The World After Oil

10 august 2004

Vladimir Milov

Resume: There are no profound grounds for the statement that global oil prices will remain high for an indefinitely long time. Moreover, it looks like the days (or rather years) of oil as a leader among global energy sources are numbered.

 

World oil prices have been consistently high since the end of 1999; this is an unprecedented long period of time. This situation prompts an analysis of two questions: What long-term effects will high oil prices have? What will happen following the collapse of oil prices? The price for the main oil grades, including Brent oil, has been consistently exceeding $25 a barrel. This is causing the analysts to speak seriously about the start of a lengthy “era of high oil prices.”

 

Obviously, there are clear geopolitical implications for the price levels of the world’s primary source of energy. First, oil exporters (above all, the Middle East countries, with Saudi Arabia and Iran being the leaders) can seriously influence the global geopolitical situation. Second, oil prices introduce new forms of international confrontation which is rooted in the developed oil-importing countries’ struggle for control over energy resources (the Iraqi war is a graphic illustration). Third (this factor being particularly important for Russia), high oil prices give a renewed impetus of economic development for the transitional economies and emerging markets. Although the threat of the ‘Dutch disease’ is always present, these economies still have an opportunity to draw nearer to the most developed economies in the natural course of events. Finally, another factor affecting the redistribution of economic influence in the world due to high oil prices is the weakening of the economies of the world’s leading geopolitical nations, since the bulk of them are net oil importers.

Therefore, some countries entertain high hopes on oil prices, while others anticipate stagnation. How justified are these prospects in the long term? Too many analysts are unduly concerned about the situation; even U.S. Federal Reserve Chairman Alan Greenspan said recently that world oil prices will remain high for a long period.

 

Are these predictions correct? How justified are the current super-high prices, and how long can they stay at such levels? Are there factors that could send prices plummeting in the foreseeable future? What would this plunge look like and what implications are there for Russia?

 

WHO CALLS THE TUNE?

 

Despite my deep respect for Mr. Greenspan, I must say that there are no profound grounds for the statement that global oil prices will remain high for an indefinitely long time. To understand how solid the prospects are for consistently high prices, it is necessary to analyze the world oil market structure somewhat deeper than many analysts tend to do. As a rule, they proceed from standard parameters related to real commodity flows, such as oil demand dynamics, oil production by main oil producing countries, and strategic and commercial oil stocks in the importer countries.

 

But it is erroneous to believe that current world oil prices depend on the relationship between real demand and supply as on the classic commodity market. This is no longer the case. Since the end of the 1980s, the prerogative of world price formation for oil and refined products has been determined by three trading floors – the New York and Singapore mercantile exchanges (NYMEX and SIMEX) and the International Petroleum Exchange (IPE) in London. Physical trade volumes on those three exchanges offering uninterrupted round-the-clock trading, amount to less than one percent of the total international oil trade volumes. Rather than trading on commodities (a mere 1-2 percent of all deals), they trade on derivatives – futures contracts for oil supplies. So, world oil prices are determined today not by trade in commodities, but by trade in financial instruments. Even though these prices take account of the risks on the real oil market, they are mostly based on projections and momentary fluctuations in the global economic and political situation.

 

The structure of supply and demand on the world oil market in 1999 through 2003 witnessed no real problems in oil supply, nor are they expected in the future. Even during the “tough” years between 1994 and 2003, oil shortages never exceeded 2.6 million barrels a day, or 0.1 percent of commercial oil stocks in the countries grouped in the Organization for Economic Cooperation and Development (OECD) (current shortages can be easily covered by oil in stock), while during most years they ranged between one million and 1.5 million barrels.

 

It is not surprising under such circumstances that the actual availability of oil on the world market is not a crucial factor in oil price formation – most decisive is speculative trading by financial investors. Oil market analysts generally believe that financial derivatives traded on international oil exchanges have become a safe and sound capital investment now that interest rates have remained low in the Western financial systems, above all in the U.S. Federal Reserve System.

 

Algeria’s energy minister stated recently that oil prices could go down substantially if the U.S. Federal Reserve increased its rate. Speculation on the oil market could then become less attractive for investors than on the traditional financial markets. Some economists believe that a market bubble is emerging on the international oil exchanges, similar to the one which occurred on the American stock market in the late 1990s.

 

Speculators have effectively taken advantage of all trends and even rumors that are more or less significant for the world market: first there is the ‘Iraqi factor’ (even though in 2003 the market failed to receive only 686,000 barrels of Iraqi oil a day and the gap was rapidly filled by other producers); OPEC’s repeated refusal to increase oil production quotas (even though cartel members have never strictly observed agreements on quotas); strikes in Nigeria and political instability in Venezuela.

