Issues of Prices and Shortages in the Oil Industry
Introduction
Oil, one of the most significant economic commodities affecting production, as well as economic markers such as inflation and GDP, has for long influenced international economic policy, Until a decade ago, the future of the global oil supply was considered uncertain, fueled by debates surrounding the expected dwindling of oil supply.. With OPEC (Organization of the Petroleum Exporting Countries) primarily driving the oil market in the 20th century, conservative projections of oil reserves caused the search for alternative options.
While some observers following Hubbert’s approach indicate that there is a likelihood of ‘peak oil’, alternative analyses suggest that it will be possible to eliminate any potential problem in oil reserves with new knowledge, technology, and increased efficiency. This paper focuses on the possibility that the global oil supply will continue to grow significantly, and factors that can cause an increase in oil prices.
Myths in the Oil Industry
According to Adelman (2004), conventional wisdom has for decades contributed to inaccurate information about the oil industry, while at the same time downplaying the actual problems of rising oil prices as a function of OPEC’s monopoly, the impact of operating cost on the viability of oil production, and estimations based on varying definitions of ‘proved reserves’. One myth says that the oil reserves will be depleted by the increasing demand due to a rise of energy needs in developed and emerging economies. The main problem related to oil involves the cartel that is comprised of OPEC’s member countries. These countries restrict their oil production, with the aim of controlling supply, and raising oil prices. Hence, it is wrong to assume that increase in oil prices automatically means reserves are dwindling. Adelman asserts that ‘known reserves’ may not necessarily reflect the oil supply, since if the operating cost of extraction is higher than expected returns, the “probable reserve” is merely an estimate based on current prices, and technology.
New knowledge, advancements in technology, and the discovery of new oil reserves are some of the factors that provide a good indication that oil will never be depleted. Potential economic rewards are a precursor to explorations in knowledge, which in turn leads to development of technology that reduces the production costs, and makes finding new deposits an economically viable investment. For instance, in 1950, only conventional oil was produced, but 25 years later, it was possible to drill offshore oil 1000 feet deep. It is predicted that 50% of US oil production will ultimately be comprised of offshore oil (Adelman, 2004).
The Issue of Oil Reserves Depletion
The issue of depletion of oil reserves is primarily a function of analysis. Lynch (2003) and Watkins (2006) argue against Hubbert’s ‘life cycle’ approach to analyzing oil reserves and production. Disputing the alarmist findings of Hubbert modelers, specifically Campbell and Laherrere, Lynch terms the results as unsubstantiated, since the studies do not acknowledge the impact of technology on oil reserves. According to Lynch, Campbell and Laherrere focus on geological constraints, rather than understanding the relationship between exploration, discovery, and production as the effects of demand and political and economic policy. Although the analysts focused on improving earlier findings that relied on the Hubbert model, the model’s main issue that it does consider ultimately recoverable resources (URR) as a dynamic variable, but relies on the URR as a static number. This is wrong, as the URR is likely to be affected by changes in technology, infrastructure and a range of other factors, but especially its growth.
Various research projects have been conducted to help in dispelling the idea that the world is running out of oil. For instance, Maugeri (2012) paper focused on illustrating how oil supply capacity has grown at an exceptional rate to the extent that it is likely to be higher than forecasted global consumption. A prerequisite for these estimates of oil production is oil price at $70 per barrel. Although, early 21st century projections by U.S. Geological Survey (USGS, 2003) and World Energy Council (WEC, 2007) estimated ‘9 trillion barrels of unconventional oil resources beneath the surface of our planet, with only 300 billion barrels of them potentially recoverable’, the data did not include ‘shale/tight natural gas and oil boom in the U.S’ (Maugeri 2012).
Maugeri’s forecasts rely upon field-by-field analysis of a database of investments in oil production in ‘23 countries representing more than 80 percent of current production capacity, and more than 95 percent of future production growth’ (2012). Results indicate an ‘increase in world’s oil production capacity from about 93 mbd in December 2011 to 110.6 mbd in 2020’. Maugeri asserts the importance of unconventional oil extractions using technologies such as horizontal drilling and hydraulic fracturing in liquid additional unrestricted production, and the potential problems of inadequate infrastructure for transportation and refining, and environmental hazards. Increased oil production forecasted at 49 million barrels per day (mbd) of oil by 2020, could result in increased supply caused by overproduction resulting in lower oil prices. The Issue of Oil prices
The rise in oil prices can be explained using various reasons. Kilian (2006) examines whether the reduction in oil production in OPEC countries caused by war and other exogenous political episodes that have happened since 1973, had an impact on oil prices, the U.S real GDP growth and U.S CPI inflations. Five oil shock episodes were analyzed: Arab-Israeli War (1973/74), Iranian Revolution (1978), Iran-Iraq War (1980), Persian Gulf War (1990/91), and the Venezuelan crisis and Iraq War (2002/2003). The findings of this study reveal that the Persian Gulf War had the most impact on reducing real U.S GDP growth, while the increase in oil prices during 1973/74 and 2002/03 was due to ‘strong demand for oil rather than exogenous oil production reductions’ (Kilian 2006).
