Saturday, October 13, 2007

One Decade into a New Era

Monthly oil price chart from
By Peter McKenzie-Brown

Ten years ago, oil prices hit their lowest levels in two decades, and pundits proclaimed that an era of lower prices was here to stay. Industry insiders felt that not even OPEC could help the world’s producers. Prices had plummeted because of increased production from Iraq, lack of demand growth in an Asia struggling to recover from an agonizing economic crisis, and high world oil inventories following two unusually warm winters.

In addition, OPEC's members were cheating on their export quotas, and large new volumes of oil were flowing into world markets from such non-OPEC countries as Norway and Russia. The oil industry had given up hope that prices might rebound. The chairman of Royal Dutch/Shell unveiled a five-year plan that assumed a price of $14 a barrel; he then began to muse about oil at $11. BP began working with similar assumptions. Algeria’s oil minister was so worried about the inability of OPEC to cut production that he raised the spectre of $2-a-barrel oil.

Drowning in Oil: So pervasive was the general oil-price pessimism that in March, 1999, one of the world’s most highly respected business magazines, The Economist, issued a special 20-page supplement about the prospects for crude oil. The magazine’s lead editorial described “A world drowning in oil.” With spectacular bad timing, the publication argued that crude oil prices could drop to US$5 because of a glut in world supplies, and suggested that nothing could save the price of oil. “Crude is gushing from the ground at the rate of 66m barrels a day, half as copiously again as in OPEC’s prime. The world is awash with the stuff, and it is likely to remain so.”

As The Economist hit the newsstands, OPEC began to bring new discipline to world crude markets. The cartel pledged its third round of production cuts in just over a year, thereby reducing exports during that period by 4.3 million barrels per day. In addition, the organization negotiated coordinated cuts by other major oil exporters – Russia, Mexico, Norway and Oman. The cartel and its co-conspirators (except Russia) stuck to their guns, and a new bull market began.

Three Eras: In my view, the rise in oil prices over the last ten years reflects a third era in the petroleum industry’s 160-year history.

 • The first period lasted from 1860 until about 1970; call it the “era of growing surpluses”. During that time, the key events in oil pricing had mostly to do with new discoveries and other events that increased production. In other words, the events affecting crude oil pricing reflected increases in supply. There was a general decline in real oil prices, because the amount of oil available was steadily climbing.

 • What we might call the “era of energy price shocks” lasted from 1973 until almost 2000. Three price shocks – each a combination of geopolitical events and market forces – helped drive oil prices. The first two shocks were the price spikes of 1973 and 1979-80, which were responses to events in the Middle East and OPEC’s control of supplies.

Then market forces – less demand from the world’s consumers combined with increasing production, especially from OPEC producers – asserted themselves. In 1986 this led to the third shock – a rapid collapse of oil prices. Oil prices did not begin to recover until near the end of the millennium.

 • The third period began a decade ago; we can call it the “era of tighter supply”. Virtually all observers agree that prices have been steadily rising because oil supplies are “tight” – that is, there is little surplus oil supply to compete for existing demand.

Much of the reason for this strong demand is the powerful global economy, which demands ever-greater supplies of oil. In such a seller’s market - the petroleum industry is producing 30 billion barrels of oil per year but only discovering ten billion - there is not enough competition among oil producers to drive prices down, or keep them at lower levels. As a result, geopolitical events and concern about the availability of oil supplies are having strong impacts on crude oil prices.

Many factors are now in play. These include war, terror and political instability; industrial incidents like plant and pipeline failure; storms and abnormally high and low temperatures; rapid economic growth in the developing world; industry reports and financial news and rumour, especially as they apply to oil demand and supply. During the era of tighter supply, these factors can be powerful short-term forces driving changes in crude oil prices. Rarely before has this been the case, and never before could seemingly small incidents trigger such large price movements.

Peak Oil: This summary of the oil ages does not mention peak oil. The reason is that we have not entered that fateful period yet. Whether it arrives next year or next decade, it will represent something fundamentally different from our experience today. In the era of tighter (though still growing) supply, the world can carry merrily on. Just pay more and get on with it. In the fourth oil era, all the rules will change. We won’t be able just to pay more for our oil. Because of the nature of the beast, we will have to learn to use less. The chart at the beginning of this post shows the astonishing growth in oil prices during a decade of gathering scarcity. You ain’t seen nothin’ yet.
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