Think oil prices are high? You ain't seen nuthin' yet
By Jeffrey Rubin, chief economist and managing director of CIBC World Markets
The Globe & Mail, September 23
By any measure, the rise in crude prices over the past 19 months qualifies as an energy shock as great if not greater than either 1973 or 1980. In fact, this summer's rise in gasoline prices is the greatest on record.
So too, may be the spike that awaits home heating oil this winter. And unlike past energy shocks, natural gas prices have climbed almost as much as crude.
But clearly the most troubling aspect of today's energy crisis is the supply context in which it has occurred. Whereas in the past, oil shocks have been triggered by the Organization of Petroleum Exporting Countries turning off the tap, this time around crude prices are skyrocketing with the tap wide open. Instead of a temporary blip in prices, we seem to be on the threshold of a new era of energy inflation.
Despite the latest 800,000-barrel-a-day increase from OPEC, crude prices continue to soar while inventories languish near record lows. That's finally forcing the market to question its complacency about energy supply. The prevailing notion that the world is awash with cheap oil is largely based on the assumption that OPEC is sitting on endless reserves of crude. Yet, with every passing OPEC meeting, it's becoming increasingly obvious that even a fully accommodative OPEC can't keep pace with global demand.
Since March, OPEC has boosted daily production by no less than 3.2 million barrels a day. With the exception of Saudi Arabia, Kuwait and United Arab Emirates, the rest of the cartel is already running at full capacity. Even with Saudi Arabia and its Persian Gulf neighbours, surplus capacity for OPEC is no more than another three million barrels a day -- less than what the cartel has already raised production this year. At current growth of about 1.5 per cent a year, global energy demand will exhaust that capacity within two years. Once that point is reached, demand must be rationed purely by price.
What about the prospects of new supply from outside OPEC? Production outside of OPEC still accounts for roughly 60 per cent of global production. Historically, it's been the boost in production outside the cartel that has unwound past shocks. Non-OPEC production rose 4 per cent a year following the 1973 shock and 3 per cent following the Iranian revolution.
This time around, there has been less supply response. Despite a near tripling in spot crude prices, non-OPEC production is up less than 1 per cent a year since the beginning of 1998. That response flies in the face of one of the canons of conventional economic theory, namely that rising prices bring greater supply.
There is nothing wrong with the theory of an upward sloping supply curve, providing of course, the supply physically exists. Unfortunately, for oil, that's a faulty assumption, with the exception of a handful of Persian Gulf producers. While the region's current reserves are being stretched, the Middle East still has substantial deposits that have not yet been exploited.
For the rest of the world, production may have already peaked and will decline steadily over time. North America, for example, reached the zenith of its production in the early 1970s -- it's been downhill ever since. Today the region actually produces 25 per cent less oil than it did in 1973. And North America is by no means unique. Even North Sea production should peak this year or so.
If Western consumers feel uncomfortable with OPEC's 40-per-cent share of global production, they're going to feel a lot more uncomfortable in the future.
As non-OPEC production begins to decline over time, future demand growth will require the rapid development of new Persian Gulf fields. Over the next decade or so, OPEC's share will rise steadily, possibly reaching as high as 60 per cent of global production.
How high oil will rise in the interim will depend largely on how quickly those reserves can be exploited. At a minimum, crude prices will go through $40 (U.S.) a barrel this winter, a level from which they are unlikely to retreat.
Barring a global recession that crunches energy demand, OPEC production will peak in the next two years. If you think prices have spiked now, wait till you see what happens then.
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