According to an expert cited by a publication of the Swedish Energy Agency, the oil market will eventually come into “balance”, although ostensibly it will take some years. The thing that will ostensibly bring this ‘equilibrium’ about is new investment and production in the Gulf of Mexico, off the West Coast of Africa and the East Coast of Brazil, and in the Caspian. Unfortunately, false premises have a way of leading to false conclusions, and that is especially true in the present case. The last time that oil discoveries matched consumption was almost 25 years ago, and in the light of this sad fact alone, profit maximizing businesses will find other uses for their resources than searching for and trying to produce oil that does not exist.
This is a sermon that a few of us have been preaching for a long time, and until recently in vain; however it is less important than the fact that the few remaining oil superpowers are not going to make the dreams of the International Energy Agency (IEA) and the United States Department of Energy (USDE) come true by eventually producing the 20 or 30 million barrels of oil per day that will be required to fill the global demand-supply ‘gap’ in their target year of 2030. Saudi Arabia, for instance, is not going to produce the 20 mb/d that is desired from them. In fact, I consider it unlikely that they will produce the 15mb/d that a high ranking member of the Saudi government said was possible.
THE REAL DEAL
My source for the above opinion originates in a staff report to the subcommittee on international economic policy of the Committee on Foreign Relations of the United States Senate, which appeared in l979. On that occasion, Crown Prince Fahd of Saudi Arabia made it quite clear that his country intended the “establishment of a calculated balance between the present and the future.” In other words, economic development was going to be factored into the Saudi pricing-production agenda, and it might occasionally take precedence over keeping our Cadillacs and Volvos in the fast lane.
This is the kind of language that the major oil companies made it their business not to understand when they were calling the tune in Saudi Arabia, and it is possible that they still find it uncomfortable. The same is likely for their political masters, as well as the hard working economic researchers of the IEA and the USDE. What it boils down to is that not only is there a basic shortage of oil in the crust of the earth – given the relatively inelastic demands of the immediate future – but of late there are good reasons for the governments of Saudi Arabia and the other Gulf states not to pretend otherwise. Oil in these countries is a national asset, which means that selling it for bargain basement prices could be interpreted by certain people as a betrayal of future generations.
Luckily, this state of affairs benefits just about everybody, because there is no point in encouraging those of us on the buy side of the market to conclude that in the last analysis, as we liked to say in engineering school – or ‘at the end of the day’, as people are now murmuring into their mobile phones – we will always have access to cheap motor fuel.
A few months ago the price of oil dropped by about 15 percent from its top notation of $55/b. Unfortunately, at the present time, that was not a sufficient deescalation. The journalists of the Financial Times have been told – or told themselves – that high oil prices no longer have the same deleterious macroeconomic effects as they did during earlier escalations, which may well be the case, but I certainly am not ready to accept this hypothesis. As one canny observer recently said, “the US economy is an accident waiting to happen”. The last time I heard that kind of language, I was teaching international finance, and while it sounded right, I did not make the necessary adjustments in my wife’s portfolio. I am doing everything possible not to make that mistake again, because if another round of bad news takes the oil price above $50/b, and it stays there for a while, a great many investors are going to be in deep trouble. (And here I am thinking at first remove of bonds, because when looked at in historical perspective, that market is very definitely out of equilibrium. Furthermore, if interest rates adjust (upward) too fast, then they will impact on equities.)
The Association for Peak Oil (ASPO) has come to the conclusion that Saudi oil production could peak soon after 2010. If true, this could turn out to be a very unhealthy outcome for the world economy. The ultimate recoverable resources of Saudi Arabia have been estimated at 300 billion barrels, and with present day proved reserves at about 265 billion barrels, then the ‘half-way’ or ‘midpoint’ rule suggests that (assuming no large changes in production, and no large additions to reserves) a ‘bumpy’ one way downward trip for Saudi output could begin in 12-15 years. (The basic logic here is found in Banks (2004b), but needless to say many observers do not accept the figures given above.)
More reserves will almost certainly be located, perhaps a great deal more, but even so the present physical condition of the large Saudi reservoirs is said to be such that they may not be able to continue to deliver at the present rate. This is very definitely not certain, but instead of spreading fairy tales about the unlimited expansion possibilities of Saudi production, as some persons are inclined to do, it might make more sense to think in terms of the optimal situation being one where something close to today’s output (and ‘spare capacity’) can be maintained for a long time.
In the Economist (May 29, 2004), there was a long discussion that centered on the so-called “spare-capacity crunch”. In l985 OPEC apparently had about 15 mb/d of spare capacity. Five years later there were down to 5.5 mb/d, and today they may have only 2 mb/d, with all of the latter located in Saudi Arabia. This kind of arrangement should make it clear that the price forecasts of only a year ago – when the oil price was pictured as falling to $21/b – were not only inaccurate but foolish. At the same time though the Economist still peddles the song-and-dance that “the rise of energy futures markets over the past two decades also offers some scope for the world to deal with short-term price shocks.”
