-OPEC production declines, or do not sufficiently factor in project delays, have overestimated the non-OPEC contribution in past years. CGES expects 2007 non-OPEC supply growth to be 0.7 million b/d — 0.4 million fewer barrels per day than the IEA, and 0.6 fewer than OPEC projects.

Ali Al-Naimi, the Saudi Arabian oil minister and de facto head of OPEC, is wont to tell consumers that OPEC always works "diligently" to keep the oil markets in balance. The Gulf Times quoted King Abdullah as saying that Saudi Arabia "seeks to guarantee fair oil prices and boost output capacity to meet rising demand." This is not the view of the IEA, CGES, and most consumers in the developed nations. Nor is it likely the view of poor countries like Guatemala, whose economies are inordinately damaged by high oil prices.

OPEC keeps its own counsel, and decides what its oil production output will be independently of requests by OECD representatives to increase it. OPEC's evaluation of its obligations to safeguard the world's oil supply is self-serving, and its recent behavior confirms this observation. This conclusion is hardly a surprise, but does not augur well for a world that will become increasingly dependent on OPEC's oil. Greater energy security for the OECD nations will follow only from reduced consumption that decreases their foreign dependencies. Al Hamli's thinly veiled threat should not influence future oil demand. OPEC will always act out of self-interest, regardless of whether their actions coincide with consumer wishes.

Postscript -- Calling OPEC, with a Dickensian "Twist"

The International Energy Agency (IEA) calls the OPEC Hot Line (OHL) at 1-800-OIL-OPEC

OHL:  Welcome! You have reached The Organization of Petroleum Exporting Countries.
           Main menu: Press #1 to get information about upcoming meetings. Press #2 to
           inquire about the oil supply. Press #3 to ...

IEA:    (presses #2)

OHL:  Sorry! We're not taking calls on the oil supply right now, but please feel free to leave
           a message at the tone. You may press the pound key to review your message, and then
           press #1 for more options, or simply hang up when you are finished. (tone sounds)

IEA:   Yes, Hello! This is the International Energy Administration calling from Paris. We're
          calling, ahhh ..., about how much oil you're pumping?  Please, sirs, we want some
          more. (pause) OK? (silence) Thanks!

          (fumbles with phone, hangs up)