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August 14, 2004

Oil Price Disaster?

The oil price recently moved up into the mid-$40's per barrel (exactly where depends upon which price you want to look at, West Texas, Brent or Saudi Light) and we've had the usual outbreak of chicken littles claiming the sky is about to fall. The concerns range from imminent recession as the rising price runs a shock through the entire system to the imminent death of that entire system as the long awaited Hubbert's Peak arrives.
It's time to take a slightly closer look at the current situation so as to put some of the worries to rest. Yes it is true that, other things being equal (or as economists put it, ceteris paribus) a rising oil price will reduce growth. It will also reduce oil consumption as behaviour changes, increase the attractiveness of alternate fuels and smaller cars and shorter commutes, things that those who worry about Global Warming desire, so it is not all bad, in and of itself.
The Hubbert's Peak argument is simply absurd in both geologic and economic terms. According to the US Geologic Survey (www.usgs.gov) there is still 1.5 to 2 trillion barrels out there that can be recovered, enough for another 50 - 80 years. We might also note that the Athabascan tar sands are profitable to exploit at $30 a barrel giving us another 8 centuries at current rates of consumption.
So while we may be facing a short term pain in the wallet and slightly lower growth, oil at current prices is not the end of either the oil age or the capitalist system.
There are also a few technical points that can be made. The Russian Government is in the process of confiscating the oil producing subsidiary of Yukos (it's a long story), a company that pumps two percent of the entire world's supply. As part of this process there have been repeated claims that Yukos must stop pumping only to be relieved a day later, then around the process again. Instantaneous removal of 2% of the world's supply of anything will have markets jumpy so at least part of the current price must be attributed there.
We might also note that there is a war on in the Middle East, one in which terrorists are repeatedly trying to blow up the export pipelines of both Iraq and Saudi Arabia: again, markets tend to be a little frothy when such things happen.
We also have Venezuela, provider of the largest chunk of the US's imports, in political turmoil as the recall referendum against Hugo Chavez goes ahead.
Any one of the above three events would lead to a rise in price, all at the same time are simply re-inforcing each other.
So, while not everything in the garden is rosy, what we are seeing is not the end of the oil age, or of oil supplies in the medium term, we have a series of unconnected events which are causing a temporary spike. One that will indeed cause slower growth in the short term, at the outside of the possibility envelope even a recession.
Yet we might remember that in 1981 the oil price peaked at $80 a barrel (in current dollars) and while the early 1980's were not completely wonderful for everyone in economic terms it wasn't the sort of disaster that people seem to be predicting now from a much lower price.
Finally, we have proof that oil is less important than it was, as theory would predict when something rises in price. Back in 1981 crude oil sales were 8% of world GDP. They now make up 2%. So, in order to have an oil shock equivalent to what we had back then, oil has to rise to $160 a barrel today. It ain't gonna happen folks, it just ain't gonna to work that way.
In the end we have oil prices that are not historically high, long term supplies are fine, the current bounce can be explained by minor unconnected events around the world and anyway, oil is only 25% of the importance to the economy that it was two decades ago.
Sure, filling the tank is a pain at the moment but it's not a crisis. Back to sleep everyone.

August 14, 2004 in Economics | Permalink


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I'd be interested in your comments regarding REFINERY capacity.

Is it correct that there is less than 3% "slack" in the refinery system and that each time a refinery has to change over from one source of crude to another (Say, Saudi crude to Russian) it goes out of production for awhile?
What does that, (and changing from one source to another at increasing frequencies as crude prices of each source fluctuate) do to price of petrol/gasoline?

If some powerful nation like the US decided to build a gov't refinery "for miiitary fuels" would that compete usefully with the existing capacity, introduce useful "slack" -- or would it just exagerate flucuations?

Posted by: Pouncer | Aug 16, 2004 5:19:14 PM

To take them in order:
Absolutely the best place on refineries is Lynne Kiesling's blog " Knowledge Problem". An academic economist who specialises in such areas as the electricity grid and network and has done good work on refining capacity. She had a lot in the spring about the change over from winter to summer fuels for example, and also on the 30 - 40 different blends of gas you have in the US not.

