Tuesday, August 26, 2008

Chatham House Report.

I just posted this on a forum where I'm a member, and though I would re-post it here.

The Coming Oil Supply Crunch
A Chatham House Report
Paul Stevens

Executive Summary

...unless there is a collapse in oil demand within the next five to ten years, there will be a serious oil "supply crunch..." [where] excess crude producing capacity falls to low levels and is followed by a crude outage leading to a price spike.

Most conventional forecasts expect a very large increase in the production of liquid fuels. However, these forecasts simply assume this will be forthcoming...[but] the expectations are likely to be disappointed.

The willingness of the IOCs [that is, "International Oil Companies." This author also uses NOCs to indicate "Nationalized Oil Companies."] to invest is constrained by the adoption of "value based management" as a financial strategy. Thus they are returning investment funds to shareholders rather than investing in the industry...

NOCs are...starved of funds...and also experiencing a resurgence of resource nationalism...[and] rising domestic oil consumption is eating into the ability to export. Investment in developing oil supply is inadequate and likely to remain so for the foreseeable future.

...a supply crunch appears likely around 2013...it will quickly translate into a price spike...a price spike of over $200 is possible...

...Energy policy needs to reduce the demand growth of liquid fuels...[but] only extreme policy measures could achieve a speedy response - and these are usually unpopular...


Unless there is a collapse in oil demand sometime within the next five to ten years, the world will experience a serious oil supply crunch...

..an oil supply crunch is defined as a situation where excess capacity falls to low levels and there is some form of outage which leads to physical shortage and triggers a price spike...

Oil Market Context

...Today various pundits are talking of prices at levels ranging from $150 to $200 [April 2008]...

...India and China...[are subsidizing their citizens gas prices]...one of the reasons why current oil demand growth has not fallen in the face of such high international prices and indeed why much of the growth in oil demand in the last two years has come from these countries...

...Saudi oil minister, Ahmen Zaki Yamani...effectively signaled to the IOCs that their future access to the reserves of the major producing countries was to be limited...[resulting in] a gradual reduction in supply to consumers to prevent them from redirecting oil to their sanction targets...

Together, economic growth and low prices created very strong oil demand growth...[but] since 2002, without the former Soviet Union (FSU) - mainly Russia - non-OPEC growth would actually have been negative.

Security of supply is back on the agenda. It has become a major driver of energy policy...[and] resource nationalism...[which is] nations wanting to make the most of their endowment.

This report assumes resource nationalism to have two components: limiting the operations of private international oil companies, and asserting greater national control over natural resource development.

The drivers of resource nationalism are many...[one is] by national independence and the end of colonialism...[another is] by the perceptions that the resource will be needed for domestic uses, or by a belief that the potential customers are somehow "unworthy." Yet another driver is the perception among ordinary people that they have seen little or not benefit from the extraction of their oil and minerals...

..Oil demand has continued to gown in the face of such high prices.

Energy demand is a derived demand: consumers are not interested in the fuel per se, but in energy as a source of light, heat and work. To get this, usable energy must be converted into useful energy by means of an energy-using appliance.

[Hold that thought, I'll get back to this issue at the end of these excerpts.]

While some reduction in capacity use in the form of conservation is welcome, real reduction requires deprivation, which is undesirable.

...Oil is burnt largely in the transport sector, for which there ar as yet relatively limited alternatives.

...There is also an issue of affordability thresholds...[and] this issue of non-linearity of own price demand elasticity is not well captures in much of the empirical literature.

[See below.]

Today, it is difficult to see where new potential on such a scalre might lie...

...conservation, fuel-switching and increasing energy supplies are all areas riddled with market failure which requires governments to intervene. Left to the market they will not happen, or at best happen very slowly. In addition, many of the necessary interventions are politically unpopular. Thus in the current situation there as not yet been any significant government intervention to reduce demand or increase supply.


There is virtually no discussion of the willingness or ability of the producers to invest in order to be able to produce at [the new, higher] required level. The willingness and ability of oil producers, whether IOCs or NOCs, to deliver on these numbers must be in question. It is this which creates the argument of an impending supply crunch.

The performance of a company is measured by the return to the shareholders...[not consumers].

