Two Cheers for Expensive Oil

THE MARKET AT WORK

Widespread fears of waning oil reserves are obscuring the real reasons for the cost of crude oil today. The truth behind high prices is mundane: they are the result of extreme economic processes, not geological limitations. The current "crisis" is being driven by the reduced availability of crude on the world market and the inadequacy of the oil industry's refining capacity. Both conditions were brought on by years of low oil prices, inadequate investment in infrastructure, and producers' fears of surpluses. Since 2003, the situation has been exacerbated by an unexpected increase in the global consumption of crude.

As market forces have kicked in, high prices have already started to generate more investment, which will boost both production and refining capacity in the future. In other words, high oil prices are a painful but necessary cure for the disease that has affected the oil market for about 20 years.

Still, the danger remains that prices could stay too high for too long, provoking a drop in demand just when new production and refining capacity start to come on-stream. This, in turn, could send prices spiraling downward and put an end to the current move toward greater investment, leaving the fundamental problems of the oil market unsolved. Such a development would delay needed changes in the consumption habits of industrialized societies and set them up for another crisis in the future.

NOT SO DRY

Despite all the predictions of impending catastrophic shortages, the world still possesses immense oil reserves. "Proven" reserves alone, more than 1.1 trillion barrels, could fuel the world economy for 38 years even at current rates of consumption. And this figure understates potential production, because the accepted definition of proven reserves includes only those reserves that can be exploited with currently available technology at conservatively projected prices. An additional 2 trillion barrels of "recoverable" reserves are not classified as proven but will probably meet that standard in a few years as technological improvements, increased knowledge of the subsoil, and the economic incentive created by higher oil prices (or lower extraction costs) come into play. Consider, for example, that only 35 percent of the oil contained in known oil fields worldwide can be recovered today with existing technologies and based on current economic fundamentals (up from 22 percent in 1980). Current estimates of recoverable supplies also ignore large deposits of so-called unconventional oil, such as ultraheavy Venezuelan oil and oil that can be extracted from Canadian tar sands. Moreover, huge areas of the planet have yet to be thoroughly explored.

In other words, what little is known about the world's underground oil resources justifies a positive view of the future, not the alarmist vision of oil catastrophists. The pessimists assume that the world has been fully explored, that neither the dynamic of crude prices nor technological progress has any bearing on the "finite" nature of oil resources, and that consumption is bound to increase more and more, inexorably depleting the existing oil stock. Their pseudoscientific fatalism, camouflaged with quasi-sophisticated models, has turned out to be wrong repeatedly in the past, and it is unlikely to be right in the future.

Today's limited spare production capacity is the result of two decades of inadequate investment in exploration, especially by the countries richest in oil. The reasons behind this sluggishness are complex and date back to the early 1980s, when OPEC countries and their national oil companies (which control nearly 80 percent of the world's crude reserves) began to worry about overproduction. The adjustment the oil industry had made to the crises of the 1970s proved excessive, and the resulting surpluses caused the price of crude to collapse in 1986. From then on, the de facto guiding principle of several OPEC countries was to exploit only those fields that were already in production and to develop no new fields beyond those necessary to maintain steady production levels. In the 1990s, low prices and limited growth in demand, as well as yet another price collapse caused by overproduction in 1998-99, reinforced the determination of producers to minimize excess capacity.

At first, nobody noticed the potential risks of this approach. According to many economics textbooks, the producers' reaction was rational, perhaps even optimal: it made no sense to spend money to develop capacity for products that were unlikely to find a market. Most opinion-makers considered the price collapse of 1998-99 to be bad for producing countries and oil companies but good for everyone else. Even as late as the start of the new millennium, none of the major oil-producing countries had shed its fear of overproduction, and all of them kept a very tight rein on spending to develop new capacity.

International oil companies (IOCS) were just as risk averse. Although the influence of the IOCS over the world oil market was and still is marginal -- their contracts with producing countries give them access to little more than 20 percent of global crude reserves and complete control over only about 7 to 8 percent of reserves -- their behavior is instructive. Facing low prices and anemic consumption growth, and operating under the assumption that the industry had fully matured, they squeezed their assets as much as possible and limited their investment in new exploration ventures. Traditional energy companies, especially in the 1990s, came to be labeled as dinosaurs, while Enron and other multinationals that spurned investment in heavy assets were hailed as the energy companies of the future. Between 1986 and 2005, the world's spare oil production capacity dropped from about 15 percent to between 2 and 3 percent of global demand.

