Energy special: Surprise—the oil price isn’t higher

Given the number of oil-producing countries in turmoil, and the fact that the world economy is now picking up momentum, why is the oil price not higher?

The possibility of military action against Iran later this year and the threats this may pose to the vital Strait of Hormuz might be expected to lead to panic buying and stock building. To make matters worse, there are still problems in Libya, Iraq is finding it difficult to build up production, and Syria is out of the market. Add the upheaval in Yemen, Nigerian civil unrest, and the damage President Hugo Chávez has done to Venezuela’s production, and things look pretty bad.

Then there is the recovery in the world economy. China—increasingly the dominant force in fossil fuel markets—is still powering along at over 7 per cent per year GDP growth. At that rate its economy will double in size by 2020. India has slipped back a bit, but is still at over 6 per cent per year. Overall the world is back at about 3.5 per cent GDP growth, the United States is recovering fast, and even Europe looks to have turned the corner.

If ever there were a combination of supply and demand problems, this should be it. And yet, here we are at only $120-$130 a barrel for North Sea oil, and around $100 for US oil—in real terms, less even than it was at the peak in 1979, when the developed world was much more energy and oil intensive.

Behind the hype and panic lie profound changes in global energy markets, in large part caused by the rising price of oil over the last decade. When the price goes up, demand is reduced; and substitutes thrive. It’s a process that takes time—and in those lags, all sorts of volatility are possible—just like we are witnessing now.

Think back to the late 1970s—the last time there was an oil panic. After years of complacency in the 1950s and 1960s, the margins between supply and demand tightened. The Opec cartel ramped up the price of oil by a factor of four, and then came the Iranian revolution, and the price doubled.

Failure to develop new resources, and failure to diversify away from the Middle East cost the west dear, but once price shocks occurred, the conventional wisdom of ever declining prices was replaced by an assumption that prices could only go up. There followed a demand and supply side response: the energy ratio (a measure of the energy intensity of GDP) cracked, and on the supply side a host of non-Opec supplies became viable—in Alaska, the North Sea and Africa. France embarked on its nuclear programme, and Margaret Thatcher committed Britain to ten new nuclear power stations. But for the Three Mile Island accident in the US it would have built more. Coal was a winner.

By the mid-1980s the jeremiahs were proved wrong, and the price collapsed, to remain flat for the next two decades, except for the short burst when Saddam Hussein invaded Kuwait and set fire to its oil wells. The oil companies focused on cost cutting and mergers. What was the point of investing in new resources and technology, if the price was to be as low as $10 in 1999?

China’s growth, fuelled by cheap energy, and the failure to develop new resources and technologies in the 1990s meant that the supply-demand balance tightened, and prices rose. The US and Britain’s massive fiscal and monetary expansionary policies boosted their demand for China’s exports, which in turn drove up the demand for oil, coal, gas and a whole host of commodities.

As in the late 1970s, energy policy has come to the fore. Governments are pressed to “do something.” The short-term expedient is to consider releasing emergency stocks and sending their navies to the Gulf. There is surprisingly little else they can actually deliver. But that does not much matter, because the market is doing it for them, and if anything the risk is that populist politicians will wade in with measures to prevent customers and companies being forced to confront the prices. Across the world, politicians are being pressed to subsidise petrol, domestic fuels and bail out energy intensive industries.

What matters is what has been going on behind the political scenes. On the supply side, there has been a quiet revolution in technology. Faced with rising prices, new techniques have opened up supplies. The earth’s crust is riddled with fossil fuels, and new resources have been found, some of them now economic. On the demand side, energy efficiency—by definition a good thing—has been boosted by the higher prices, and again the march of technology is impressive.

While all eyes have been on China’s insatiable appetite for fossil fuels and commodities, the US has witnessed an extraordinary technological revolution. A combination of three separate technologies has come together: horizontal drilling, fracking and seismic advances. The ability to drill horizontally opens up a greater area. Fracking means that shale rocks can be split at depths. Seismic advances mean that drills often at great depths can be directed from the surface to hunt down the pockets of oil and gas. High prices make this an economic proposition.

To get a handle on what all this means, the goal of energy independence, whilst still a long way off, is no longer such an unrealistic ambition for the US—Richard Nixon’s goal in the 1970s and ever since the Holy Grail of American energy policy.

