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High oil
prices are here to stay. The era of cheap oil is over. We will have
to get used to paying a lot more for our energy supplies.
Oil
– and other primary commodity – prices are being squeezed by two
powerful fundamental market forces: strong demand and tight supply.
On the demand side, China and India are transforming the structure
of the global economy bringing 2.5bn aspiring consumers to market.
On the supply side, political constraints and rising costs inhibit
investment in new production and refinery capacity, helping to force
oil prices up. Neither is likely to ease significantly in the next
five to ten years.
Despite rising oil prices, demand continues to grow strongly in
China and India fuelled by a combination of rapid economic growth
and domestic price controls and subsidies. Last year, China’s
economy expanded by 12pc and India’s by 9pc – and oil use grew by
5pc in China and 7pc in India. Together two countries accounted for
half of world oil demand growth of just over 1mn b/d in 2007. As
consumers in China and India are protected from rising oil market
prices by domestic controls and subsidies there is little incentive
for them to become more efficient. Oil is also widely used for
electricity generation – especially small diesel generators used to
avoid grid blackouts.
At the same time, oil supply is getting tighter. Upstream, crude oil
production outside the Opec countries is now falling, creating a gap
that only Opec can fill. In the first four months of this year, non-Opec
crude supply fell by 600,000 b/d (1.5pc). But, despite much higher
oil revenues, Opec member governments are still not investing enough
in new production capacity as they prefer to spend the money for
other purposes. And with so much of the world’s remaining untapped
oil reserves concentrated in Opec countries – especially in the
Middle East – and controlled by state companies, it is becoming
increasingly difficult to expand supply.
Oil prices collapsed after the two oil shocks of the 1970s because
both demand and supply ultimately reacted to higher prices.
Industrialised countries became much less dependent on oil as
industry and power generation switched to other fuels, especially
natural gas. And Opec lost its grip on the market as the
international oil industry developed new fields in Alaska and the
North Sea that kept a lid on oil prices. But this is unlikely to be
repeated.
Demand is now concentrated in the transport sector where there are
no cheap substitutes and most of the growth in oil consumption is
coming from developing countries which need oil to fuel their
transition to a more advanced economy. Oil remains a uniquely
flexible fuel that can be easily distributed without the need for
expensive infrastructure and applied to many end-uses. As a result,
oil demand is less responsive to higher oil prices than it was in
the 1980s, forcing oil prices even higher to slow the rate of growth
of demand.
And there are no easy alternatives to Opec oil now that production
has peaked in Alaska and the North Sea and started to fall in Russia
and Mexico. Opec now supplies just over half of the world’s crude
oil production and its members own just over three-quarters of the
world’s proven oil reserves. And as governments in both Opec and
non-Opec countries become more nationalistic about who develops
their oil reserves, the international oil industry is finding it
impossible to boost production. Growing barriers to investment
together with rising costs, higher taxes and shortages of equipment
and skilled staff mean that the industry cannot find enough new
sources of oil to weaken Opec’s grip.
But that is not all. This year, oil prices are being forced even
higher by a shortage of diesel. Diesel demand is growing at an
unsustainable rate as oil refiners cannot make enough of the
product. In the first quarter of this year, demand for diesel grew
by 8pc compared with the same period a year ago. But demand for
other key refinery products was either flat (gasoline) or fell
(heating oil and residual fuel oil). Demand is growing fastest in
China and India where diesel is being used both for transport and
electricity generation – especially in small generators. Diesel
demand was up 14pc in these two countries in the first quarter.
Oil refiners cannot cope with such a wide disparity in demand for
the different joint products that they make. Although oil refineries
have some flexibility to vary the mix of product yields, they cannot
keep pace with surging diesel demand without producing a surplus of
other unwanted products – especially residual fuel oil – that
undermines their processing margins. In addition, diesel is becoming
much more difficult to make as more countries require lower sulphur
content for environmental reasons. As a result, diesel fuel is not
only becoming more and more expensive relative to other products,
but also driving up the price of oil in general.
Rapidly growing demand for energy and other primary commodities from
developing countries is one of the biggest challenges facing the
global economy. If everybody in China used as much oil per capita as
the citizens of the United States, then China’s oil consumption
would be equivalent to the entire world’s oil consumption today.
Although more investment in upstream production and refinery
capacity is urgently needed to ease the current tightness in the oil
market, the fundamental problem remains – there is not going to be
enough supply to meet potential demand unless we all become much
more efficient in how we use oil and other sources of energy. Which
is why the era of cheap oil is over.
David Long,
Director, Oxford Petroleum Research Associates Ltd
www.oxfordpetroleum.com
If
you want to hear more from David about the price of oil and how it's
driven, where it comes from, or even what it is, then come and hear
him speak at our Global Oil Markets course at:
http://www.mjmenergy.com/oil.htm
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