THERE'S MORE WHERE THAT CAME FROM

Rather than facing any shortage of crude, many OPEC and non-OPEC countries, especially those in the Persian Gulf, continue to have an enormous potential to produce oil. Oil resources in Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates are still relatively underdeveloped and underexplored, despite these countries' extensive history with oil.

The relative underdevelopment of production in the Persian Gulf countries dates back to well before the 1980s. From the 1920s to the 1970s, the major oil companies then known as the Seven Sisters (Exxon, Shell, BP, Mobil, Chevron, Gulf, and Texaco) dominated the industry in the region and throttled exploration and production to avoid flooding the market with excess crude. Then, with the nationalization wave of the 1970s, Western oil companies were thrown out of most Middle Eastern countries, causing a sharp decline in the region's access to technical know-how and reducing possibilities for additional development in the future. In Iraq, for example, three-dimensional seismic surveys, deep and horizontal drilling, and advanced techniques for recovering crude have never been used, even though these practices have revolutionized the oil industry in the rest of the world since the 1980s.

The Persian Gulf is also underexplored compared to other parts of the world. Only about 2,000 new-field wildcats (exploratory wells designed to find hydrocarbons in the subsoil) have ever been drilled in the region, compared to more than one million in the United States. Over the last 20 years, more than 70 percent of oil exploration in the world has taken place in the United States and Canada, two countries widely seen as mature producers in decline and which together hold less than 3 percent of the world's proven reserves. Only 3 percent of exploration has taken place in the Middle East, even though the region holds about 70 percent of proven reserves. Between 1995 and 2004, fewer than 100 new-field wildcats were drilled in the Persian Gulf, compared with 15,700 in the United States. During the same period, only about 150 appraisal wells (which test the production capacity of an oil field) and fewer than 5,000 development wells (which help prepare an oil field for production) were drilled in the Persian Gulf, in contrast to more than 12,300 appraisal wells and 250,000 development wells drilled in the United States. Only 2,500 wells of any kind have been drilled in Iraq; one million have been drilled in Texas alone.

Saudi Arabia -- the largest oil producer in the world -- still has a huge potential for increases in oil production, despite recent claims that its production may soon reach its peak. These gloomy forecasts rest on exaggerations and mistaken views of developments in the Saudi oil sector, especially the alleged depletion of the Ghawar field, the world's largest oil field and the source of more than half of Saudi crude. Ghawar's drying up is supposedly demonstrated by a high "water cut," the percentage of water brought to the surface with the oil during drilling. A field's water cut does tend to increase as the field ages, and in Ghawar it had reached 37 percent by 2000, compared to 25 percent across the entire industry. (In other words, for every 100 barrels of oil produced in Ghawar, 37 barrels of water were also pumped out.) But factors other than a field's depletion can account for an increasing water cut, such as inadequate drilling systems, poor field management, the absence of modern techniques to enhance oil recovery, and overexploitation of certain parts of a field. In Ghawar, moreover, improved reservoir management and the introduction of new technology that recovers oil more effectively have already brought the water cut down to about 30 percent.

More important, Saudi Arabia's vast resources are underexploited. The 260 billion barrels of proven Saudi reserves (which account for nearly 25 percent of the world's total) represent only a third of the oil known to lie beneath Saudi soil. And there may be more oil still to be found: fewer than 300 new-field wildcats have been drilled in Saudi Arabia since the first bit hit the ground in the early 1930s, and fewer than 30 were drilled between 1995 and 2004. This explains why, despite the catastrophists' prediction that Saudi Arabia has already reached its peak, the kingdom recently announced it would increase its production by about 2 million barrels per day (to about 12 million) by 2009.

Likewise, the potential of Russia -- currently the world's second-ranking oil producer -- is often underestimated. According to DeGolyer and McNaughton, the leading oil-reserve-assessment firm in the world, Russia's potential reserves are three times as large as the country's proven reserves of 50 billion barrels. Since 1965, only about 8,500 new-field wildcats have been drilled in Russia (roughly as many as were drilled in the United States in the last five years). Russia's oil industry has also been hampered by two byproducts of the Soviet era: inadequate technical know-how and poor field management. These factors have limited the amount of oil the Russian oil industry manages to recover: it typically retrieves less than 20 percent of a field's content, about half of the world average.

