Are high oil prices here to stay? The answer is probably yes. Demand growth remains strong despite a doubling of the oil price over the past eighteen months. And supply is constrained by capacity bottlenecks upstream and downstream. After twenty-five years in which the industry has struggled with the problem of surplus capacity, the oil market is now being driven by the over-riding need for more investment rather than cost minimisation.
The change is profound. Oil is a capital-intensive business with high fixed costs and low variable costs. When there is spare capacity available, supply adjusts quickly and cheaply to changes in demand making it difficult to defend prices or sustain margins. But when capacity is tight, supply becomes much more rigid and prices rise sharply in order to signal the need for new investment and to discourage demand for the scarce commodity.
None of this is surprising. The basic economic principles are well understood by all in the industry. What is surprising is the scale and persistence of the price changes that are taking place and the slow response of investment to the new price environment. At $60/bl, crude oil prices are far above the fully-built up cost of finding and developing even the most expensive source of oil liquids supply. Yet companies remain reluctant to boost upstream expenditure in response to the higher oil prices and Opec seems unwilling to compensate for the shortfall.
The major oil companies still use a hurdle price of around $20/bl to test the viability of new upstream investments and are only prepared to relax this rigid constraint (a little) for projects with a quick payback. After being accused by their shareholders of destroying capital when oil prices plummeted to $10/bl at the end of 1990s, directors are unwilling to risk investing in long-term projects that require a higher hurdle price. As a result, there seems little prospect of a strong supply-side response to higher oil prices from the international oil industry.
But the problem is not just a question of attitudes to risk. It also reflects a lack of opportunity. The distribution of global oil reserves is very unequal. Most of the world’s oil reserves are contained in a very small number of very large oil fields. Around 94% of the known oil reserves are concentrated in 3% of the known oil fields and most of these very big oil fields are in the Middle East. Even though there are more than 35,000 fields in production, half the world’s oil supply comes from around 120 very big oil fields.
If these very large oil fields were allowed to produce to the technical limit of their geological potential the price of oil would only be a few dollars a barrel – which is why the industry and Opec have always sought to control their development so that the rest of the world’s oil industry could remain in business. The history of oil is a succession of agreements to restrict the output of ultra-low cost oil from very large oil fields in order to protect higher-cost investments in smaller fields. Until now this has worked to benefit of all producers (although consumers have paid a much higher price as a result). After Opec member governments nationalised the upstream assets of the major oil companies – sparking the oil price crises of the 1970s – they took on the role of swing producer, allowing their production to fall as demand collapsed in order to slow the decline in oil prices in the 1980s. But this also enabled non-Opec producers to develop their higher cost oil reserves secure in the knowledge that Opec was not going to let prices fall too far.
During the 1990s, the cost of developing new non-Opec oil supplies effectively set a limit on how high oil prices could go as there were plenty of opportunities for companies to boost investment and expand production if oil prices rose. But the scope for additional investment became much more restricted with the start of the new century. Production began to decline in more of the mature non-Opec provinces as new discoveries failed to replace reserves. Although new fields were still being discovered, the average size was getting smaller and there were only a limited number of new areas where large new fields might be found. Outside the former Soviet Union, non-Opec conventional oil production has levelled off – leading some to predict a peak in total non-Opec oil supply by the end of this decade.
Now it is doubtful whether non-Opec producers can respond in the same way to higher oil prices. Although companies are still investing heavily upstream and there is a long list of new projects set to come on stream during the rest of this decade, it is becoming very difficult to find additional projects or to speed up the pace of development. Most of the big new developments are technically-complex deepwater offshore projects and construction yards and drilling rigs are close to full utilisation already. At the same time output has either passed or is close to a peak in many established provinces, creating a growing capacity deficit that has to be filled by new fields before non-Opec production can rise. More investment may slow the decline and extend the life of an individual oil field, but it cannot restore capacity to its former peak.
Looking forward, the balance of power in the oil market appears to have shifted permanently in favour of Middle East producers – as long as global oil demand continues to expand faster than non-Opec supply. Nearly two-thirds of world known oil reserves are concentrated in the Middle East – primarily Saudi Arabia, Iran and Iraq – in countries that remain largely closed to foreign investment by the international oil industry. In the past, competition between these three countries for market share periodically threatened to undermine oil prices but this threat is greatly diminished because of the continuing unrest in Iraq and the absence of spare capacity in Iran.
