The G forces of energy insecurity

June 10, 2006

“Prediction is difficult, especially of the future.”

-Niels Bohr, 1922 Nobel Laureate in Physics

The next six to twelve months should see the maintenance of high oil prices—above $70/barrel—due to tight supplies, steadily increasing demand and a lack of significant improvement in ‘above ground’ conditions (Iraq, Iran, Nigeria, Venezuela, Gulf hurricanes, etc.). Given this situation, prices could spike given several scenarios. If the U.S. and Tehran go to war over Iran’s nuclear ambitions, oil would rise above $100/barrel; if war is avoided but guerrillas are increasingly successful in disrupting the flow of oil in Nigeria and/or Iraq, oil prices could trade between $80-$90. If peace is maintained and guerrilla movements suppressed but 2006 sees another strong hurricane season in the Gulf of Mexico, prices could hover above $80/barrel by September. If all three scenarios occur simultaneously it would be a ‘Perfect Storm’ for energy markets, with oil prices rising significantly above $100/barrel before year’s end.

The foundation for this possible ‘Perfect Storm’ is a combination of factors that have coalesced to achieve a paradigm shift from the pre- and post-Cold War period of energy security to a new long-term era of 21st century energy insecurity. These factors are identified in this Research Note as the G Forces of Energy Insecurity: Growth, Geology, Geopolitics, Guerrillas, Global Warming & Green Energy. Together, they represent a structural as opposed to phenomenological change in energy market dynamics that will keep prices elevated for many years.

The Paradigm of Energy Security: 1985-2003

After the two oil crises of the 1970s, followed by the end of the Cold War and the resolution of the 1990-91 crisis, the world passed into a decade of lower oil prices and overconfidence about energy security—and, indeed, security overall. During this period the paradigm of Energy Security achieved a consensus (around 1986) that the long-term oil price would generally trade between $18 and $21 per barrel. For more than 20 years the back end of the crude oil futures curve rarely went outside the $18 to $21 price range (even during Desert Storm, this band was somewhat maintained). The $18 to $21 range became market orthodoxy and was supported by the evidence. The rationale behind this view held that if prices rose far above $20, it would trigger demand destruction and over supply of the kind that occurred in the 1980s.

The twin impacts of rising supply and falling demand would then push prices back to the $20 benchmark. Very few would argue today that $20 is the correct long-term price for oil ($40 is becoming the new floor), but it was a foundation of the Energy Security paradigm. What is unusual is that this paradigm was abandoned not due to a single extraordinary event (embargo, etc.), nor to a prolonged period of concern over inadequate supply to meet soaring demand. Instead, oil prices rose over a wall of forecasts that a correction was imminent. For nearly four years now, the front of the oil price curve has been increasing sharply and the risk of sudden spikes to over $100 barrel is accepted as a possibility—an unheard of thought back in the late 1990s (think of the famous cover of The Economist for March, 1999 “Drowning In Oil” that predicted oil could sink to as low as $5/barrel).

The New Paradigm of Energy Insecurity

The best explanation for the steady rise and maintenance of higher oil prices is the structural transition brought about by what this Research Note has identified as the evolving G Forces of Energy Insecurity. They are as follows:

· GROWTH: Globalization-fueled economic growth has increased energy demand, with billions of people in the developing world (e.g. China, India) beginning to use energy—primarily gasoline and electricity. This growth sits atop a doubling of U.S. energy consumption during the last two decades.

· GEOLOGY: Supply constraints have increased due to the end of ‘easy oil’ (e.g. poor exploration results, rapid inflation of energy production costs, mature field depletion).

· GEOPOLITICS: The loss of nearly one million bpd of Iraqi production has removed the old paradigm’s assurance that the projection of U.S. military strength into the Middle East can secure oil supplies. This has been concurrent with increased use of the ‘energy weapon’ amidst resurgent Cold War tensions (e.g. U.S., China, Russia).

· GUERRILLAS: Guerrilla and terrorist groups have shut down more than one million bpd (bpd) of crude oil production (e.g. Iraq, Nigeria) and threaten further attacks.

· GLOBAL WARMING: Significant risks of hurricane disruption, rising environmental compliance costs, and a growing regulatory consensus on climate change have made Global Warming a major energy issue (e.g. Hurricane Katrina, Kyoto Protocols).

Taken together, these forces have undermined the market’s confidence in achieving reliable and predictable energy supplies for the next several years. Buffeted by these G Forces, the global economy is at risk of decelerating growth rates while oil markets become more volatile. In particular, these G Forces will keep the risk premium in oil prices high as buyers realize the relatively permanent nature of tight supply conditions, worsening geopolitical and weather-related risks and growing threats to energy infrastructure from asymmetric attacks.

The reality that none of the G Forces of Energy Insecurity are improving, but rather are worsening, leaves scant room for significant price corrections in the next 12 months—and continues to establish a base for the long-term trend of higher global energy prices.


Tags: Energy Policy, Fossil Fuels, Nuclear, Oil