Other areas, too, show great promise. Throughout the Caspian region, oil development is still in its infancy. The proven reserves of Azerbaijan and Kazakhstan stand at around 18 billion barrels, but these countries' total recoverable reserves are estimated to range between 70 billion and 80 billion barrels. And in long-ignored areas of Africa, exploration and development began only a few years ago, at about the same time that Canada's vast tar sands started to attract large investments.

But only high prices create the incentives for producers to tap the vast amount of oil waiting to be brought on-stream. Over the past few years, higher prices have already prompted the industry and oil-producing countries to make new investments. Since 2002, investment in exploration and production has grown at a real rate of more than 10 percent a year (after adjusting for inflation). There is always a time lag before the results of increased investment in oil production become visible: on average, six to eight years generally elapse between the discovery of new oil in a midsize field and the start of crude production. But once it gets going, production is difficult to stop.

Recent field-by-field estimates by Cambridge Energy Research Associates (CERA) suggest that worldwide production capacity will exceed 100 million barrels per day by 2010, compared to just under 86 million today. According to CERA, much of the increased production will come from non-OPEC countries such as Angola, Azerbaijan, and Kazakhstan. All of OPEC, except for Saudi Arabia, is expected to struggle to find market shares appropriate for its members in the near future. But it should be able to recover market shares over the long term, so long as it takes into account less conventional sources of supply (new suppliers in Africa and Asia or Venezuelan heavy oils and Canadian tar sands) and new technologies (such as those allowing enhanced oil recovery or the conversion of natural gas into liquid products, which are easier to transport). Put simply, the world will continue to have plenty of oil.

THE HEIGHT OF REFINEMENT

A substantial increase in production alone, however, cannot ease current high prices. Crude oil comes in a wide variety of qualities, and only very complex refining systems can cope with the lowest-quality oil. High-quality crude, such as West Texas Intermediate or Brent, which contains little sulfur and is light, or has low density, yields more gasoline and other high-value-added products and less residual oil and other undesirable products than does lower-quality oil, such as Mexican Maya or Iranian Heavy. (The proportion of high-value-added, environmentally sound products yielded through refinement also increases dramatically when lower-quality crude is processed in complex refineries equipped with sophisticated conversion equipment.) Developing more refining capacity is thus insufficient by itself; the new capacity must be able to convert different grades of crude into the refined products, such as gasoline and diesel, needed in various regions. Without such flexibility, even excess supplies of crude will not satisfy market demand.

Refining has been the weak link in the petroleum production chain for the last 20 years. The 1970s, when petroleum consumption growth was projected to exceed 5 percent per year for at least 25 years, saw an investment spree. But instead of growing at a consistently brisk pace, consumption abruptly leveled off at 64 million barrels per day in the early 1980s and even dropped somewhat during subsequent years. In the meantime, refining capacity jumped to 80 million barrels per day. Thus, between 1980 and 2000, the main problem facing the sector was the need to absorb excess capacity. The overhang remained even after demand began to increase again, because demand rose much more slowly then (by less than 2 percent a year) than it had grown during the so-called golden years, between 1950 and 1970 (when it grew by a galloping 7 percent a year). To make matters worse, during the second half of the 1980s, new environmental regulations imposed severe burdens on existing refineries, and local groups suffering from NIMBY ("not in my backyard") syndrome strongly opposed the construction of new facilities.

At the start of the new millennium, several elements converged to further exacerbate the refining problem. Ever more stringent environmental regulation of both fuel quality and emissions boosted demand -- and the price -- for better-quality, high-yield crude. Inadequate investment in new or improved refining capacity caused further problems. Because only about 20 percent of crude oil falls into the light or low-sulfur categories, the failure to develop the refining capacity for lesser-grade crude produced shortages of finished product.

As a result, significant imbalances exist today in every regional market. Europe is short on its favorite fuel, diesel, and oversupplied with gasoline, which cannot directly enter the United States because it does not meet U.S. quality standards. The oil market in Asia is largely inefficient, mainly because the region's refineries are unsophisticated and cannot cope well with medium and heavy oils.