For the past twenty-five years, Opec countries have had little incentive to invest in expanding upstream capacity. With strong competition from rising non-Opec supply, Opec’s priority was to agree how to share out the remaining market between its members in order to prevent competition from eroding prices. But stronger demand growth and a slowdown in non-Opec supply this decade has unexpectedly eliminated most of Opec’s long-standing capacity surplus – forcing members to consider spending more of their oil revenues on expanding upstream capacity. So far the response is muted. Saudi Arabia – which has the greatest potential by virtue of its huge oil reserves – only plans a net increase of 1.5mn b/d by 2009.
Without effective supply-side competition from non-Opec producers to limit oil prices on the upside, it is no longer clear where oil prices will settle. Although Opec claims to be concerned about the effect of high oil prices on demand, the Organisation appears to be quite content earn $50/bl rather than $25/bl as long as this does not provoke a global economic recession or a collapse in demand. If Opec expands upstream capacity too fast, it risks undermining these windfall gains if its members start to compete amongst themselves for market share once a margin of spare capacity opens up again. It makes perfect sense therefore to spend the minimum necessary on upstream investment to expand capacity just enough to prevent a damaging price spike and to let oil prices rise to the highest level that the global economy can stand.
"there seems little prospect of a strong supply-side response to higher oil prices from the international oil industry"
That price could be very high indeed. Oil remains the most important source of primary energy and still has no effective substitutes as a transport fuel. Unlike the 1980s – when oil demand collapsed as a result of global economic recession and widespread switching away from oil in power generation and household heating – oil demand (so far) seems much more resilient to rising oil prices. Although crude oil prices are at record levels in nominal terms, they are still well below the $80/bl peak reached in real terms during the 1979 crisis after the Iranian revolution. In addition, the general increase in wealth in the developed world since the 1980s means that cost of oil now represents a much smaller share of both personal and national budgets so it may require a higher price to have the same impact on demand.
Oil also plays a unique role in global economic development. Unlike other fuels it provides a compact and highly portable source of energy that is particularly well-suited to a developing economy that lacks the necessary supply infrastructure required to distribute natural gas or electricity. Last year, oil demand grew more strongly than it has done for 25 years fuelled by a booming global economy and the accelerating development of the world’s most populous countries, China and India. At present, their oil consumption per capita is very low, but – like the United States in the 1920s and western Europe and Japan in the 1960s – this is rising as China and India become wealthier and more industrialised. Over the past five years, oil demand has grown at an annual average rate of 8% in China and nearly 4% in India.
Taken together, the constraints on upstream investment – for both Opec and non-Opec – and the renewed potential for strong demand growth as economic development in Asia takes off, paint a very bullish picture for oil prices over the rest of this decade. This does not mean that oil prices will necessarily remain high as there is a huge gap between the price that is required to limit demand growth – possibly as much as $100/bl – and the price that is required to justify new upstream investment – probably as little as $15/bl. If oil demand slows too rapidly or if a major new source of supply – such as Iraq – suddenly emerges it could be difficult to stop prices falling back towards the bottom end of the range. But there is rational case that can be made for an extended period of sustained high oil prices if Opec does not get too greedy and no easy substitute becomes available for oil as a transportation fuel.
Paradoxically this strong medicine may be just what is required. Despite fears to the contrary, the world is not about to run out of oil. But there is a limit to how much oil production capacity can be sustained and there is certainly not enough oil for everybody in the world to use it as intensively as the industrialised world does today. If Chinese consumers were to match US consumption per capita, global oil consumption would almost double from today’s levels. Huge gains in energy efficiency will be necessary if the oil industry is to accommodate the needs and aspirations of both the industrialised and the developing world– and high oil prices provide a strong incentive to make those improvements.
Interestingly, consumer governments now appear to accept the inevitability of higher oil prices. Although there are complaints about rising prices and worries about the impact on economic growth, Opec has so far escaped strong political pressure to bring prices back down to the consensus levels of the past decade. With growing concerns about global warming and the need to take action to limit carbon emissions, energy efficiency is back on the agenda. And environmental concerns are being reinforced by strategic considerations. Even the United States is worried about its dependence on Middle East oil and seems willing to pay a higher price for oil if this will help to limit imports from what is now seen as a politically unstable region.
The era of cheap oil may well be over. A structural change is underway that will shape the behaviour of oil prices for at least the next decade. The economic development of Asia requires increasing amounts of energy that the oil industry will be hard pressed to supply. Competition between the industrialised world – especially the United States – and the developing world – especially China – for oil supply is already a key factor in driving up and supporting high oil prices. Only the Middle East has the oil reserves to satisfy both. But if the owners of these reserves choose not to develop them to their full geological potential because they can earn more by restraining development, then oil prices can only remain high.
This article was published in Oxford Energy Forum (August 2005) as a contribution to a debate on oil prices and fundamentals.