Www. ecomentary. com 1 Economics, Demography & Oil What’s Going On? 10/14/04.

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www. ecomentary. com1

Economics, Demography & Oil

What’s Going On?

10/14/04

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Does 9-11 explain recent oil market moves? Do the current problems in Iraq explain the oil

market? Is the world going to be more dependent upon

Middle Eastern oil? What will this mean for U.S. Middle East Policies?

Oil and the Middle East:Four Possible Questions

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1999: Year of Change

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A Closer Look: Weekly 2002-2004

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Moving into the 40’s

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Oil is different because it is ‘Strategic’

Modern economies require oilModern military power requires oilStates intervene when dealing with

oil because price volatility creates distrust of markets and politicians like to claim “solutions”

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Historical Notes Churchill and Admiral Fisher—don’t

depend on coal and the politics of coaling stations

GB Invests in the D’Arcy Concession—Anglo Persian Oil (now BP) is formed

Lawrence overturns the Mid East in WWI and oil becomes the currency of Middle East Geopolitics

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Oil and the Cold WarThe “Dark Side” of Cheap Oil

U.S. begins from a position of ‘independence,’ but gradually becomes a significant importer of oil (after 1971)

The Soviet Union’s interests in the Middle East during the Cold War become the context for ‘resource nationalism.’ (Libya) US loses its absolute control over Middle East Oil, but not its interest in a stable oil supply

OPEC tries to regulate oil prices but the cartel is unstable in the face of burgeoning non-OPEC supplies. Saudi Arabia then imposes “discipline,” and oil falls below $10/barrel in 1986 undermining longer term reserve development

The Soviet oil industry collapses under the price pressure and revenue losses hasten the collapse of the entire Soviet state

“Energy Independence” in the U.S. falls by the wayside but lingers as a continuing political theme

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The Post Cold War Oil Market From the end of the first Iraq War until 1996, crude oil rises

from about $20 to over $25 with a pit stop at $15 in 1993 The US economic “boom” begins after the Mexican Crisis

(1994) and oil moves above $25 With the Asian Crisis of 1997, falling world aggregate demand

conditions push oil downward toward $12/barrel, again undermining new capacity expansion.

After the Russian default (September 1998), oil essentially triples to an unsustainable $37/barrel during the Tech Boom

In the Bust of 2001, oil collapses once again, climaxing with the 9-11 attack driving down consumption, but the US recovery in 2002 moves oil up again, this time over $50

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Government or Markets?Understanding Recurrent Themes

Oil demand is price inelastic and for fast growing economies, highly income elastic

Over time, new sources of oil become harder to find and more costly to develop

If oil were strictly a ‘market commodity,’ oil supply would be far more responsive to expanded demand conditions, but oil is a ‘strategic resource’

Sources of ‘cheap reserves’ are under government control, making it virtually impossible for private companies to ignore governmental policies regarding oil supply development

The SPR undermines private incentives to hold private inventories (the law of unintended consequences) creating conditions for even more price volatility

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Crude Oil isn’t the Only Thingpetroleum products are the ‘inflammables’

‘Crisis’ not only about crude supply but about the supply of refined products. Can have adequate crude and inadequate product supply, but high product prices invite bad policy

Refined product supply very affected by NIMBY sentiment Balkanization of gasoline supply reflects our Federal system The US has insufficient ‘cracking’ capacity to use cheaper

heavy, sour barrels. Why is refining an area of ‘underinvestment?’

US energy policy is political parochialism in extremis. Supply expansion or demand restriction? Which party wins in November?

Only a crisis will stimulate political cooperation but usually the wrong policies are chosen

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Demographics of New Oil Demand

New Sources of oil demand growth include China and India See next slide

China is responsible for some 40-50% of additional demand Other Asian Demand is also rising (India, Korea, etc) Oil demands include transportation fuels and space heating (or

power generation). Oil demand in the emerging markets is highly income elastic and petroleum products are used less efficiently than in the developed countries

These sources of new demand are likely to continue rising Oil price instability leads these governments to adopt State-run

oil reserve holding (adding to demand) but undermining a market based solution

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New Demands

A n n u a l W o rld O il D e m a n d G ro w thA n n u a l W o rld O il D e m a n d G ro w th

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3 .0

1 99 1 -1 99 9

A v era ge

20 0 0 2 00 1 2 0 02 20 0 3 2 00 4 20 05

Mil

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F o rec as tH is to ry

S o u rc e : E IA , S h o rt -T e rm E n e rg y O u tloo k , S e p te m b e r 2 0 0 4.