The situation is especially severe in the United States, and because the country consumes almost 25 percent of the world's petroleum, its problems spill over into the global market. Not a single new refinery has been built in the United States for 30 years, and improvements to existing plants have failed to keep up with either growing demand or increasingly tough environmental standards. The United States is now the only market in the world with a net deficit in refining capacity (which amounts to about 20 percent of domestic demand). The decentralization of the United States' regulatory system further complicates the problem. Each state establishes its own quality criteria for gasoline and other petroleum products, creating a crazy quilt of inconsistent regulations with curious results. For example, gasoline produced in one state may not be sold in another. As of this writing, 18 different types of gasoline are sold in the United States.

Things may be changing, however. Recent price spikes have brought increased profit margins to the industry and prompted a new wave of investment in refining. Worldwide refining capacity increased by 2.7 million barrels per day between 2004 and 2005 -- the largest such increase since the early 1990s. Asia leads the race to expand old refineries and build new ones. The major oil-producing countries -- led by Saudi Arabia and Iran -- are launching huge projects to build refineries that can process their lower-quality crude. Many African countries are also looking to build or revamp their refineries so that they can boost local production and, leveraging their proximity to Europe and the United States, export finished products to those key markets. Additional capacity from marginal new investments in existing refineries may add around 4 million barrels a day to global production by 2010. And new technologies that can squeeze additional high-quality product out of lower-quality crude are being introduced, including methods for handling ultraheavy oils and tar sands. All of this should add up to a major leap forward: today the difference between the amount of crude that enters the refining system and the amount of usable refined product that comes out is estimated at 10 percent of the 85 million barrels of petroleum produced globally per day; in other words, every day more than 8 million barrels -- nearly as much as Saudi Arabia's daily average output -- are effectively lost.

Finally, a careful analysis of field-by-field future production assessments suggests that by 2010 the production of light crudes will have grown to 25 million barrels per day from 17 million barrels per day today, helping to ease the global refining imbalance. All of these developments suggest that well before 2010, the imbalance between refining capacity and market demand could be overcome.

A SUSTAINABLE DEVELOPMENT

This relatively optimistic scenario must take into account one final issue: the unexpected rise in global demand over the past few years. After hovering at low growth rates of less than 2 percent a year from 1986 to 2002, global demand for oil jumped by more than 3 percent between 2003 and 2004, driven mainly by demand in China and the United States. The fast expansion of Chinese demand, which rose by 40 percent between 2000 and 2004, has been a particular source of international concern. Structural features of the Chinese economy suggest that this demand will continue to grow. Average per capita petroleum consumption in China is still a meager 2 barrels a year, compared to 12.5 barrels a year in Europe and 26 barrels a year in the United States, leaving plenty of room for expansion. And although China is still decades away from mass motorization, as access to cars increases, so will China's per capita consumption of oil.

Still, one should not lose sight of the forest for the trees. For one thing, the recent phenomenal jump in China's demand for oil is the result of exceptional circumstances that may not last. For another, it has had more limited effects than is often recognized. China's increased demand over the last several years was largely due to an adjustment away from the stagnation of previous years; as the country was catching up, demand was partly driven by intensified industrial production and the need to solve one-off issues, such as electricity blackouts due to problems in coal and nuclear plants. Even after its recent buying rush, China still accounts for only about 8 percent of global oil demand, and even sustained Chinese consumption growth would have only marginal effects on an otherwise normal global petroleum market over the short and medium term. (China's construction boom, in contrast, has had a far more potent effect on the world's cement and steel markets: today, China consumes half of the cement and nearly 30 percent of the steel produced throughout the world.) Even if China's demand for oil continues to rise, oil prices will not rise at a commensurate pace, because today's oil prices already reflect tomorrow's anticipated growth in demand.

Oil experts have generally tended to underestimate supplies and overestimate demand. They assume that petroleum is irreplaceable and that demand will grow forever, free of any restraints. For years, they thought that petroleum consumption was inelastic and impervious to price fluctuations, only to discover later that this was not the case. In fact, price always affects demand, even if the connection takes time to manifest itself, as consumers try to maintain the lifestyle they are used to for as long as possible. Consumer inertia makes it difficult to establish quick and direct correlations between the demand for oil, the price of oil, and economic or demographic growth, but these links do exist.

It would thus be a stretch to cite high consumption over the last two years as evidence that consumers are indifferent to cost, especially since the prices of most petroleum products in much of Asia -- including China -- have long been checked by vast subsidies and other forms of state intervention. In fact, early data for 2005 reveal that the sky-high prices reached during the year have already substantially cooled demand for petroleum products. And growth in demand dropped from 3 million barrels per day in 2004 to about 1.2 million barrels per day in 2005.

