Washington, DC—One of the central issues facing policy makers in
Washington and around the globe in 2005 is the prospect of further
instability in world oil markets. This new reality carries both
economic and security risks. Another oil shock could tip the world
economy into a premature recession, while the massive flow of oil
revenues into the Persian Gulf and Russia threatens to derail
economic reforms and foment political unrest.

The dramatic rise in oil prices from $24 per barrel in 2002 to
between $40 and $55 in late 2004 stems in part from a sharp increase
in consumption in China and the United States. But it also reflects
the fact that for the first time in more than two decades, there is
virtually no spare oil production capacity left—with far-reaching
implications for national security, economic stability, and all of
our pocketbooks. Although oil prices have fallen over the past month,
this is likely to prove a brief respite from the oil escalator we’re
now riding.

Already, oil production is falling in 33 of the world’s 48 largest
oil producing countries, including 6 of the 11 members of the
Organization of Petroleum Exporting Countries (OPEC). Among the
countries where oil production is declining are Great Britain and
Indonesia. In the continental United States, oil production peaked at
8 million barrels per day in 1970, and has fallen to just 2.9 million
barrels per day in 2004. In this year of soaring prices, only Russia
and the Persian Gulf countries have been able to increase production
significantly—and they are now pressing against their current limits.

The urgent question is whether the recent difficulty in boosting oil
production represents a temporary challenge or something more basic.
Many government agencies still believe that there is plenty of oil
left, and that higher prices will open the floodgates. They argue
that there is enough for world oil production to keep rising for the
indefinite future—reaching 115 million barrels per day by 2020, or
more than 40 percent above the current level according to the
International Energy Agency.

However, a growing number of geologists question whether remaining
oil reserves are sufficient to keep production going up much longer.
For the past three decades, they argue, oil companies have not been
finding as much oil as they have been extracting—a gap that has
widened in the past ten years. Royal Dutch Shell’s repeated
downgrades of its estimated reserves over the last year have raised
further alarms, as have figures showing that even the limited
exploration that is being done is no longer very productive.

These developments suggest that the stable oil prices of the past two
decades may soon be a distant memory. PFC Energy, a Washington-based
oil forecasting group, has carefully analyzed global reserve figures,
and concluded last month that world oil production might be unable to
meet projected demand as early as the middle of the next decade. PFC
and a growing number of other forecasters now project that world oil
production will peak in the next 10-15 years. Some believe it could
happen even sooner.

In the past, it was assumed that if oil supplies got tight, Persian
Gulf countries would quickly and easily provide whatever oil the
world needs. But today, the ability of countries like Saudi Arabia
and Iraq to raise production substantially is in doubt. Some of the
largest oil fields in the Persian Gulf are aging rapidly, according
to experts, and no independent verification of their claimed oil
reserves has been permitted for decades.

The oil industry is hitting the wall at a bad time for the world
economy. Demand is surging in developing countries—particularly in
China and India—adding to the market pressures generated by the huge
fleet of gas-guzzling SUVs already on U.S. roads. China in particular
has been building factories, houses, roads, and virtually everything
else at a furious pace, scouring the world for resources. China’s oil
consumption went from less than 5 million barrels per day in 2002 to
6.2 million barrels per day in 2004, a 24 percent increase. Two
decades from now, China could be importing as much as 10 million
barrels of oil per day—as much as the U.S. now imports or Saudi
Arabia now produces.

It is time for political leaders to recognize—as former U.S.
President Bill Clinton did last week when he called for efforts to
reduce U.S. reliance on unstable Middle Eastern sources of oil—that
an oil-hungry world is on a collision course with an overstrained
resource base—laying the stage for a period of instability in energy
markets. Among the potential impacts:

► Economic growth will slow and inflation will rise if oil prices
stay at or above their current level of more than $40 per barrel. The
United States will spend roughly $160 billion on oil imports this
year, and many oil-dependent developing countries could soon fall
into recession if prices stay high.

► Growing dependence on Persian Gulf oil will alter the international
balance of power, flooding those countries with extra cash. If the
past is guide, these growing revenues may delay economic and
political reforms, and further line the pockets of a wealthy elite.

► Dependence on Russia, the one other country where production is
growing substantially, will also grow dramatically, shifting the
international balance of power. With China rapidly rivaling the
United States as the world’s largest oil importer, international
pressures will grow.

► Additional airline bankruptcies are likely given the oil intensity
of the industry. A major shakeup in the automobile industry is also
possible. Companies such as Toyota that have pioneered highly-
efficient hybrid-electric cars may benefit, while some of the U.S.
companies that have relied heavily on SUVs for their profits may be
in trouble.

The bottom line for consumers, industries, and governments alike is
the urgent need to conserve energy and step up efforts to develop new
energy sources. Among the urgent priorities that could make a

Update car and truck fuel economy standards, which have been static
in many countries for a decade or more. It is essential that SUVs,
which comprise a growing share of auto fleets, be covered by these
standards. The rest of the world would do well to follow the lead of
China and California, both of which announced new standards this

Provide incentives for accelerated introduction of a new generation
of fuel-efficient cars. Hybrid-electric drives; clean, efficient
diesel engines; and light-weight composite frames and bodies have the
combined potential to nearly double the fuel economy of cars—but
manufacturers need additional motivation to develop and market them.

Speed up the use of “bio-fuels”—ethanol that can replace gasoline,
and vegetable oils that can substitute for diesel fuel. Already,
government incentives are spurring market growth in Europe, Brazil,
and the United States.

Raise automotive fuel taxes in countries like the United States,
where they are too low. Higher gasoline taxes will promote
conservation, and will tend to smooth out the likely roller coaster
in fuel prices in coming years. The higher cost to drivers can be
mitigated by offsetting reductions in income taxes.

About the author: Christopher Flavin is president of the Worldwatch
Institute and author of Power Surge: Guide to the Coming Energy
Revolution. He is co-author of the chapter “Changing the Oil Economy”
in State of the World 2005, to be released January 12, 2005.