Barsky & Kilian (2004) noted that the 1973 Arab oil embargo against pro-Israeli OECD (Organisation for Economic Co-operation and Development) countries had little impact on OPEC oil production. In 1972/73, the increased global demand for oil led to expanding oil production, much to the reluctance of Saudi Arabia, the country with the largest spare capacity, Saudi Arabia repudiated the Tehran/Tripoli agreements in October 1973, due to the unsuitability of the posted price in 1971 against contractual requirements of higher supply, which was due to ‘dollar devaluations and rising U.S. inflation.’ This resulted in deliberate production cutbacks in OPEC countries that had increased production.
According to Kilian, the 1978 Iranian revolution caused an endogenous Iraqi response of increased oil production, exogenous to global macroeconomic conditions, leading up to the 1980 Iran-Iraq war (2006). Conventional wisdom has insisted that major rise in oil prices are due to the occurrence of exogenous political episodes in the Middle East. According to Kilian, among exogenous political events, only the 1980/81 oil price increases can be attributed to exogenous oil supply disruptions. The author asserts that oil prices are mostly influenced by shifts in global demand for oil, and uncertainties of future oil supply fluctuations such as the threat to Saudi oil fields in 1990.
Adelman (2004) points out OPEC’s monopoly as one of the primary influences on oil prices. The main problem that OPEC oil cartel encountered in the late 1980s in maintaining the high prices was ensuring that none of the cartel members cheated by failing to constrain its level of production. Saudi Arabia’s restraint in oil production to avoid the problem did not deter the cartelists from profiting as a result of producing over quota. OPEC’s decision in March 1999, led by Saudi Arabia, caused constrained world oil production, and a spike in oil prices. As major suppliers of oil in the world, OPEC countries maintain high oil prices by reducing the levels of production.
However, just like in 2001 during prospects emerging of a U.S recession, when the prices began to decline rapidly, the members cannot continue having significant reductions in oil production when they experience falling demand (Barsky & Kilian, 2004). Additionally, the impact of uncertainty of future oil supply interruptions influences oil prices, such as during the 2003 Iraq war. Prices in 2003 were close to nine times higher than those in 1973 (Watkins, 2006). Increased oil production from non-OPEC countries also means an increase in prices can cause importers to source oil from other exporters, reducing the quantity demanded from OPEC countries, and its price controlling strategies.
Conclusion
The world is not likely to face oil shortages in future due to depletion of oil reserves. However, other factors can result in supply disruptions, and a rise in oil prices. Both the threat of wars in the Middle East, and fears of a reduction in oil supply from reserves can cause a rise in precautionary demand is likely to result in a sharp rise in oil prices, due to inelastic oil supply during capacity constraints. Additionally, macroeconomic conditions may shift the demand for oil. With technological advances in oil extraction, and increased projections of global oil production, expansion of fuel reserves could lead to a reduction in the prices. The resultant weakening of the oil cartel could bring about parity in oil availability, and steady prices.
References
Adelman, M. A. “The real oil problem”. Regulation, 27, 2004, pp. 16-21.
Barsky, R. B., & Kilian, L. “Oil and the Macroeconomy since the 1970s”. The Journal of Economic Perspectives, 18(4), 2004, pp. 115-134.
Kilian, L. “Exogenous oil supply shocks: how big are they and how much do they matter for the US economy?”. The Review of Economics and Statistics, 90(2), 2008, pp. 216-240.
Lynch, M. C. “The new pessimism about petroleum resources: debunking the Hubbert model (and Hubbert modelers)”. Minerals and Energy-Raw Materials Report, 2003, 18(1), pp. 21-32.
Maugeri, Leonardo. “Oil: The Next Revolution” Discussion Paper 2012-10, Cambridge, MA: Harvard Kennedy School. Belfer Center for Science and International Affairs, 2012.
Watkins, G. C. “Oil scarcity: What have the past three decades revealed?”. Energy policy, 34(5), 2006, pp. 508-514.