Commentary: An oil shock in 2012?
(Note: Commentaries do not necessarily represent the ASPO-USA position.)
The price of oil is once again daily in the news. The Western Europe benchmark Brent crude has hovered near $100 / barrel for much of the last month, and the IEA is again warning of the burden of oil consumption. Is this a harbinger of things to come, or a mere statistical blip in a market that is "well supplied"? How will events play out in oil markets in the coming year or two?
Certainly, oil prices have surged on the back on strong demand, of which some is structural, and some transient. The northern hemisphere has seen a strikingly cold winter, leading to increased heating oil usage. And the global economy is recovering from a deep recession, with demand bouncing off the recessionary trough. These are, to an extent, passing events. But in many respects, increased prices fundamentally reflect an oil demand that is increasing faster than supply.
Indeed, the recent growth of demand has been described as "astonishing". While it is not unexpected from our perspective, demand growth is still impressive. According to the EIA, world petroleum liquids consumption was up 2.8 million b/d, that is 3.2 percent, in the three months through January 2011, compared to the same three months a year earlier. While this is a high number, it is not unprecedented. In the twelve years to 1972, world oil consumption increased by 30 million b/d, representing 150% demand growth over the period and 2.7 million b/d average annual demand growth.
And demand increased by 7-8 million b/d in the three years of recovery following the oil shock of 1973 and the 2001 recession. (These recessions were arguably the most comparable to the recent one. After 1973, the western world was still continuing the process of motorization, and thus demand recovered quickly. This was also true after 2001, when China first made its impact on global oil markets.) Today, as after 1973 and 2001, the pace of motorization continues—indeed, has accelerated—in the developing world, and thus demand growth at a pace of 2.5 million b/d / year through 2012 should not be surprising.
Nor should oil demand growth compared to other energy sources be a surprise. Natural gas and coal consumption increased by 3.2 percent and 5.1 percent per annum, respectively, from 2002 through 2008, the start of the recession. It is hard to imagine that oil consumption would forever lag other fuel sources if the oil were available.
And available it was in 2010. According to the EIA, the oil supply increased by 2.1 million b/d in the three months through Jan. 2011, compared to the same period a year earlier. Non-OPEC liquids contributed 1 million b/d to this, consisting primarily of the US (+0.4 million b/d), China (+0.3), FSU (+0.3), Brazil (+0.2), and India (+0.1), offsetting production declines, notably in the North Sea (-0.4) and Mexico (-0.2). The balance of the increase came from OPEC, with natural gas liquids (NGL‘s) contributing nearly 1 million b/d and crude a lowly 0.2 million b/d.
Still, over the period, supply lagged demand by 635,000 b/d over the last three months compared to a year earlier, and it shows in prices, which have risen $8 / barrel over the period.
What should we expect prospectively? The forecasts of the IEA, EIA and OPEC fall into the 1.4-1.7 million b/d range for oil demand growth for 2011. But the IEA and EIA expectations were perhaps a million barrels low last year, and they may be low again by a similar amount going forward. Based on both technical and historical analysis, demand growth in the 2.4 million b/d range for 2011 and 2012 seems more likely.
The chart shows the difference between our and the EIA‘s respective views. The EIA sees a break in the recent trend line, with growth in 2011 and 2012 literally half that of 2010, the first full year of economic recovery. By contrast, we think that the recovery will pick up speed this year and that no material break in activity will occur in the developing world, notably China. Thus, demand pressures in the coming two years are anticipated to be similar to 2010, and similar to the recoveries of comparable recessions in the past. As a consequence, our forecast is higher than that of the EIA. By the end of 2012, the difference between our forecast and that of the EIA totals 1.75 million b/d, with peak demand hitting 92 million b/d in some months.
EIA STEO Feb. 2011 and Douglas-Westwood Analysis
On the supply side, the EIA‘s outlook appears plausible. In 2011 and 2012, OECD production is set to decline almost across the board, albeit only slightly. The FSU will be essentially flat, and Brazil adds modestly to "other Non-OECD" supply. Brazil should, and Azerbaijan and Kazakhstan could, conceivably post better numbers than forecast. But overall the EIA numbers appear defensible. As a consequence, OPEC must increase production to meet incremental demand, and the EIA sees OPEC crude oil production capacity rising by 0.7 million b/d in 2011, and a similar amount in 2012. The lion‘s share of this is presumably Iraq; thus, the EIA supply side forecast depends on Iraq posting two stellar years back to back. This could fairly be considered optimistic—Iraq increased production by 0.3 million b/d in 2010—but not impossible. Iraq‘s contribution, however, is fully valued.