Consider the numbers. The US added more conventional oil production last year than any other country, and more than the total output of Libya. It produces more than half of its oil consumption, and the number is rising. Imports are diversified: half come from the Americas, a quarter of which comes from Canada. A quarter comes from Africa. In a decade or so, the Middle East could be of minor importance to the US (Israel aside). This has geopolitical consequences, since the same will not be true for China.

But it is the new unconventionals—oil and gas—that make the difference. The US is estimated to have at least 100 years of shale gas to meet its current demands, and lots of shale oil too. Then there are the tar sands, the tight gas, the coal bed methane and so on. On top of that there is an enormous amount of coal. The US is energy abundant.

Like Jehovah’s Witnesses, the “end of oil” brigade did not see this revolution coming, so Armageddon is postponed for another (for them, inevitable) day. They tend not to take technical progress seriously, and hence miss the dynamics of market responses.

The shale revolution is however not confined to making more resources available. It is changing the relationship between oil and gas in the energy mix, ushering in a golden age for gas. Just as there was considerable panic in the 19th century that we would run out of coal—that coal had “peaked”— so too now with oil. But coal did not have to take all the strain, for oil came along, especially for transport (and there turned out to be much more coal than the Victorians thought).

If the relative price of oil rises, the economics of gas improve. So gas substitutes directly for oil, and is the preferred fuel for electricity. Even in transport, which is oil-intensive, gas may make inroads—directly, as via electricity. It will take time, but Opec’s actions are speeding the day when oil may lose dominance in transport. Meantime, the oil price boosts the other substitute, biofuels.

It’s the gas that matters for the climate too. Abundant gas undermines the economics of wind and solar—and nuclear. There is a silver lining: gas fuelled power stations are a cheap way of getting out of coal, the dirtiest fuel and the prime cause of the rising emissions since 1990. Gas has half the emissions of coal. As a transitionary technology, gas offers one of the few ways of cutting emissions quickly in both the US and China, without raising energy prices—and potentially much faster than the Europeans.

Opec countries may think that high oil prices are a one-way bet—the higher the better. They may even convince themselves that they “need” $100 a barrel to pay for the demands of their rapidly growing, young and underemployed or unemployed populations. It is true too of Russia, with a rather different population dynamic. They are all cursed with oil—and the politics that go with it.

But just because they “need” high prices does not mean they are going to get them. Ramping up the price is not without consequences. The customers have faced a major recession on a scale not seen since the 1930s, and inevitably this has had its effect on aggregate energy demand. The demand for oil in the US and Europe is falling. The “golden goose” has lost a lot of feathers.

Worse still for Opec countries, the rise in prices makes a host of energy savings investments much more economic—as it did in the late 1970s and early 1980s. These gains are irreversible. Further ahead there is a demand side revolution in the offing that may turn out to be every bit as dramatic as the shale gas one. The application of smart information and data technologies to transport and electricity is only just beginning. Improvements in conventional cars and in hybrids are considerable, road management offers further savings, and the coming of smart meters and smart grids— and eventually smart buildings—should send shudders down the spines of many oil sheikhs and Russian autocrats.

The developments in the US and Europe might lead some in Opec to wonder whether they may be able to sell all their oil in the future—that demand and other technologies might leave some of their assets stranded. But they think they have one ace—China—and with it the other developing countries beginning to catch up with the west.

In the short run they are probably right. But only in the short run. China has massive shale gas deposits, and an authoritarian power to direct energy efficiency. Its sheer energy inefficiency has a flip side: it could make major inroads into its demand. Then there are China’s diversification options. It has coal and minerals from Mongolia, Indonesia, and Australia to draw upon to add to its gas options. It is building 24 nuclear reactors, and has plans for more. And finally, China’s economic growth may not be sustained.

This year the oil price could easily go higher—perhaps much higher—and if Iran is attacked and the Strait of Hormuz threatened it could be dramatic. In response, there are only the strategic stockpiles, Saudi’s limited additional production, and lots of military hardware. It could be very unpleasant.

But the higher it goes, the bigger the likely fall. A further burst in prices would reinforce the supply side substitutions and the demand responses. Opec (and Russia) should be very worried that while this year might be a party for authoritarian regimes under pressure, there might be a very serious hangover. By that time the US might not even care very much—and a much more energy efficient and diversified Europe might not either.