 

At the same time, the market remained indifferent to much more significant factors, such as Russia’s soaring oil production and exports (growth by nearly 2.5 million barrels a day over five years), which in 2003 easily (by more than 120 percent) offset the decline in Iraq’s oil output. Nor was the world oil market overwhelmed by the spiraling growth in oil production by the Middle East member countries of OPEC in 2003. At this time, aggregate oil production in Iran, Qatar, Kuwait, the Emirates and Saudi Arabia grew by over 2.4 million barrels a day up from 2002, i.e. a reported 14-percent rise.

Naturally, the world oil market is influenced by objective factors, as well, and to a certain extent they instigate high prices. These include the ever-growing demand for oil in Asia-Pacific nations, above all in China, as well as oil field depletion which has intensified in the major OECD oil-producing nations – the United States, Britain, and Norway. It is obvious, however, that while the world oil market depends too much on unpredictable speculative games at a time when there is actually no oil shortage, the risks are very high that world oil prices may plummet in the near future. If capital starts flowing away from international oil exchanges, neither cuts in oil production quotas by OPEC, nor a steady growth in Asia’s demand for oil will help. Something similar already occurred in 1998 when global oil prices hit rock bottom, not due to an excessive supply of real oil (oversupply amounted to only 400,000 barrels a day), but due to the crisis on the international financial markets, the crisis of expectations, and, consequently, the price crisis on the oil futures market.

 

If such a scenario reoccurs, oil prices may drop not to a critical level in terms of the profitability of commodities producers, but rather to a level that reflects oil’s ‘real value,’ which helps cover the average production and transportation costs, and has a reasonable profit margin, as well. Prices can stay at such levels for a long time. However, such a scenario would just make oil – which is now a ‘superprofitable’ commodity having ‘geopolitical significance’ – a profitable commodity, but yielding no extra dividends.

 

HOW MUCH IS OIL REALLY WORTH?

 

If we estimate the real value of oil based on an analysis of production costs, the average world prices for main oil grades – the so-called ‘port prices’ – will not be more than $8-$10 a barrel in the foreseeable future. This holds true even if certain trends that drive up prices are taken into account, such as the depletion of key oil fields (mostly in the Middle East), higher oil production costs in new regions (on the sea shelf) and the use of advanced technologies. This means that even when taking into account freight costs, the global oil market can be quite profitable even with stable prices ranging from $15 to $18 a barrel for main oil grades.

 

In such a case, Russia will certainly find itself in an unfavorable position: given that distances are very long between the oil production sites and the ports, and that crude must be carried along pipelines (other oil exporters are spared this problem), extra costs amount to approximately $4-$5 a barrel. But even under these conditions, oil exports will yield Russian oil companies ample profits. At the same time, the state budget will be seriously impaired from such a drop in prices. With the existing mineral production tax rates and oil export tariffs, the state budget bears all the risks if the price of Brent oil drops to $20-$22 a barrel. This situation will also negatively affect the oil sector’s ability to reallocate capital into other economic sectors. Under these conditions, only internal savings and foreign investment can serve as sources for Russia’s economic modernization and development, while the government’s financial system will face yet another serious test.

 

To a certain measure, oil prices have grown due to the weakening of the dollar: the dollar rate’s decline during the past few years has prompted OPEC to consider raising the price range from $22-$28 to $28-$36 a barrel. This may lead to certain adjustments in the nominal price level, but the dollar’s weakening is not a factor that can really send oil prices spiraling.

 

Will oil producers’ resources be sufficient for another round of ‘price wars?’ Can unpredictable global developments (for example, an escalation of internal tensions in Saudi Arabia, in addition to the Iraqi conflict) result in extra shortages of oil on the world market? In theory, that is possible. But over the past few years the world oil market has not grown more dependent on OPEC (even though oil production has declined in the developed nations): in 2003 OPEC’s share in global oil production was lower than during the past decade on average (39.7 percent and 41-42 percent respectively).

 

New players have entered the market, and there is much hope being placed on Brazil and Kazakhstan (they already produce more than 2.6 million barrels of oil a day, or 3.5 percent of the world’s output). At the start of this year, China’s authorities introduced investment restrictions in a number of sectors in order to curb an overheating of their economy. Thus, China’s oil demand growth may slow down, which will have a serious impact on the market (in 2003 China accounted for more than 40 percent of growth in global demand for oil).

 

Finally, the fate of Libya remains uncertain. As the West has softened its attitude to Libya, Muammar Qaddafi’s long cherished dream of regaining his country’s 1970 oil production figures (more than 3.3 million barrels a day compared with less than 1.5 million today) may come true. This would take two or three years to attain. The Western world is likely to lure Libya into energetically increasing its production and possibly even pulling out of OPEC.

