The price of oil


The price of oil[1]


 Dieter Helm

3rd December 2014


The recent falls in oil prices have come as a shock to many. Only a few months ago, the IEA and many other mainstream forecasters predicted the price would gradually go up. This fitted with the political assumptions that lay behind the dash for wind and current generation solar across Europe, and the Energiewende in Germany.


Go back a bit further, and the fashion was to believe in peak oil. Finite oil supplies would not keep pace with China and others’ growing demand. There would be an ever-rising oil price as a result. Fossil fuel dependent countries would be in for a tough time.


Suddenly it is all changed. Even the IEA has changed its tune. Europe’s dependency on Russia looks less worrying, whereas oil (and gas) producers like Russia are in real trouble as revenues fall away. Renewables which were supposed to be cost competitive by around 2020 are looking likely to be out of the market for a long time to come, as indeed does new nuclear.


Markets – and prices – work


The reasons for the recent price falls are not hard to find. Prices work. It is all about supply and demand. The gradual rise in prices since the low of $10 in 1999 to over $100 a barrel has worked its way through the market. As the oil price goes up, more and more energy efficiency measures become economic. A rise in price raises the net present value of energy efficiency investments. Other things being equal, a rise in price reduces demand. That is precisely what has happened: demand in Europe and the US has fallen.


It is true that Chinese demand kept going up despite the higher prices. The historically unprecedented catch up in China over two decades increased the demand for all commodities, and triggered the commodity super-cycle. The offsetting factors have however finally ran their course, and China is visibly slowing. Chinese demand for all commodities has tailed off as a result.


If demand has fallen back, supply has also done what it is supposed to do when prices rise. The development of shale oil and gas in the first decade could not have happened without the rise in oil and gas prices, just as the North Sea offshore oil industry could not have got going when it did without the price increases of the 1970s.  High prices spur innovation in E&P and fossil fuel technologies – and they have spectacularly.


The result was that, contrary to all the predictions of the peak oil advocates whose theory was based on claims about US peaks and declines, the US has had the fastest growing oil production in the world, and the fossil fuel revolution in the US has as a result transformed world energy markets. Even the Saudis are feeling the pain.


New supplies are not confined to the US. Around the world high prices triggered the search for new supplies. It has turned out that the earth’s crust has plenty of oil and gas left, that R&D is not confined to non-fossil fuels, and that there are physically abundant supplies for decades to come. The problem is not an imminent shortage of oil and gas, but rather a super-abundance – enough to fry the planet many times over.


OPEC is unlikely to come to the rescue


There is one final argument for persistent high prices. It is claimed that OPEC will come to the rescue. Since the oil producers have squandered the revenues from the price increases, they now need high prices to keep on buying off their populations, especially in the Middle East where Arab Spring revolutions in several countries has scarred authoritarians and dictators. It is claimed that many of the key players need a price of $90 a barrel or more.


The idea that because of the waste and corruption and populist spending, these countries can therefore enforce a particular price on the market is nonsense. A price can only be imposed if they all agree, they all actually cut production and the consequences of their behaviours is not to cut demand and increase non-OPEC supplies. None of this is likely to be true.


The first point to note is that OPEC’s market power is waning. The US (and North American) production has transformed the market. The US is still over 20% of global GDP. Half its trade deficit was oil and gas. Now the US and the rest of North America are well on their way to rough energy balance. That is an enormous withdrawal of demand from OPEC. Europe is also reducing demand and economic growth is flat. China is slowing down and developing alternative supplies.


It is now much harder in theory for OPEC to call the market. But even if it did want to fix the price, the mechanics are also a whole lot harder than they were in the 1970s, the last time it really had much impact. There are two myths about OPEC. The first is that Saudi Arabia can on its own increase or decrease production enough to make a difference. This is true now only in the very short term, and it would have to make a really big reduction to offset other increases, it would make a big hole in its budget and the result would be to encourage an even faster diversification away from it, notably by the US.


The truth is that Saudi Arabia needs the US more, as the US needs the Saudis less. For the first time in decades, Saudi Arabia faces a real threat to its Middle Eastern dominance. The Sunni-Shia divide is altogether sharper and nastier than before, and Iran is challenging Saudi Arabia for regional dominance. Iran effectively won much of Iraq when the Sunni Saddam Hussein was ousted. Iran supports the Syrian Alawites against the Sunni insurgents, and the religious pack between the more extreme Wahabis and the (now aged) Saudi royal family has become horribly exposed by ISIS in northern Iraq.


