labels: Shivshankar Verma
This oil price surge is no bubble news
23 June 2008

Predictions of an imminent crash have fallen flat as oil prices continue to set new records. Except for a significant breakthrough that can change the long-term demand-supply scenario dramatically, nothing can burst this oil bubble. Because this is no bubble, this is for real! By Shivshankar Verma

Big oil producers and consumers just finished their weekend deliberations at Jeddah, Saudi Arabia. The conclave's agenda - discuss ways to ease oil prices - was quite serious and of pressing importance for the global economy. Most major oil consumers were represented and India sent finance minister P Chidambaram to voice its concerns.

The meeting, which was officially called the Jeddah Energy Summit, might appear a bit quixotic to most. Here is a meeting to talk about how to bring down oil prices, organised by the biggest oil exporter who benefits the most from higher prices. The organiser is also the chief promoter and most powerful member of a price cartel, whose other members were also present at the summit, and whose primary goal is to keep oil prices high. Despite these obvious conflicts of interest, they all promised to seek and find ways to ease the burden of high oil prices. The Saudi king, who presided over the meeting, even called for a global 'energy-for-the-poor' initiative whatever that means.

In the end, nothing significant came out of the meeting. Saudi Arabia said it is ready to increase production for the rest of the year while other OPEC members were non-committal on higher output. Delegates from consuming countries went home after a pleasant weekend at the Red Sea resort city. It must have been a welcome relief for those like Chidambaram who have been facing intense political heat over rising inflation.

But, when the oil futures market opens for trading today, discussions at the conclave will barely register on prices.

This is about the very long term
The current oil price surge is not about short- or medium-term supply-demand dynamics. This rally is based on a fundamental long-term fact the world will run out of oil one day and we don't have any viable alternatives, not yet.

In recent years, the demand for oil has proved to be much more inelastic than earlier thought demand doesn't respond much to higher prices. There are many reasons for this, like the over-reliance on private transport in major consuming countries and the replication of this model in big emerging countries like India and China. Higher income and aspiration levels in these countries have also contributed, by pushing up the threshold of affordability. Hence, it is safe to argue that there will not be any appreciable decline in oil demand even if prices were to stay at these levels.

On the supply side, there have been no major oil discoveries for a long time until the recent finds in Brazil. But the Brazilian fields are in deep water and it will take some time, maybe even a decade, before this oil comes to market. Production is well past peak in older fields like North Sea while Russian output is believed to have done so recently.

Then there is the refining bottleneck. Older refineries cannot process the heavier or dirtier crude which comes out of newer fields. Given the environmental protection restraints in many countries, it is not easy to increase refining capacity. New refineries like the Jamnagar facility of Reliance may end up exporting most of its output, but still won't make a big enough impact to influence prices. That will take a complete revamp of the existing refining infrastructure in major markets like the US.

Small gains won't register
"I am convinced that the supply and demand balances and crude oil production levels are not the primary drivers of the current market situation and that markets are already well-supplied",  said the Saudi oil minister at the Jeddah summit. For quite a while now, OPEC has been insisting that markets are well supplied. And that seems to be the case as there is no physical shortage of crude oil. If you are willing to pay the price, oil is readily available.

Saudi Arabia has already increased its output by more than half a million barrels per day over the last couple of months and its output will nudge 10 million barrels a day later this year. Saudi is investing nearly $130 billion over the next five years to increase output by another 2.5 million barrels a day. Other oil producers are also scaling up production, wherever they can.

But, these small additions to overall supplies don't matter anymore. The half million barrels Saudi has added recently is only slightly more than one-half per cent of total global demand. Even if global oil demand increases by half a million barrels every year, the additional output the Saudis are now talking about will be absorbed. And demand is likely to increase at more than a million barrels a year!

There is a lot of talk about a demand decline in the US. The sharp decline in SUV sales and increased demand for smaller cars are cited as indicators to a possible fall in demand. Here again, it will not make a big enough fall in total demand. It is estimated that all vehicles in America become as fuel efficient as those in Europe, total US consumption will decline by more than 2 million barrels a day. The number may appear impressive, but is less than 5 per cent of total global demand. Again, such a shift to more efficient vehicles will take a very long time and even higher prices.

No point blaming speculators
"While a few reckless speculators are counting their paper profits, most Americans are coming up on the short end" - John McCain, US presidential candidate.

Blaming speculators for high oil prices has become a common refrain among politicians in most countries, whether they are socialists or free-market champions. Undoubtedly, speculative trading in oil and commodities in general has increased substantially in recent years. Fund flows into oil and other commodity futures have jumped manifold over the last decade. Big investment banks and hedge funds have raked in billions from commodity speculation, and a few have lost many billions too.

It may also be true that 20 or 30 per cent of the $140 a barrel of oil costs now is directly because of increased speculation. Ban oil futures completely and limit the market only to genuine producers and consumers, and prices will easily fall below $100.

But, that will not alter the fundamental long-term factors that now dominate the energy markets. Speculators are only betting on the potential long-term energy supply shortages and the world's lack of readiness to face such shortages. As long as these underlying factors remain unchanged, and as long as they are allowed, speculators will bet on those. 

Only structural breakthroughs will make a difference
Except for significant breakthroughs which can dramatically change the demand-supply dynamics, nothing can cause a sustained fall in oil prices. Such breakthroughs must offer much more than incremental gains like development of a new engine technology which is twice as efficient as existing ones or a completely new technology to harness and store energy from renewable sources, easily and affordably. Only such developments can change energy demand or supply to a meaningful extent, by 10 or 20 per cent or even more.

This is not to contend that oil prices will not fall from their current levels in the near future. Many factors can lead to a short to medium-term correction in prices, say to $100 per barrel. Further weakness in global economic growth outlook and improved political stability in the Middle East can get us there.

But, that will only be a 'correction' within a long-term up trend and not a sustained decline. Until someone comes up with a breakthrough, someone will one day, oil prices will remain high.

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This oil price surge is no bubble