...this led to heavy focus on production growth, cost-cutting, operational efficiency and short term profitability.

As far as future supply growth is concerned, this aggravates an already difficult situation.

Currently there appears to be a growing view among major producing countries that option 1 (ie leaving it in the ground) is the most attractive. This is causing many producer governments to revisit their capacity plans. ...the only exception to the "leave it in the ground" approach among large oil exporters appears to be Saudi Arabia, and even here the oil minister indicated in public on a number of occasions during April 2007 that there were no plans to go beyond 12.5 mb/d.

Leaving aside willingness, the IOCs abilities to increase production face several constraints. As already indicated, a key problem is their inability to access low cost reserves. Over 50% of global proven oil reserves are in four countries - Iran, Iraq, Kuwait and Saudi Arabia.

At the same time, growing resource nationalism and a revival of the "obsolescing bargain" within many oil producing countries is further limited their access to acreage.

One of the consequences of value based management has become an obsession with maximizing share prices. A key tool in this pursuit is trying to cut costs and reduce working capital. One result has been the shedding of manpower on a massive scale...the 25 largest IOCs gave got rid of almost one million workers... Today the real corporate constraint for IOCs is manpower rather than capital. This is likely to get worse in the near future. It has been estimated that within the next 10 years half the current workforce of the international oil industry will retire.

New projects have become horribly expensive, and many have been put on hold in the hope that future conditions will be more favourable. ...Upstream costs for developing new oilfields have more than doubled in the last four years (Yergin, 2008). Some elements of cost have increased even further. A deep-water drill ship costing $125,000 per day in 2004 today costs more than $600,000 per day - even assuming there is one available.

Many NOCs are being starved of financial resources which seriously inhibit their ability to develope their producing capacity.

If, therefore, the IOCs are excluded because of resource nationalism, this will inhibit the ability of many producers to expand their producing capacity or indeed maintain it at its current level.

Whether public or private, petroleum-producing firms are likely to maximize their revenues from petroleum production and sales, but this target may conflict with the goals of the government, which may prefer to increase its own fiscal revenues for non-oil purposes, or even allocate part of the oil rent in subsidizing energy prices for domestic consumption, or in encouraging labour demand from the petroleum sector.

The world oil markets are interested in the oil exports from producing countries rather than their actual production levels. Therefore domestic consumption is an important factor. ...Domestic oil consumption has been growing strongly and there is little sign of the rising international prices slowing this trend.

Thus for many of the major oil producers, rising domestic consumption is seriously inhibiting their ability to increase their exports of oil into international markets.

Clearly, OPEC is failing to meet its own targets on capacity expansion for crude oil. This view is supported by any reading of the trade press... Part of the reason for this poor performance is that the natural decline rates in the OECD fields have taken analysts by "surprise." Furthermore, in many of the deep-water fields where much of the new non-OPEC capacity is coming on-stream, maintaining production is difficult because operations such as in-fill drilling are much more complicated and far more expensive than in traditional oilfields.

Tight market conditions have resulted in high oil prices over the last few years. However, exploration and production among international oil and gas companies has remained stagnant...[and] investment in developing oil supply is inadequate and likely to remain so for the foreseeable future.

In the near future, the industry will find its spare capacity to produce crude oil eroding close to zero and therefore any subsequent outage would trigger a price spike...

It is clear that higher prices are causing demand to slow, with an expected lag given that it takes time to change the nature of the fuel-burning appliances way from oil or to use less oil.

[Any chance all cars in the US will be converted to electric or hydrogen in 5 years, or even 10 years? No, class. No chance.]

In the sort of time period being considered in this report - five to ten years - only an economic recession could slow oil demand growth and it would take a major recession to actually reduce demand.

The demand projection also assumes there will be no major policy changes in the OECD aimed at lowering oil consumption other than those either in place or in the process of being put in place.

Even allowing for some increase in capacity over the next few years, a crunch appears likely before 2014. The message is clear. As the oil market approaches the end of this decade, spare crude producing capacity moves closer to zero. Any supply outage [or demand increase from any source] would therefore create a supply crunch.