From what I'm aware, US refineries run at 95% capacity. Given maintenance timeouts that if flat out.
The problems are not so much that the crude changes (I'll explain that in a moment) but that the blend of outputs changes. Obviously less heating oil is produced in the spring, for example. Each such change requires a short shut down and a tweak.
Crude inputs don't actually change that much. Yes, there are different grades of crude, but most refineries run off blends of such grades. Not so much Russian/Venezuelan/West Texas as a little heavy high suplhur, lots of light low sulphur and a little bit of something else for spice.
Military refineries? Not sure it would work.Now that ships are nuclear or gas turbine they really only use aviation, gas and diesel. That would leave huge amounts of the heavier fractions that they would have to dump somewhere. And also large amounts of aviation fuel that refineries already produce going spare.
The solution to refinery capacity is to relax the ability of NIMBY's to stop them being built. It would also help (and this is taken from Lynne's blog above and a recent TCS piece by someone whose name I can't remember, sorry), to reduce the number of different gas blends, returning the US to a nationwide market.

Posted by: Tim Worstall | Aug 16, 2004 6:25:41 PM

"I'd be interested in your comments regarding REFINERY capacity."

Political talk about oil always is always near-exclusively based on today's prices, with even recent history forgotten.

But way back in 1998 oil was actually down below $10/b. The story was: "OPEC Has Lost Control", "The New Era of Cheap Oil" and so on.

Of course the result of that was that the oil companies and OPEC closed down production and cut back on facilities all through the supply chain -- wells, refineries, transport, skilled people, everything.

E.g. look at this report from the time, with posted oil prices down as low as $4.65(!):

"By October, employment in oil and gas extraction was down 7.2 percent ... Companies have been laying off less experienced lower paid workers, but the cuts are now moving up the experience ladder. If prices do not recover soon the industry will lose valuable human capital. Thus the producers dilemma: lose talent, lose reservoirs or lose the business? In many cases, it will be all three."


OK, so after that prices stabilized, with both Japan and the US in recession.

Then, all at once, there are booms in the US, Japan for the first time in more than a decade, and China (*plus* a Mid-East war and terrorism in Saudi Arabia that add several dollars of risk premium to each barrel). Demand explodes with all those supply facilities gone -- so what happens to price?

To reverse the post-1998 cutbacks and bring new production on line in response to all this takes even the Saudis two years, and they can do it faster than anyone else.

So what we are experiencing is not the exhaustion of oil supplies in any way, shape or form -- despite the constant secular-religious mantra saying it is so -- but a classic economic cycle, just like with anything else where demand moves faster than supply can shift in respose.

It's called "volatility". Demand falls, prices plunge right away, production is cut back with a lag ... then demand rises, prices rocket up, production increases with a lag -- and the press is full of "the end oil" because nobody can remember five years back.

Posted by: Jim Glass | Aug 16, 2004 6:33:01 PM

"and the press is full of "the end oil" because nobody can remember five years back."
Bings to mind a comment of Nigel Lawson's when Chancellor of the Exchequer. Financial journalists and analysts are just "teenage scribblers".
Indeed, it's a commonplace in the City that the next financial crisis will turn up on the day that the last person who can remember the one before retires.

Posted by: Tim Worstall | Aug 16, 2004 8:43:45 PM

That's why we need a breakthrough in increasing human lifespan. So that there will be plenty of people around who are old enough to provide perspective.
Oh--and one more thing. We need capital punishment strictly administered for stupidity and dishonesty in the news profession. You might see Krugman starting to put out a superior product.

Posted by: Fleming | Aug 18, 2004 2:34:39 AM

One of the fundamental points of trade economics is comparative advantage, the idea that countries (it extends to people as well) should do what they are least bad at. As PK was a much better economist than he is columnist, (and his work was all about trade and comparative advantage) he should realise that both he and the general world would be better off if he moved from his low productivity job as a columnist and back to his high productivity job as an economist. We don't need the death penalty, just the rigorous application of his own professional expertise.

Posted by: Tim Worstall | Aug 18, 2004 8:47:03 AM

I'd like to learn more about the impact shale oil and other synthetic oils like coal to gas is expected to have in the future. Will they automatically create a price ceiling?

Also, I highly recommend Daniel Yergin's book "The Prize" it's a history of the oil industry and it's inevitable busts and booms.

Posted by: Russell | Aug 18, 2004 1:12:55 PM

I pretty sure that oil shales will create a ceiling for the long term price of oil, just as any substitute would. Coal gasification I know less about.
Yergin's "The Prize". Indeed, excellent book.

Posted by: Tim Worstall | Aug 18, 2004 1:51:03 PM