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Why Can’t the Market do the Job?Vicious Circles!

Private Inventory Holding and the SPR New Government ‘strategic reserves’ The financialization of oil markets

Risk sharing and uncertaintyGovernment can create uncertainty and undermine

markets by state reserve-holding Financialization plus insufficient ‘excess capacity’

produces additional price volatility Price volatility produces more political intervention

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Why Are Prices More Volatile This Time?

economists: no spare capacity prices have upside volatility when

excess capacity drops below a critical value (3mb/d). See slides 16-17-18.

financialization: futures are heavily influenced by traders and the marginal barrel is priced this way

Financial optics attract bad politics

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Unusual Feature: Little Excess Production CapacityUnusual Feature: Little Excess Production Capacity

0

5 0

1 9 9

9 Q1

2 0 0

1 Q 4

OPEC 10 (OPEC excluding Iraq) Iraq0

5 0

1 9 9 9 Q1 2 0 01 Q3

OPEC 10 (OPEC excluding Iraq) Iraq

0

5 0

1 9 9

9 Q 1

2 0 0

1 Q 4

OPEC 10 (OPEC excluding Iraq) Iraq

18

20

22

24

26

28

30

32

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'99Q1

'00Q1

'01Q1

'02Q1

'03Q1

'04Q1

'05Q1

Mill

ion

Ba

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er

Day

OPEC 10 (OPEC excluding Iraq) OPEC 10 (Alt. Forecast)Iraq Annual OPEC 10 C apacity

History Forecast

Sources: History: EIA; Projections: Short-Term Energy Outlook, September 2004.

Excess Capacity Problem

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Spare Capacity and Pricing

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Significant OPEC Production Grow th Is Significant OPEC Production Grow th Is Required in 2004 and 2005 to Balance Dem andRequired in 2004 and 2005 to Balance Dem and

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2000 2001 2002 2003 2004 2005

Mil

lion

Bar

rels

per

Day Annual Oil

Demand Grow th

Annual Non-OPEC Production Grow th

Sources: History: EIA; Projections: Short -Term Energy Outlook, September 2004.

WTI Spot Price, 2004 WTI Spot Price, 2004 –– 20052005Implied Equilibrium Around $40Implied Equilibrium Around $40

0

5

10

15

20

25

30

35

40

45

50

Ja

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Ma

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Ma

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$/B

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Stage 2 – “OPEC Loses Control”

Source: EIA, Short-Term Energy Outlook, September 2004.

DESPITE ‘DEBATES’ PROBLEMS

WILL REMAIN

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New Oil Supply is a long run proposition subject to politics

(“all politics are local”)

Alaskan North Slope Gulf of Mexico Territories of the Former Soviet Union West Africa Venezuela Brazil Libya PG countries including Iraq, Iran and Saudi Arabia Global Warming and the Green Movement

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Oil and the Middle East:Four Possible Answers

9-11 heightened fears of terrorism, creating “uncertainty” but not fundamental

Only superficially. Key is expanding capacity

Yes, because it is the cheapest barrel and the reserves are known

Inevitably, the geopolitics of energy cannot be avoided

Does 9-11 explain recent oil market moves?

Do the current problems in Iraq explain the oil market?

Is the world going to be more dependent upon Middle Eastern oil?

What will this mean for U.S. Middle East Policies?

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“oil is a greasy business”Calouste Gulbenkian as quoted in The Seven Sisters

Calouste Gulbenkian: “Mr. Five Percent,” long ago discovered a basic truth about oil. Oil generates a great deal of money. The “pen may be mightier than the sword,” but money trumps the pen!

Jessup’s Law: politicians can’t handle the truth because they fear their electorates. The result is almost always an inferior solution to an energy dilemma

The “CRIC”cycle (courtesy of Robert Feldman) applies to Energy Policy in the US Crisis Response Improvement Complacency

Www. ecomentary. com 1 Economics, Demography & Oil What’s Going On? 10/14/04.

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