The implication of the supply crunch projected...is that it will quickly translate into a price spike. This requires qualification. The IEA carries at least 90 days crude oil supplies in the form of stocks as part of its emergency response system. ...However, the IEAs past record of using stocks to smooth markets has not been encouraging. Moreover, the system has never been tested in the face of a serious global shortage and it can be argued that in that event it would be "everyone for themselves" and the system would rapidly break down.

[Also], since the start of 2007, there has been a growing disconnect between paper and wet barrel markets. [ie stock speculation] This behavior, of course, creates a self-feeding cycle, which is reinforced by the apparent (but illogical) connection between the dollar devaluation and rising oil prices. ...There could be in the near future a sharp downward adjustment in price to reconnect paper and wet barrel markets.

[We have just seen that occur, class, as prices went back down to the one-hundred-'teens per barrel lately. We can presume that the one-'teens is the base market price under current conditions as outlined in this study and in the press, and therefore market fluctuations will begin their adjustments from more or less this baseline value.]

Thus the base from which any supply crunch will lead to a price spike must be extremely uncertain. However, given recent price experience, a spike in excess of $200 per barrel is not infeasible.

Policy Implications

To avoid a crunch, energy policy needs to reduce the demand growth of liquid fuels, to increase the supply of conventional liquids or to increase the supply of unconventional liquids. Ideally, it should be some combination of all three.

[Here I would disagree. Time to wean ourselves off of non-renewable resources while we still have the economic ability to do so.]

However, when discussing policy it is important to remember the long lead times between applying any policy instrument and any significant supply or demand responses.

To reduce liquid fuel demand requires either greater efficiency or fuel-switching. In reality, both would probably take too long to be effective in the time frame suggested by this study. One a major recession in the short term could reduce demand growth and even then the probability is that this would merely delay the supply crunch.

How realistic is it to expect [OPEC or non-OPEC] sovereign governments to bow to [international] external pressure is a moot point.

Perhaps a more realistic and constructive policy option is to encourage a change in depletion policy to produce sooner rather than later...a carrot to increase capacity and create some surplus capacity.

[Good luck with that. Give us all the rest of your wine now, and well give you...what?...later. I wouldn't go for this, and I don't imagine most oil producing nations will go for it, either.]

Encouraging new sources of liquid fuels is another option though this itself is controversial. Biofuels are already provoking a public backlash because of their alleged role in pushing up food prices and the doubtful claims regarding carbon emissions. Tar sands, oil shale and coal-to-liquids all have environmental implications, not least in terms of their carbon emissions. Gas-to-liquids or compressed natural gas in the transport sector are much less controversial from an environmental perspective, but again the economics of such projects are debatable and they are also likely to suffer from long lead times.

[Not to mention they fail to solve the underlying inherent problem of relying on non-renewable resources in the first place.]

In reality, the only possibility of avoiding such a crunch appears to e if a major recession reduces demand - and even then such an outcome may only postpone the problem.

As the 20th century ended...the "trickle-down" mechanism, whereby everyone benefited, appeared not to be working. This disillusion with market forces was also linked into a growing anti-globalization movement, driven in large part by the sense of many in the emerging-market economies that they had seen little benefit from the process.

[Well, being exploited rarely benefits the exploitee.]

In energy, many were beginning to question that such a strategic sector could simply be "left to the market."

It is quite feasible to argue that a supply crunch leading to an oil price spike would be sufficient to break down some of the last vestiges of opposition to a much greater interventionist approach by governments in their energy sectors.

[Really, class, what this British economist is saying is that the only real chance of dealing with sustainability is to wait for the economy to get so bad, people are willing to allow the government to do just about anything to fix it - an invitation to fascism, in other words.]

Of course, this is not necessarily guaranteed to produce positive results.

[No - really?]

However, it seems clear that given the market failures associated with energy markets, governments must intervene to a much greater extent that they have so far been willing to do this century. ...What is needed is intelligent and informed debates about which energy policy interventions are desirable and which are not, and on what basis such judgments should be made.


That's the end of the report, the very last words which say, in essence, government should decide how it's going to step in and take control of destroying oil demand, becuase people will not themselves conserve and switch to mass transit.

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