Contrary to prevailing public assumptions, the dominant position of oil as an energy source has been eroding for many years. In 1980, oil accounted for 45 percent of global energy consumption. Today, the figure is down to 34 percent, with oil having given up some ground to natural gas, coal, and nuclear energy. In much of the industrialized world -- with the notable exception of the United States -- oil consumption appears to have reached its peak during the last decade. It now faces long-term decline.

Still, it is safe to assume that the overall demand for oil among developing countries, including China, will continue to increase considerably. These countries' consumption will likely concentrate in the one area -- transportation -- in which oil will have no viable competition in terms of price or efficiency for many years to come. In the developed countries, oil is now primarily consumed for transportation: in the United States, for example, more than 70 percent of oil consumption is in that sector. At present, about 35 percent of China's oil consumption is for transportation, leaving room for considerable changes in allocation.

Another big guzzler to watch is the United States, where low tax rates on fuel, consumer disregard for efficiency, and demographic growth have increased oil consumption. The United States needs to adopt courageous new policies to curb dangerously high consumption levels, as it did in the 1970s. Although the rate of oil consumption in the United States has dropped slightly, from an average of 32 barrels per capita in 1978 to 26 barrels per capita today, it remains the highest rate of any country in the world. To reduce it further, Americans will have to consume more wisely. The quality of life of Europeans is comparable to that of Americans, yet Europeans consume about half as much oil as do Americans (and even they are guilty of substantial waste). There is little point in criticizing oil-producing countries for sky-high prices when more than half of the 17 million cars sold in the United States each year between 2000 and 2004 were gas-guzzling sport-utility vehicles. No policy promoting energy independence will succeed unless U.S. legislators can muster the political courage to change the habits of American consumers.

High oil prices can help. Looking ahead, several powerful forces will tend to moderate the growth of demand in the future: the maturity of oil consumption in the industrialized countries, the continuous shift away from oil in sectors other than transportation, and the advent of new vehicles, especially hybrids, that consume less oil. Above all, pollution and environmental concerns will force governments to deal with the need to lower oil use, even if major international attempts to tackle the issue, such as the Kyoto Protocol, have so far failed to produce convincing results.

THE RIGHT BALANCE

However paradoxical it may seem, the only cure for today's oil "crisis" is for prices to remain substantially higher than the pre-2000 average of $18-$20 a barrel for an extended period of time. Only high prices can turn around two decades of sluggish investment in exploration, production, and refining capacity. Only high prices can encourage the use of less energy-intensive vehicles, such as hybrids, and, however marginally, the development of alternative energy sources for transportation. Only high prices can reduce irresponsible consumption in many parts of the world and move governments to adopt the measures necessary to curb it.

Despite current predictions that the upward shift in oil prices is permanent, however, there is no single market force that can maintain prices at any specified level. Political tensions, psychological factors, poor data, flawed analyses, erratic patterns of demand and production, and even freakish weather and other acts of God help determine the price of a barrel of crude at any given moment. The oil market involves too many actors with too many conflicting interests for prices ever to be shielded from fluctuation.

According to standard economic theory, the world oil price should be set by the price of the most expensive, so-called marginal, barrel -- that is, by the price of the last barrel needed to meet market demand. Today, the price of the marginal barrel would range between $30 and $32, which is the cost of extracting and marketing crude from the tar sands of Canada plus a profit margin for producers. (The cost of producing a barrel in the Persian Gulf is less than $4.) If the world oil price were to fall too far below the marginal-barrel level, producers would no longer have an incentive to make appropriate investments and there would once again be a risk of shortages in the short and middle term. But if the price were to shoot too high above that level for too long, demand would drop, creating a temporary oil glut that would stop the current wave of new investments. This would represent the worst-case scenario, because it would push the industry back to the risk-averse psychological mindset of the last 20 years.

The price of oil is unlikely to fall substantially in the short term and could even experience more spikes, especially if politically driven disruptions occur. But the longer the current wave of investments persists, the higher the probability that the price of crude will drop significantly down the road. In other words, nothing suggests that the first spike in the price of oil of the twenty-first century is an exception to the pattern of booms and busts that has characterized the oil market since its inception. One hopes that the magnitude of any price reversal will be small enough not to hamper the investment cycle currently under way or that such a reversal will come only after the bulk of new production and refining capacity is already in place. In dealing with oil, however, hopes often turn into wishful thinking.