For Saudi Arabia to have a big impact on price, it would need others to cooperate. But why would they? As the price falls, there is a scramble to balance budgets and hold up expenditure to keep a lid on unrest across the Middle East. The response to a fall in revenue is to increase supply, making the price fall even bigger. Discipline in a cartel is much easier when the fundamentals are tightening a market. It is pretty hopeless when the price cracks, and hence production cuts have a big impact on revenues. The others are not going to cut back, and those of the fringe of OPEC like Russia now desperately need the money.


More oil to come


For those who still think that OPEC controls the market, it is sobering to think that the price of oil has fallen in the context in which the scale of the political upheavals has rarely been bigger, and the violence and disorder worse. Looking across the main producers, corruption and inefficiencies in Russia have taken their toll on its infrastructures. Its political conduct and revisionism have weakened the faith in its customers. In the Middle East, wars are taking place in Syria and Iraq. Iran remains a pariah subject to sanctions. Libya has split into at least two parts and has no effective central government. Nigeria is the scene of daily horrors and its control over piracy and corruption is limited. Venezuela’s oil industry has suffered form the terrible Chavez years. And so on.


Even with all this going on, the world’s demand is easily supplied. It is hard to think of anything worse that could happen, except perhaps a revolution in Saudi Arabia, and even then any revolutionary new government would need to keep pumping the oil to keep the money flowing. (Even ISIS relies on oil revenues.)


There is much more potential to come. Two sources stand out. First there is the capacity of Iran and Iraq to ramp up production. It would be hard for either to produce less than they do now. Both have enormous very low cost reserves, and both could in theory produce much much more. Indeed both could one day join Saudi Arabia, Russia and the US in producing 10 million barrels a day. That may be a long way up, but the risks are asymmetrical – hard to reduce output, easier to increase. It is not fanciful to imagine that the US-Iran relationship could gradually thaw, and eventually the old alliance could be very slowly restored. The removal of sanctions would make a big difference, and the US finds itself on the same side in Iraq (against ISIS) and it needs Iran to deal with the problems in both Syria and Lebanon.


Second, the fracking genie is out of the bottle. Lots and lots of countries will apply the new technologies. Some of this will be gradual and largely unnoticed outside the industry. More will be got from existing conventional reserves, and gradually new reserves will be opened up. There is no shortage of shale reserves around the world.


To these two further supply side boosts a third more longer term one can be added. The power of technical progress, when incentivised by the price, should never be underestimated. In the 1970s, drilling in the shallow North Sea was pioneering stuff, spurred on by higher prices. In the 2000s, it was shale, spurred on by higher prices. Further out there are two major technical frontiers – deep water offshore, and low cost renewables.


Deep water offshore, such as the Arctic, are frontiers because the platforms are on the surface and exposed to ice and cold. This need not be the future. Seabed platforms are possible, though getting electricity to power them underwater is a huge challenge. But it would be foolish to write off the Arctic because current technologies make it prohibitively expensive. It should be remembered that the scale of the conventional reserves is very large.


Leaving it in the ground


The longer-term threat to oil is that it may be uncompetitive against new renewable technologies. Wind and current generation solar present little challenge: they cannot generate enough useable energy in a dense enough form at a low enough cost to make much impact. But new technologies might do the trick, and if they did then demand for oil may gradually decline, leaving a lot of the deposits in the ground.


These new technologies are coming thick and fast, and the possibility of out competing oil is not as fanciful as many oil producers would like to believe. Opening up the light spectrum, using graphene for fuel cells and solar, new applications like solar film – these are just some of the many possibilities coming out of the universities in research laboratories. There is no shortage of solar energy potential: it is capturing it that is the technical challenge.


Even those of the producers who see the threat argue it will not happen for decades. But again this may be wishful thinking on their parts. The IT revolution took only two decades to transform the world’s production and consumption. Technical progress may have been extremely slow in the uses of oil, gas and coal over the last 100 years. That was because it was so cheap.


The possibility that demand rather than supply may have peaked, and that demand for oil might stagnate and even eventually fall is spurred on by the concerns about climate change, and more importantly the desire of governments to do something about it. Carbon prices tilt the balance a bit the other way, and emissions performance standards impact directly on demand. Keeping the price of oil low might delay the process, but it is unlikely to stop it.


For many bright young researchers in the universities, their commitment to develop new low carbon energy supplies is a further source of optimism about technical progress, and their motivation is exogenous to price. It is the one bit where the market’s reach is limited. The likely product of this research is very large, and indeed is already producing a bewildering number of options and opportunities.


Taken together, these various factors point to the possibility that the price of oil might be on a medium to longer term declining path. There will almost certainly be price spikes, but as with the price spike during the first Gulf War in 1990, it would be a mistake to confuse spikes with trends.


