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Environment

The Oil Game

11 August 2005

The Oil Game

By Gwynne Dyer

“We ran out of $2 oil in 1973,” said Henry Groppe of Groppe Long and Littel, at 79 the oldest active oil consultant (and one of the most respected) in the business. ” Then we ran out of $8 oil, then $15 oil. Now we’re running out of $40 oil.” It’s a different way of looking at what is happening to the price of oil, and a much more useful one.

Last week the price of a barrel of oil reached $65. Oil has doubled in price in the past eighteen months, and oil industry experts freely speculate that the price might hit $80, even $100 a barrel before year’s end, hugely depressing world economic growth.

But here’s an interesting fact. Oil companies still decide whether a new field is worth developing by calculating whether they would turn a profit from it when the price per barrel falls to only $25. Do they know something that the rest of us don’t?

Not really. They just know that prices always fluctuate, that swings in commodity prices tend to be much wider than in other goods — and therefore that “running out of $40 oil” doesn’t mean that the oil price will never fall below $40 again. It won’t stay down there for good, but as John Maynard Keynes once remarked, “markets can remain irrational longer than you can remain solvent.” You have to be able to make a profit from your new field when oil drops to $30 a barrel (even if it is for the last time) and stays there for a couple of years.

The price of oil may hit $80 or even $100 this year, but if it does it will be an extreme market fluctuation, not a new average price. It will eventually fall back towards the $40-$55 band — but “eventually” is the key word as far as the current global economic boom is concerned.

Despite low growth in Japan and most of the eurozone, the global economy as a whole grew at an unprecedented annual rate of 4.5 percent over the past eighteen months. The rule of thumb says that $20 on the oil price means a drop of one percent in global growth six months to a year later, so we aren’t in bad trouble yet.

Oil prices have gone up around $30 in eighteen months — one and a half percent off the growth rate — but some of that lost growth is already accounted for in that remarkable 4.5 percent figure. If the oil price stabilised now, the world economy would still be growing at a comfortable 3 percent after the rest of the damage feeds through.

If, on the other hand, oil goes up to $100 and stays there for a year or two, that’s another 2 percent off the growth rate, and then everybody hurts. The current growth spurt is bound to end sooner or later — they haven’t abolished the economic cycle yet — but sharp swings in the oil price don’t necessarily mean that we are headed for an especially severe recession. Nor have we any reason to think that the oil price will stay up in the stratosphere forever.

This is not like the two “oil shocks” of the1970s, when a sudden constriction in the oil supply drove the price sky-high. THIS price peak is driven mainly by rapidly rising demand in the emerging Asian economies and in the United States, so their people are still spending and the impact on the global economy is much less.

Moreover, the big oil producers now have much more developed economies than in the 70s, so they are also able to spend their extra income and keep the wheels turning, rather than letting it pile up as surplus “petrodollars”. And developed economies are much less “oil-intensive” nowadays — it takes only half as much oil as it did in the 70s to produce the same amount of Gross Domestic Product — so oil price rises no longer lead to runaway inflation.

After all the current turmoil is past, the important thing is that the median oil price for the next half-decade, say (until we run out of ALL the $40 oil) will be in the mid-$40s. That is good news in terms of the real crisis, climate change.

It’s high enough to encourage energy conservation and drive people towards alternative, preferably non-carbon energy sources, but it doesn’t actually paralyse the economy. We will need more pressure from a higher price later on if we are to avoid a global climate disaster, but the economy can only respond so fast. And we are practically guaranteed a higher price later on — another doubling of the average price by 2010 or 2012, say — because we are probably at peak oil production right now.

Seventy percent of the world’s oil comes from big fields that were discovered before 1970, and they are almost all in decline. The new discoveries are mostly smaller and more expensive to develop, and Henry Groppe recently predicted that oil production worldwide will decline by a million barrels a day each year from now on.

We can take no credit for it, but maybe we are on the best available glide-path for a soft landing on climate change. Whether that will be good enough is, of course, another question.

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To shorten to 725 words, omit paragraphs 9 and 10. “This is not…inflation”