6th September 2012
With Britain and the eurozone in recession and global trade volumes falling crude oil prices should have come down to reflect falling demand. As Brent crude approaches $114 a barrel, however, it seems clear that this has not happened.
Indeed, as Evans-Pritchard observes, "we [now] face a world where Brent crude trades at over $100 even in recession".
To an extent this is to be expected. Despite an ongoing slump in developed economies, emerging market demand has continued to grow at a rapid pace. In fact the non-OECD countries are forecast to overtake their OECD peers in terms of oil demand by 2013. This figure is all the more stark when you consider that in 1990 OECD countries were consuming 42 million barrels/day compared with non-OECD consumption of 25 million barrels/day.
Evans-Pritchard concludes that the only reason there has not been a sharper oil spike is due to American shale oil coming on-stream. The reality of peak cheap oil, however, poses a number of challenges.
"The price increase has been led by both demand and growing supply costs. It is unlikely that we will see a return to an average of $50 a barrel with the current floor around $70-80 a barrel," says Will Riley, an energy specialist at Guinness Asset Management. "OPEC openly talks of targeting $85 a barrel."
In order to sustain the market, the oil price usually trades between the marginal cost of supply and the point at which it begins to cause demand destruction. Riley estimates that the marginal supply cost is currently between $80-90/bbl while demand destruction occurs at around $125-145/bbl.
The important point to note, however, is that at $100/bbl the oil bill accounts for almost 5% of global GDP. This figure is higher than at any point since 1984 and demonstrates a key consequence of the end of peak cheap oil – spreads between the cost of supply (the traditional price floor) and the point where demand is impacted have narrowed.
The implications for the global economy could be profound. Evans-Pritchard quotes Kamakshya Trivedi and Stacy Carlson from Goldman Sachs who claim that "the price of oil is in effect acting as an automatic stabilizer [to the global economy]". That is, when the global economy begins to recover the price of oil goes past the point of demand destruction and undermines growth.
Why is this happening?
Higher supply costs mostly reflect a lack of new, low cost sources of production. Deep-sea oil, oil sands and shale oil are all far more expensive to extract than conventional onshore or shallow offshore. These supply issues have been exacerbated by increased demand from fast growing emerging economies.
With stagnating Western economies and falling real incomes, however, an argument could be made that falling developed market demand may help offset the demand picture. Riley is not convinced:
"You might well think that demand has a ceiling in the developed world, but that ignores the low base that many of these emerging countries are coming from. Vehicle penetration in China, for example, is currently below where it was in the US in 1920 so there is still plenty of room for growth."
He is equally unsure of the claims made in Leonardo Maugeri's paper "Oil: The Next Revolution" published by the Harvard Kennedy School. As the title suggests, Maugeri's thesis is that the world will be awash with new oil supply by 2020 but some have suggested his forecasts are too optimistic.
Maugeri claims that non-OPEC supply could increase by 6.9 million barrels a day while OPEC supply could grow some 10.1 million. Riley says it is highly unlikely that OPEC would allow production to increase by that level and if new supply, from countries like Iraq, came on-stream then cuts would be made elsewhere to accommodate.
Moreover, analysts from Citigroup have warned that Saudi Arabia's own oil consumption could force it to cut exports over the coming years. They suggest the kingdom may have to halt exports altogether by 2030.
Whether that proves the case, it is clear that the cost base of oil production has grown while the ability of the global economy to absorb high oil prices has not kept pace.
The future for oil
For many environmental campaigners the low cost of oil relative to alternative energy solutions has been a sticking point. If this changes then it will help make the economic case for nuclear or green energy.
That said, it is unlikely that the global economy will be able to wean itself off the commodity overnight. The Western world is already projected to see a dip in its demand over the next few years and may never again hit its 2007 peak, but emerging market demand will more than counterbalance this effect.
Few governments, however, will want their economic prospects to be at the whim of global oil markets. What is needed now is a sensible debate over the future of energy policy that takes into account the structurally higher and growing costs of the commodity. If peak cheap oil has already passed then we must begin this discussion in earnest.
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