“Short term” could mean anything, but regardless, the oil futures markets are some of the best functioning in the world, and I am sure that there are many transactors who are grateful for the facilities they have offered for hedging price risk. But even so, it needs to be appreciated that futures markets (and other derivatives markets) cannot ameliorate the miseries that could be caused by a long stretch of tight physical supplies. As far as I am concerned, this can only be done by imaginative economic policies, designed and implemented by intelligent governments that are capable of thinking in terms of long-term realities
THE OIL PRICE AND MACROECONOMICS
In a recent discussion in the Journal of Economic Perspectives (Fall, 2004), it was claimed that "disturbances in the oil market are likely to matter less for US macroeconomic performace than has commonly been thought.
This is in some sense correct - if we add 'up to now'. Recessions/downturns in the US immediately followed the oil price increases of 1973, 1980, 1981, and 1990, and they featured real growth falling and inflation rising (i.e. 'stagflation'); however in the macroeconomic sense recovery did not take a long time (especially for the last two).
There were of course individuals and firms for whom recovery never really arrived, and needless to say "disturbances" in the US impacted on the rest of the world to one degree or another. The present situation appears to be different - so different as to lead to the opinion by some observers that the band between oil price increases and macroeconomic downturns has finally been broken.
We can certainly hope so, because the situation with the present oil price is not reassuring at all according to the economics and finance that I teach. The previous oil price rises were 'spikes', but even so real growth was seriously depressed in some countries. Now we have a sustained price rise - a situation that (in quantitative terms) is not very far from the scare-scenario posited by the leading investment bank in the US, Goldman Sachs, in its Global Economics Weekly of April 10, 2002. In that 'script', the bad news was that Gross National Product (GNP) growth fell sharply, while inflation increased; but the good news was that central banks posessed enough firepower to quickly get the situation under control. Most important, there was also an assumption somewhere in the background that if things really got bad, Saudi Arabia would be able to prevent the oil price from going through the roof.
As April 2005 approaches, the frailty and basic inflexibility of certain central banks becomes more apparent every day - especially those in Frankfurt and Tokyo; while it will be years, if ever, before Saudi Arabia is able to once again put a cap on the oil price. I am sure that important people in every country in the world have started to give some consideration to this problem, but once again it might be wise to suggest that it is not enough just to come up with good new concepts and/or solutions, but to get rid of some of the bad old ones as quickly as possible. The worst idea of all is that 'disturbances' in the oil market, originating in the neighborhood of 45 dollars per barrel, can always be experienced without a considerable amount of macroeconomic discomfort.
One person who has few doubts on the present subject is the Chairman of the US Federal Reserve System (i.e. Central Bank), Alan Greenspan. At least once a year Greenspan has informed the US Congress of the crucial importance of oil (and gas) for the stability of the US economy. His choice of words is such that it would be extremely difficult to doubt that his opinions on this subject apply to the global economy.
And not just the 'real' economy - i.e. production, employment, and prices - but also the financial markets. The thing to remember is that despite the Chairman's power and skill, and luck, the 'Fed' is basically a 'one-machine operation': that machine (or instrument) is the interest rate. Alan Greenspan has understood it perfectly, it has served him well during his long term in office, and I feel confident that he will continue to inform his friends and neighbors of the truth in Ludwig Wittgenstein's observation that there can be a big difference between the functioning of an ideal machine and the kind often encountered in the workaday world. To be exact, the kind of machine that might break down completely if energy prices go into orbit.
SOME CONCLUDING REMARKS
The ‘great game’ is an expression that we often hear nowadays when the discussion turns to oil. I never use that figure of speech myself, because most of the game theory that I look forward to teaching again is not as great as many observers think – as the Princeton mathematician Paul Halmos once noted.
But sometimes it is useful. I occasionally hear estimates of Russian and Caspian oil resources that make no sense at all, and the former Prime Minister of Canada, Jean Chretien, had some thoughts about the availability of oil in Canadian tar sands that could have originated in a video clip.
Evidently, there are still some decision makers, movers and shakers, and political celebrities who want us to believe that there is more oil out there than is actually the case. Why is this? Well, you know – just as I know – that where oil is concerned, in the chasm between what is true and what some people say is true, there are often some beautiful opportunities for the persons manufacturing or dealing in various categories of misinformation to enrich their lives both spiritually and intellectually, and perhaps in some other ways.
Banks, Ferdinand E. (2005a)‘. ‘A ‘new’ world oil market’. Geopolitics of Energy, December.
______ . (2004b). ‘Beautiful and not so beautiful minds: an introductory essay on economic theory and the supply of oil’. OPEC Review, March.