The implications


It is remarkable how little consideration has been given to a falling oil price scenario – not least by the IEA who regularly predict the opposite (indeed, last time around at the end of the 1970s, the IEA projected continuing rises in prices right through the 1980s and was consequently spectacularly wrong).


There are several likely impacts – a large economic stimulus to oil importing countries; a large economic shock to major producers; a big change in the relative costs of current generation renewables; and a negative impact on nuclear.


The economic stimulus of a halving of oil prices is enormous. It compares with the QE type measures and the fiscal deficit spendings of the post crash world of the period from 2008 onwards. In addition to the immediate impacts on consumers who have to spend less to fill the tanks in their cars and heat their houses, there are lots of indirect impacts as the costs of production throughout the economy. Governments will get less in oil taxes but more form higher consumer spending. There will also be benefits from improved trade balances. For the US and Europe, the aggregate impacts are considerable.


The impact on the oil producers is likely to be big too. Having become addicted to the oil revenues and ramped up spending to buy off their populations, they now face very painful retrenchment. Some – Venezuela, Russia and Iran – are very exposed. Putin in particular will find it hard to come to terms with the economic conditions last experienced in the 1990s, and may have to ramp up nationalism and border wars to keep a grip on power. Venezuela is already bust. Iran will need to increase output and escape the grip of sanctions as revenue falls.


Saudi Arabia has lots of reserves, as do a number of the Gulf states. But even here the falls in revenue will be serious, and the room for maneuver restricted. Though they will not quickly fall back to their “former littleness”, they may find themselves having to court new customers – like China – in a less auspicious bargaining position. Coupled with the gradual moves toward a degree of energy independence in the US and North America, these countries may find themselves much less politically important than they have assumed. Without the US defense umbrella, their vulnerability to a variety of threats will increase.


In the narrower energy world, the biggest immediate impacts are on the current expensive renewables, and in particular on the EU’s renewables policies. The assumption when European leaders signed up to the Climate Change Package in 2008 was that fossil fuel prices would keep going up, and so by around 2020 the renewables would cost competitive, and the US would be in competitive trouble because of their addiction to what by then would be very expensive fossil fuels.


They got it spectacularly wrong. Just as the ink was drying on the new directives, shale oil and gas was getting going. Now the renewables are further and further out of the market, as first coal, then gas and now oil prices fall away. There is a widening gap between the Feed-in-Tariffs and other mechanisms to guarantee prices, and the underlying fossil fuel costs. Before the US expansion of production hit oil and gas prices, it had helped to push down the price of coal. The Europeans as a result have witnessed a dash-for-coal, and now emissions are rising in Germany and the UK.


The result is that the subsidies that were supposed to wither away will have to be permanent. Investors in these expensive technologies will therefore have to rely for the foreseeable future on governments forcing customers to pay, and industry faces a widening competitiveness gap. Governments may see falling fossil fuel prices as offsetting the price increases renewables would cause, but voters may take a different path. Already the Europeans have had to retreat form another nationally binding renewables target for 2030.


For nuclear, the risk is that the 2020s will turn out a lot like the 1980s. The great expansion planned for France and the UK in the 1980s and 1990s were predicated on rising oil and gas prices. The political leaders at the time thought that the oil price in 1979 ($39 a barrel) was a floor not a ceiling. It turned out that the 1979 price would only once be seen again – very briefly – and that for almost all the next 30 years it would be significantly below in real terms (at around $70 now it is significantly less than half the real level in 1979). The French nevertheless held the course, whilst the British project of building one a year for 10 years, starting in the mid 1980s, produced only one.





It is often hard for politicians to comprehend points of substantial structural change when they are living through them. The reason is that they are almost always prisoners of the past. They live in the world of yesterday – and in the energy world this is one of peak oil, volatile and rising prices. Worse, they tend to cling onto the past, because the decisions they made can then only really be justified in the world they assumed would go on indefinitely.


A glance through the speeches of Barroso, Hedgeard, Miliband, Huhne and Davey reveals the certainty that they had. Davey in particular kept warning of the risks of rising fossil fuel prices, and he was proud of protecting customers from volatile gas prices. They will not now thank him for protecting them from the advantages of lower prices – but this was something he never really contemplated.


The most important policy conclusion is that future policy should be grounded in humility and not an asymmetrical and self-serving assumption that prices can only go up. An energy policy that is defined upon knowing the future energy price is always risky, and the consequences are all around us. A better assumption is that prices and markets work: high prices reduce demand and increase supply. That is precisely what has happened. In due course, low prices will increase demand and reduce supply, but cycles take a long time in energy markets to work themselves out, and in the meantime technical change might radically change the game. It would be better therefore to concentrate on the R&D, and waste less on expensive technologies that were always unlikely to be cost competitive, and now should be treated for what they are – stranded assets.





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