Can this boom be sustained?
How macroeconomics and geopolitics are driving the price of oil
As the New Year kicked off with $100 oil, the murmur of recession and bust began to circulate throughout the industry. The economic slowdown of the early to mid 1980s influenced both the softening of demand for oil and the price per barrel. Now, with oil hovering around $100, economists and industry leaders are contemplating another downturn. Is $100 oil the harbinger of the next bust?
Although high energy prices can be characteristic of an economic downturn, there are critical macroeconomic and geopolitical influences currently at work that were not present at the last bust. As a result, the supply and demand dilemma is a primary factor contributing to geopolitical instability across the globe as both developed and emerging economies compete for the limited supply of oil. The combined effect of these factors support a prolonged boom in the oil market, but can world economies continue to increase consumption with oil at these prices?
The new demand
Economic development in China and India is often cited as the primary factor driving the increase in global demand for oil, but other developing nations are beginning to reveal their appetite for crude as well. In fact, EIA data show triple–digit demand growth in 17 countries from 1996 to 2006.
While the majority of these countries represent a small impact on total consumption, their marked increase in demand demonstrates that growth is achievable in a climate of rising prices. Furthermore, despite the relatively volatile governments of many of these nations, political instability does not appear to have hindered their increasing consumption of oil. The economic development of these nations, in addition to the demand of countries like the United States, Japan, etc., is nearly outstripping our global supply. In the mid 1980s, this type of exponential growth in demand was not present.
Today, the rapid economic development occurring worldwide is helping to sustain the relatively high price of oil. While the US may show signs of a slowing economy, it is unlikely anything but a prolonged worldwide recession would jeopardize this continued growth. However, supply issues also continue to be a source of uncertainty and speculation in the market.
Uncertain supply
The global quest for oil has never been more intense than it is today. Emerging economies are in fervent competition for the world’s limited supply of crude.
Although it is difficult to know the production capacity of the OPEC nations, we can make some reasonable assumptions. For decades, Saudi Arabia has been the swing producer of oil for the world. That country’s production capacity has been sufficient, in the past, for affecting both upward and downward pressure on the price of oil.
While high prices favor the oil–producing nations in the short term, the long–term ramifications can be negative. Inflated prices introduce alternative products by enhancing the economics for producing non–conventional oil such as tar sands, and to a lesser degree, the production and use of alternative fuels. In this way, it is in the oil–producing nations’ interest to maintain a moderate price for oil. However, when the world experienced record oil prices in 2007, OPEC production quotas remained unchanged.
Why has the strategy of maintaining a moderate price been altered? There is much speculation that Saudi oil production is approaching its peak just as US oil production did in 1970. As shown in Figure 1, world production began to plateau despite the continued increase in the price of oil. This could be an indication that increasing existing production is no longer a viable option.
While new oil discoveries continue, the quality and relative size of these discoveries pale in comparison to the giant discoveries of the past. Consequently, it could be difficult to meet global demand in the next few decades, and this tight supply situation is prompting geopolitical uncertainty.
The geopolitical fear factor
Geopolitical tensions are motivated by more than ideological differences. The global quest for resources is the underlying issue generating much of the world’s political unrest, and these tensions are having an immense impact on the price of oil.
For more than 30 years, oil has been used as leverage by the producing nations as demonstrated when OPEC embargoed the United States on oil in 1973–1974. As the world’s largest source of gross domestic product struggled to survive, global economies began to feel the pressure of the spike in oil prices. However, the embargo lasted only five months. Cutting off the largest consumer of crude also cut off the world’s largest customer. Despite elevated prices, the embargo was not feasible in the long–term. However, this circumstance could be changing.
Developing nations are increasing their appetite for oil; alternative oil markets could enhance the feasibility of a future embargo. Therefore, the possibility of political retaliation through an embargo remains a serious threat, and this threat continues to motivate the volatility of prices.
The rapid development of emerging economies and global supply challenges will continue to spur worldwide geopolitical uncertainty as governments continue to engage in fierce competition for oil, and as this uncertainty intensifies, high oil prices should be sustained. The boom is just beginning.
About the author
Jason Reimbold is vice president of The Theseus Group (www.thetheseusgroup.com), an energy M&A consulting firm based in Tulsa, Okla. In 2005, Reimbold founded www.GlobalOilWatch.com, an energy research portal for industry analysts and investors. In 2007, he co–authored The Braking Point: America’s Energy Dreams and Global Economic Realities (www.thebrakingpoint.com) with Mark A. Stansberry.