Breaching ‘The Breaking Point

The recent oil rally and record-high prices have sprouted a thriving cottage industry of energy millenarians — doomsayers warning that oil production has peaked and that a toxic mix of soaring demand and plummeting reserves is leading the world on a global collision course toward the “End of Oil.” That such predictions have been repeatedly proved wrong in the past is no guarantee that they won’t ever be right. But there are two problems with the theory: the assumption that geology is the main constraint on supply, and that demand is price inelastic.

In fact, oil supply is as much a function of politics as of geology. Politics, rather than physical depletion, is what’s been holding back supply and fueling the current rally. And while global oil consumption and the world economy have yet to show the impact of high oil prices, demand will respond eventually.

Simple economics and conventional wisdom would suggest that higher oil prices beget higher supply, which in turns causes prices to fall as producers seek to profit from the rally and higher-cost production becomes economical. That is a flawed argument that consumer countries often have used to exhort OPEC to boost output or risk loosing market share. In fact, the current rally has proved the opposite: Rising oil prices foster resource nationalism, which is bad news for production growth.

Russian oil production is a case in point. From 2000 to 2004, Russian production soared annually by nearly 700,0000 barrels per day, providing the lion’s share of global non-OPEC production growth. Growth in Russian output went a long way toward meeting soaring demand from Asia, notably in China. Since late 2004, however, Russian production has slowed to a trickle. The world will be lucky if Russian output stays flat in 2006, before swinging into decline in the run-up to the 2008 Russian presidential election.

There are many reasons for the drop, but they have little to do with resource depletion — even when taking into account the fact that some big Russian fields are clearly past their prime. More potent factors include the crackdown on the Yukos oil company, back-tax claims against other companies, changes in the oil royalty and taxation regimes, a new sub-soil resource law restricting foreign company access to hydrocarbon reserves, rising corruption and capital flight, President Vladimir Putin’s weakening grip on Russian political power and a general deterioration of the investment climate.

While the slowdown of Russia, an oil giant whose production was rapidly recovering from a post-Soviet slump, clearly stands out, it is not unique. Other oil producers whose output is expected to slow, if not decline, in the near term include, among others, Venezuela, Nigeria, Angola and Iran.

Again, politics prevail. As oil prices rise, producing countries come under decreasing pressure to boost output. Giddy with fast-rising export revenues, they find it more expedient to further boost revenue by claiming a larger share of the oil rent than by inviting oil companies to produce more. In the more benign cases, taxes and royalties for new projects are simply raised — as seen in Russia, Kazakhstan, Nigeria and Venezuela. This alone can be enough to scare off investors by fanning fears that projects will become unviable in a price downturn.

In more severe cases, companies are slapped with hefty back-tax claims: Think Yukos, but also TNK-BP in Russia, Shell, Harvest and others in Venezuela, and most recently Chevron in Nigeria. In extreme cases, existing contracts are changed retroactively, and recalcitrant companies are either forced to shut down their operations or shut out of new projects, as was the case in Venezuela.

In authoritarian petro-states, oil companies also can be punished for good performance when high oil prices turn them from cash cows into political threats. Thus Russia has not only cracked down on Yukos, but also reasserted state control over the entire industry. In Venezuela, President Hugo Chavez repeatedly reshuffled management at state Petroleos de Venezuela, eventually replacing all executives with government officials.

In Iran, hard-liner President Mahmoud Ahmadinejad started his term in office by launching a major crackdown on “corruption” at the National Iranian Oil Company, replacing a consummate oilman at the helm with a political ally who has no oil background. Government control is strengthened, but at the cost of future production.

Ironically, high prices also work to weaken government by fanning grass-roots demands for a greater piece of the oil rent by disenfranchised groups. This, too, undermines supply. In Nigeria, high prices boost “ethnic fighting” in the oil-rich, but environmentally wrecked, Niger Delta region, a chronic cause of export cuts. High prices bring into sharper focus the plight of the delta’s distressed communities, even as it helps arm local ethnic militias who benefit through higher oil-smuggling profits. In Ecuador, high prices have fueled similar demands by oil workers in the oil provinces of Sucumbios and Orellana, causing labor unrest and production cuts.

Last, high oil prices in a tight supply environment enhance the risk of oil being used as a political “weapon,” à la the 1970s. Iran’s leaders are reportedly warming up to the idea of cutting back exports to counter international pressure stemming from its resumption of nuclear activities.

Resource nationalism is, of course, itself a cyclical phenomenon compounded by the reality of resource depletion elsewhere. Chavez couldn’t play hardball with Western oil companies if reserves weren’t already past their peak in the continental United States (Arctic National Wildlife Refuge excepted) and the North Sea, or if resource development in Iraq wasn’t held back by civil war. It also wouldn’t be possible if demand hadn’t been booming. That may not last forever.

So far demand has been surprisingly resilient to high prices, but price effects on demand and the broader economy always lag behind the actual price changes, not unlike changes in interest rates. In the current rally, price effects have been partly offset by record global economic growth — demand is more sensitive to income gains than to price increase — and by price controls or subsidies in parts of the emerging world. But the cost of subsidizing oil consumption has become too big a burden for countries ranging from Indonesia to Nigeria, which are ramping up domestic prices — as is, notably, China. In the United States, which accounts for one-quarter of the global oil market, prices are taking a toll on consumer spending, and a real-estate market slowdown or crash would further brake demand growth. Already, jet-fuel demand, a leading economic indicator, has become wobbly.

This may not suffice to bring down the oil price if demand impacts are offset by more bad news on the supply front. And the risk of bad supply news seems constantly on the rise. Although much oil is held back from the market by politics rather than resource depletion, many of those political issues have no quick fix.

This is also balancing the prospect of new oil from those few countries where production problems are rolling back resource nationalism — countries such as Algeria, Indonesia and Libya, where low or fast-falling output is forcing government to try and attract more foreign investment. Continued high prices in an economic slowdown, on the other hand, would in turn put additional pressure on the economy, potentially extending and deepening any downturn. This could cause a price drop, if one finally occurs, to be steeper.

But even if prices do fall back from their current highs, the dip will not last. Oil remains a cyclical market, with its ups and downs, but the broader trend in oil prices is upward, and sharply so, as demand continues to expand while available reserves thin out and other reserves remain out of reach or difficult to turn into supply.

This is precisely what “Peak Oil” theorists tend to leave out of the equation. Energy doomsayers tend to adhere to an apocalyptic view of resource depletion — something like running into a wall at full speed — and to think of supply in strictly geological rather than economic terms, ignoring the salutary effect of market mechanisms. A fatal crash may be avoided, however, if price effects midwife the adjustments in consumption, changes in lifestyle and city planning, efficiency gains and technological breakthroughs needed to bridge the widening gap between fast-rising demand and supply constraints. The recent oil price rise is as much a challenge as a threat, and may be the ticket out of our energy mess.

The views and opinions expressed in this article are the author’s own and do not necessarily reflect those of the Forward.


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Breaching ‘The Breaking Point

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