With our outlook for demand running ahead of the EIA and our supply outlook aligned, presumably the difference would be made up from reductions in spare capacity as OPEC lifts output. And in OPEC, only Saudi Arabia matters. As of January 2011, Saudi represented 78%—3.65 million b/d—of OPEC and, as a practical matter, global production reserves. How much of this capacity actually exists? During the oil price spike of 2008, Saudi Arabia never committed the last million barrels of its nominal capacity. Many observers, including the author, believed that the Kingdom lacked the capacity—it withheld nothing from the market. By this measure, Saudi excess capacity could be only 3 mbpd or perhaps a bit less today.
How will the Kingdom commit this reserve? Many observers believe that Saudi will never pump more than 10 million b/d—only 1.4 million b/d more than its produces today. This belief is based on history: Saudi production has never sustained above 10 million b/d. Some doubt that the Saudi‘s can lift production volumes, and indeed, recent Wikileaks documents cast doubt on Saudi reserves and production limits. Neither of these arguments is entirely convincing. True, much of new developments in the Kingdom are related to either heavy, sour, or offshore crude, enhanced oil recovery, or natural gas.
None of these is suggestive of a country in which one could stick a straw in ground and draw light sweet crude without effort. However, when the Saudis were pushed prior to the recession, they were able to add nearly two million barrels of capacity is relatively short order and at comparatively modest cost. Saudi Arabia is no longer an Iraq—an under-developed resource—but with 260 billion barrels of proved reserves, the Kingdom still a formidable producer capable of lifting production if its national interests so dictate.
However, the Saudis, having produced aggressively for more than half a century, can envision the future, perhaps seventy years from now, when Saudi Arabia‘s resources will be largely depleted. If Saudi is not yet half way through its oil resources, it is close enough to appreciate that they are finite. This perspective may have led King Abdullah to command in 2008 to "leave it in the ground, by Allah, our children will need it." As a result, the Kingdom may be reluctant to increase production. It is certainly fair to posit that the Saudis would prefer higher prices to higher volumes, and the current environment looks likely to provide them. Both these factors would encourage the Kingdom to limit production.
EIA STEO Feb. 2011 and Douglas-Westwood Analysis
Is then, Saudi Arabia‘s nominal spare capacity to be taken at face value? No one, probably not even the Saudis, know for sure. However, for policy purposes, a conservative policy would assume that the Saudis will not exceed 10 million b/d, and based on history, an effective capacity of more than 11 million b/d should not be assumed.
Thus, effective spare capacity in the global system should be considered 1.4 - 2.4 million b/d less than the 4.65 million b/d currently reported by the EIA. Consequently, it may not be more than 2.25 – 3.25 million b/d, in essence as much as global growth in demand last year. This is not much.
Further, if we pair reduced spare capacity with increased demand, then effective surplus capacity is consumed at a brisk pace. By the middle of 2012, spare capacity could be as low as 1 million b/d, or even less, if the Saudis decide to limit production at 10 million b/d. To a certain extent, these developments could be forestalled by inventory drawdowns, and indeed, the EIA forecasts inventory draws averaging a quarter million barrels a day in 2012 to sustain spare production capacity. Such draws are not unprecedented or unusual in themselves, but they are another factor suggesting tight markets. In any event, when surplus capacity falls below one million b/d, an oil shock cannot be precluded. Thus, in the better case, the world is facing tight oil markets in 2012; in the worst case, the country may be heading into another oil shock and recession.
For policy makers, this has a number of implications. For starters, it suggests that Saudi Arabia will have a material influence on the 2012 US elections. The Kingdom will be able to create constricting oil prices not only by withholding production, but by releasing it too slowly. Therefore, the nature and quality of US relations with the Kingdom will matter. It also suggests that an oil shock is likely by 2013, even if the US is lucky enough to escape one in 2012. Such shocks are typically associated with recessions, which would imply increased unemployment, surging budget deficits and possibly more pressure on housing prices and the financial sector. Policy analysts need to run the numbers, to anticipate potential fallout and look to mitigate adverse effects to the extent possible.
Mr. Kopits heads the New York office of Douglas-Westwood, energy business consultants. The firm assists energy service providers with market research, strategy development and commercial due diligence. The author is solely responsible for the opinions expressed herein.