An interesting piece came out of BP and Oxford University this week by two eminent energy economists. Spencer Dale is the chief economist for BP, while Bassam Fattouh is the director of Oxford University’s Insitute for Energy Studies. The full report is available here.
In it, the authors argue that the paradigm in oil markets has shifted from an age of perceived scarcity to one of (presumably, real) abundance. Previously, oil producers would attempt to husband their resources, safe in the knowledge that prices would always ultimately rise as the world’s oil resources were progressively exhausted. Now, in an age of abundance, producers will be incentivised to produce more quickly – and, indeed, diversify their economies away from oil reliance. This is because prices in the future will likely be lower than they are now, due to oil demand peaking at some point in the next 20 years – though the authors point out that predicting exactly when is an exercise in futility.
This will lead to more competition in oil markets, but the authors caution that it is not simply the cost of extraction that will set the price at the margin. Rather, the “social costs” of states reliant on oil revenue – i.e. healthcare, social welfare programmes, etc. – prevent particularly Middle Eastern producers from selling their oil at or close to extraction cost. Because social change is slow – and global demand will fall only slowly if/when it does peak – these social costs will keep oil prices higher for the next decade at least.
This is a well thought out piece by two highly credentialed authors, and sets out their case lucidly. The above is my understanding of it, and I would urge readers to follow the link and read it for themselves. With this in mind, there are two key points that I’ll try to think through in the following.
First, there is an issue with the premise of an age of abundance. With the development of “unconventional” oil, particularly onshore US LTO, consensus fears over peak supply have indeed receded. However, as we argued here, to some extent they have merely been reframed. This is certainly what is happening in the BP piece when the authors write that: “The world isn’t going to run out of oil. Rather, it seems increasingly likely that significant amounts of recoverable oil will never be extracted.” Peak oil supply theorists have argued precisely this – that the cost of extracting will be too high, so barrels will not be produced. It is uncontentious that some oil will remain in the ground – the only question is whether it is through necessity (due to supplies peaking) and thus at a relatively high price where demand is destroyed or through choice (due to demand peaking) at a relatively low price where supply is destroyed.
The peak supply interpretation has in its favour that large scale development of unconventional resources has only occurred with higher prices. While this seems counterintuitive – oil prices are only just recovering from a significant collapse, after all – it is worth noting that even in the depths of the downturn, inflation adjusted oil prices were at the high end of the historical range outside of specific shocks (e.g. the OPEC embargo, Iranian revolution and 2007-9’s financial crisis). So while every barrel produced may have been replaced by two discovered in the past 35 years, as the authors say, it is a fair bet that the later barrels – particularly those from unconventionals, including Canadian oil sands, Brazilian pre-salt and US LTO – have a higher average extraction cost than the earlier barrels. There are also questions regarding quality that I will leave for another post.
Second, the argument is that the social costs of producing oil in the Middle East (ME) have the most bearing on price going forward. This point seems to be made in reference to the OPEC-plus production cut deal, which has helped prices recover. Despite low extraction costs, states that are oil dependent need to cover at least a substantial portion of government expenditure from oil revenues, and they are prepared to co-ordinate to achieve that end. This much is known. But the authors go further in suggesting that this will be the dominating factor for long-term oil prices, and, most strikingly, that LTO growth has no bearing on this assessment of prices.
Leaving aside the implicit assumption that ME producers can co-ordinate production relatively easily (which is far from clear in itself), this last point is particularly surprising, as LTO growth is probably the single most important reason market players think the world has moved from scarcity to abundance. Without the rampant LTO growth of the early part of this decade, the OPEC-plus production cut deal would have been unnecessary. Indeed, if LTO were as responsive to prices as the consensus believes, its output would have fallen precipitously in 2015, rather than growing on average.
An alternative view is that the OPEC-plus deal was an accommodation of LTO by oil dependent nations when it became apparent that low prices were not limiting global production as quickly as hoped. Our view on this is that low interest rates after the financial crisis have made risky investments, including independent E&P companies, more attractive to lenders, supporting LTO production beyond what simple profitability would suggest. Crucially, when prices were high, ME producers were adding to their wealth funds while LTO was outspending cash flow.
At root, the authors see ME oil as the marginal barrel when social costs are included, rather than LTO or any other source. Implicitly, the authors see ME social costs falling more slowly than others’ extraction costs. Time will tell whether this is the case.