It cannot be ruled out that political pressure will be exerted on Venezuela and Nigeria to force them to withdraw from OPEC. OPEC itself is not free from internal contradictions – oil production quotas it fixes have never actually been observed, while the financial position of its leading member countries (Saudi Arabia, in particular) has substantially worsened over the past years. It is very doubtful that those countries can afford to engage in heated price wars that drive prices down.

 

How realistic is the forecast that prices may plummet in the coming years? Proceeding from the above factors, this is unlikely to happen, but such a scenario is still quite realistic. It is also possible, of course, to provide reasons in favor of other scenarios, but those must be taken with a grain of salt, as well. In other words, we are entering a risk zone here.

 

THE WORLD AFTER OIL

 

Is it possible for oil to retain its leading position among global energy sources in the long term? It looks like its days (or rather years) are numbered. Naturally, global oil reserves are sufficient for oil to remain a significant energy resource for another 30-40 years. However, no one doubts that oil resources are exhaustible in principle. Earlier theories claimed that resources would be rapidly depleted (according to those theories, the world should have used up its oil resources by the start of this century), but they have not been confirmed. The global community still has some time for a global restructuring of the world political and economic system, making it possible to mitigate the effects of an ‘energy revolution.’ Still, oil has been gradually losing its global position to other types of fuel in heat and electric power production, while remaining the unchallenged leader only as a motor fuel.

 

Meanwhile, an ‘energy revolution’ will likely continue. Too many factors compel the developed nations to look for systemic solutions that would reduce their economies’ dependence on organic fuel: growing oil prices, depletion of their own organic fuel reserves, and foiled attempts to gain control over areas that are rich in energy resources (i.e. Iraq). This factor has already induced the developed nations to search for a ‘new energy sources agenda’ to be implemented after 2030. A sort of ‘global energy revolution’ is about to occur, which will permit the developed nations to do without organic fuel as a main source of energy, while promoting large-scale use of alternative energy sources.

 

It is clear that various natural renewable energy sources (solar, wind, water, and geothermal energy) cannot serve as a real alternative to oil, nor as a driving force of the ‘global energy revolution’ since their potential is quite limited. Hydrogen energy is seen as the main alternative to organic energy and its development is coming to the foreground. Hydrogen energy is promising for a number of reasons: hydrogen resources are virtually limitless; technologies for using it as a source of energy have reached a highly advanced level (applied research is required to broaden the range of application of hydrogen-based fuel cells); hydrogen energy is highly efficient and productive. Fuel cells are a universal source of energy. They can be used in power generation, as motor fuel, as well as in our homes. Actually, they are a ready substitute for oil.

 

Governments and private businesses in the developed nations have already begun energetically investing in the development of hydrogen energy (in 2003 the U.S. administration allocated $1 billion for the purpose, and Japan has started large-scale production of motorcars powered by fuel cells). With a sufficient scope of applied research providing for the use of fuel cells in everyday life, and with special incentives to promote investment in the broader application of fuel cells, hydrogen energy may become widespread by 2030. After 2030, hydrogen as a source of energy will be able to replace traditional organic sources of energy in 30 to 40 percent of applications. According to the International Energy Agency’s estimates (World Energy Investment Outlook, 2003), by that time per unit capital costs of fuel cell-based energy capacities will decrease to a level that would let them compete with traditional power-generating capacities.

 

In principle, this ‘revolutionary’ scenario in the sphere of energy could put the Western nations beyond the reach of the rest of the world in terms of economic and technological development, not to mention geopolitical influence.

 

Are there reasons for Russians to panic? No. If the country’s leadership is really concerned about diversifying the structure of its national economy in favor of high-technology manufacturing sectors, Russia will be able to do away with its critical dependence on the oil sector, promote its economic development and find its niche in the global high-technology production related to the field of ‘new energy’ somewhere between 2020 and 2030. The oil sector (with account of depletion of the main oil fields) will increasingly transform into a normal sector of the economy with annual production rates between 250-300 million tons of oil a year, and its main target will be meeting domestic demand.

 

But will the economic policy pursued by the Russian authorities allow the country to prepare for this course of events? So far, the authorities have not shown any other intention than presenting the results of restructuring accomplished in the 1990s, and the effects of the most favorable situation in the world oil market as their own achievements. Further structural reform in the country’s economy has yet again been delayed for the sake of ephemeral political stability. The government, which has proclaimed the ambitious goal of ‘doubling the GDP,’ does not have a national program for a real economic breakthrough. Meanwhile, the oil clock is ticking.

Last updated 10 august 2004, 12:40

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