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A double oil shock scenario

March 30th, 2008 by Denis Babusiaux, ENSPM, Paris

As far as oil prices are concerned, many scenarios are possible. A jump to $300 per barrel or more in the near future may be the result of a geopolitical crisis in Iran, Venezuela, Saudi Arabia or elsewhere. Low price scenarios seem unlikely today but cannot be completely excluded. Another one which we consider of interest is a “dual-crisis” or “double-shock”. It would present a number of similarities with the development observed between 1973 and the end of the eighties.

It has often been said that the recent rise in prices is not comparable to that of 1973, the first oil crisis having been triggered by a reduction in supply whilst the present oil price increase could be attributed to runaway demand. Note, however, that during the 1960s, worldwide consumption of petroleum products increased by 7 to 8% annually, but production capacities did not increase at the same rate. The events associated with the Israeli-Arab conflict (i.e., the Yom Kippur war) accelerated the rise in prices, but that rise would most likely have occurred anyway, although spread out over time as it has been the case since 2000.

In short, the rise in prices over the past few years, as in 1973, reveals the need for consuming countries to make decisions to promote energy savings and the development of alternative energy technologies. As in the seventies with the French nuclear program, several steps have already been taken, in favour of biofuels for instance. In spite of growing nationalism and a lack of opportunities for international oil companies, investment in exploration and production is increasing. Note, however, that the major part of this increase in investment is due to the inflation of costs, only a small part corresponds to an increase in activity.

In the absence of geopolitical events, it is possible that production capacities will be restored if all development projects are realized as planned. We might then see a stabilization or an erosion of prices for a few, or several, years. However, if demand continues to grow, these recent measures may prove to be not sufficient. Then, even if the “oil peak,” strictly speaking, only occurs around 2030, it is likely that the production of natural hydrocarbons will be unable to follow demand as early as the beginning of the next decade. Before prices return to a new long-term equilibrium which could be about $100 to $ 150 a barrel (in constant dollars), it is highly likely that an additional “crisis” will occur, similar to the 1979-80 crisis, with price levels of $200, $300 per barrel or more for several years. These high prices will probably be necessary to promote an inevitable energy transition, for investments to be made both on the supply side as well as on the demand side in order to develop renewable energy sources without major subsidies, to stimulate the production of synthetic fuels, to renew nuclear programs, etc.

Last but not least, we should bear in mind the role played by expectations and how forecasts can be self-destructive in the oil industry. One especially relevant example relates to the 1985 price drop. Political and industrial decisions resulting in energy efficiency, substitution, exploration and production of “difficult” oil in non OPEC regions occurred not simply because the price of crude was high but because it was considered unlikely that prices would not continue to rise. Consequently, the most effective factor for avoiding the coming crisis of a dual shock scenario would be a consensus about its arrival. In this context, the fact that the 5-6 year forward price of oil is at present reaching a hundred dollars is probably to some extent rather good news.

Denis Babusiaux, Pierre- René Bauquis

This post is derived from “Depletion of petroleum reserves and oil price trend” a report we wrote for the French Academy of Technology. You can dowload the report in French here and the English version here.

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3 Responses to “A double oil shock scenario”

  1. Gurvan RALLON Says:

    Experts are today deeply divided about the direction of oil prices, with estimations ranging between $70 a barrel for the most optimistic of them to as much as $500 for those who predict a violent double shock scenario. But in reality, many of them had not seen it coming when the barrel passed the mark of $100 at the beginning of 2008, but were instead predicting with loud drumbeat its collapse as it was passing through each new threshold — $70, $80, $90 and finally $100 – over the last year.

    Under this avalanche of predictions, it is very hard to guess with accuracy what oil prices are going to do in the future, and the reason for that is a lack of reliable data on production, consumption and inventories.
    On the consumption and inventories side, and if developed countries publish good statistics about their demand of crude and stockpiles of barrels, these countries do not account for the biggest proportion of oil demand – a demand which is also roughly flat. China, second biggest oil consumer after the US, Russia, India and Middle Eastern countries are much more opaque about consumption statistics. They instead let experts guesstimate the consumption from incomplete and unreliable trade and inventories statistics.
    On the supply side, many OPEC countries do not report reliable data for fear of admitting they are producing over their agreed-to-quotas. Some are also reluctant to disclose information about the opening of new fields and the decline of existing ones.

    Without a comprehensive picture of supply and demand, not only are we not able to predict the future price of oil, but it turns out that its current price makes disproportionate swings on small pieces of news. On May, 6th, the crude passed the mark of $123 when Arjun Murti, the energy strategist from Goldman Sachs who had been predicting that the barrel was bound to pass $100 since 2005, mentioned the possibility of having a barrel at $200 within the next two years. A week later, the price of crude fell by more than $1 after the US reported a-bigger-than-expected increase in American inventories – which do not account for much of the world oil market.

    Without a smooth relation between supply and demand, without comprehensive data about oil production and consumption, and in a market made nervous by geopolitical tensions in the Gulf, oil prices can either plunge or rocket overnight. In this context, many people will keep on playing confidently the game of guesstimating the world’s need for oil and where we stand on Hubbert’s peak. But we have to keep in mind that most of them have been wrong before. Truth is, the world is actually as thirsty for information as is it for oil.

  2. Aurélien SAUSSAY Says:

    Absent specific geopolitical events, the 1970s oil crisis might have drawn more similarities with the current “slow motion” oil shock unfolding over the past five years. Yet, it seems increasingly clear that what some have already dubbed the Third Oil Shock has specific characteristics of its own.

    The current steep rise in oil prices, which has accelerated since the beginning of the year to reach a staggering 35% since January 2008, is usually attributed to a combination of runaway demand, political instability in key producing countries and speculation on commodities markets. Most analyses consistently disregard the now persistent shortcomings in production, which are best illustrated by the flat trend in world oil output since 2005 (stagnating at around 85.2 mbd).

    While global peak oil might still be a good 15 to 20 years ahead, mounting signs demonstrate that non-OPEC production has reached its all-time peak – even Russia, which had provided most of the relief from other non-OPEC countries decline might have reached its zenith. This is most disturbing of course; first and foremost because these declines in oil output will have to be compensated in order to keep up with demand, and second, because most of this additional capacity will have to come from OPEC countries – which are increasingly inaccessible to Western oil companies (and their technological know-how) and which have shown little willingness to open their taps wider, despite numerous and growingly desperate Western claims.

    Besides, even if we consider that a combination of international cooperation and expanded investments in production and exploration capacities will provide the much needed increase in world output, a catch remains: for heavy importers such as the EU or the US, global production is of little significance – only global exports are able to quench our oil thirst.

    On this side of the issue, prospects might be even worse than those for raw production: IEA data shows that half of the surge in global demand over the past five years comes from oil-producing countries themselves. And for those – a majority – that also suffers from a drop in their crude production, this translates into a major drop in oil exports, until finally every single drop of oil is consumed within the national borders.

    The poster child for this simple Export-Land Model analysis is the UK. A major producer of oil since the discovery of the North Sea oil fields in the 1970s, it became an oil exporter in 1980. However, despite sustained investments in production infrastructure and state of the art technology, the North Sea fields reached their all-time peak production in 1999. From there, it has all been steeply downward, with an annual drop averaging 7% a year, and annual output now down by more than a half. Since in the meantime UK’s consumption kept rising by an average 2% per annum, the outcome was quite predictable: by 2005, the UK had turned into an oil importer.

    When combining both aspects of the issue, the geological factor in non-OPEC countries and the shortfall in exports worldwide, it becomes quite clear that the supply side of the equation plays a much greater part than what many analysts seem to think. This supply issue will only make matters worse for the major oil importers, especially the US, Japan, and of course the EU.

    It is worth noticing that the possibility of a supply shortfall is taken more and more into account by major oil actors and analysts, as reflected by Gazprom’s CEO’s recent prediction on the coming of a $250 barrel “in the foreseeable future”, because of “inadequate supply” to fulfill global demand.

    Finally, the most recent estimates released by IEA for April are particularly unsettling: while that month is usually associated with a 30 million barrel increase in world crude oil stockpiles, April 2008 saw an 8 million drop – indicating that the world is living of its stockpiles. This figure, which reveals the growing gap between global supply and demand, is the epitome of a situation that cannot be sustained. Demand reduction will have to occur, either through the pricing-out of some of the buyers, or – once stockpiles are significantly depleted – through physical shortages.

  3. Alastair Caithness Says:

    With the price of oil now over $140 per barrel do you think has been influenced Iraq opening the 6 oil fields to 41 Western Companies, or is this just a Coincidence!!!

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