# Are High Oil Prices Here to Stay?

Date May 8, 2006 Leonidas P. DROLLAS(Deputy Executive Director and Chief Economist, Centre for Global Energy Studies) TANABE Yasuo(Vice-President, RIETI)

## Summary

Except for the second oil crisis in 1980, the 2005 oil price of $50/bbl is the highest since the 1870s in real terms and if you do not adjust for inflation it is the highest it has ever been in nominal terms. We are in an unusual situation. How did we get to these high oil prices in the first place and how can we justify them? Are we suddenly facing very high costs in the industry? Is it due to strong demand? Is it due to expectations that prices are going to be high for a long time? Or is there a deeper problem? Many people are now saying that we are at "peak oil," having reached an oil maximum, and now we are faced with a long-term structural problem. If this is not the case, what needs to happen for oil prices to come down again? How far will they fall, and will OPEC let them? These are the big questions. In my opinion the cost of oil is not really the reason for the high oil prices. Some people have talked about expensive drill pipes, rises in labor costs, etc. This might be true in certain areas of the world, with certain oilfields; however, fully-built-up oil costs, including finding costs, are around$19-$25 at the most. I suggest that this is a long-run position and we have not reached the point when rising costs can justify$60 or $70 oil prices. Then how did these high oil prices come about? Hurricanes in 2005 created a lot of trouble for the oil business, causing spiking in the price of oil, but we are still left with a capacity shortage of around 23% in the Gulf of Mexico. We are still missing about 340,000 barrels of oil per day from the U.S. part of the Gulf of Mexico. The second reason put forward for the high oil prices is low inventory cover and indeed, in the OECD at least, oil cover is apparently insufficient at around 51 days. The key medium-term issue, however, is low spare output capacity globally, which is currently under 3%. If you want a single answer as to why oil prices are high, I believe you must look at this factor. The oil industry is capital-intensive, is dependent upon specific conditions and is vulnerable to political uncertainties; therefore, running with such low spare capacity is asking for trouble, which it often gets. In addition, we have a problem with refining capacity not only regarding crude distillation but also with respect to our ability to produce low-sulfur diesel or low-sulfur middle distillates including jet fuel. This is a current global problem that is not going to go away very quickly. Finally, there is a widely held view that we have entered a new era of oil scarcity because we are running out of oil, which worries many people. I personally am not worried about this and will provide you with some evidence that I hope will reassure you. This is the overall picture and a combination of these factors can explain the high oil prices. One factor we can discount as a real cause of high oil prices is stock cover. Historically, oil prices were the mirror image of OECD company stock cover; when stock cover was high, prices were low and vice versa. According to this relationship, stock cover of 51 days should have led to prices of around$35/bbl. However, after the second quarter of 2003 the price-stockcover relationship broke down and prices kept on rising; prices are almost at $70/bbl today. Something happened at that point that changed the market's expectations and perception of the situation, breaking this important link. The other big consideration over the last few years is the role of oil demand growth. In 2004 the world experienced incremental oil demand of 3.2 million barrels per day, a 4% per annum increase. That kind of strong demand had not been seen since 1975. China and the United States in particular were behind that surging growth, but non-OECD countries, particularly in Asia, also contributed strongly. In 2005, despite robust global economic growth, high oil prices caused incremental demand for oil to drop to just over 1 million barrels per day, a 1.3% increase. In my opinion this negative impact on incremental oil demand will continue and when - for other reasons - economic growth slows up, growth in the demand for oil will be cut back even further. As I mentioned, China is a key part of this process. China goes through cycles of inventory build-ups and draw-downs. In 2003 and 2004 there was an increase of 1 million barrels per day in Chinese net imports of crude oil and products. We suspect that half of that increase in 2004 was due to China not so much consuming oil as stocking oil. Its economic growth had suddenly accelerated, it was seeing rises in the price of oil, and it began to worry about the security of supplies, so it started building up its stocks of crude oil and products. In 2005 there was a severe slowdown in the rate of increase of the apparent demand for oil to only 100,000 barrels per day. That tells us that China had excessive stocks that it was running down. In 2006, having run down its stocks, demand is again rising strongly. In my opinion, the key to high oil prices is spare capacity. From the second quarter of 2004 onwards OPEC's spare capacity relative to global demand declined sharply. Since then spare capacity has stayed fairly flat at just under 3% of world demand. During this same period the price of oil rose steadily. It should be noted that the surges in OPEC's spare capacity that occurred in 1999 and 2002 were not because OPEC built spare capacity, but rather because OPEC cut back production in order to push oil prices up. These voluntary increases in spare capacity were thus associated with rises and not falls in the price of oil. By contrast, the fall in the level of spare capacity from the second quarter of 2004 onwards had nothing to do with what OPEC wanted; the world has actually been running out of spare capacity. There is very little that OPEC can therefore do about this situation in the short term, leading many people to believe that OPEC is ineffective currently because its low levels of spare capacity do not allow it to influence decisively the price of oil. The reason for OPEC's low levels of idle capacity is that OPEC has not invested enough to boost its spare capacity. On the contrary, two OPEC countries, Venezuela and Iraq, have actually lost capacity. Prior to the election in 1998 of President Chavez, Venezuela had a capacity of 3.5 million barrels per day. This is now down to around 2.6 mbpd, a loss of 900,000 bpd. Iraq, pre-invasion, had a capacity of around 2.8 mbpd; this is now down to around 2 mbpd. Venezuela has genuinely lost the ability to produce 3.5 mbpd of oil, whereas in Iraq the security situation prevents the country from producing oil up to its capacity although its capacity remains. We are therefore in the position we are in now essentially because OPEC has not invested enough in capacity during a time when demand has been growing. Outside OPEC the incremental demand for oil has been rising slowly, whilst non-OPEC supply - excluding the former Soviet Union, where supplies grew rapidly and have now reached a plateau - has been trending downwards. The market has taken note of this decline. The deep-seated concern about the oil industry's ability to cope with strong oil demand growth at a time of insufficient spare production capacity seems to be the key factor behind the high price of oil. Those in the oil industry attempt to reduce the price risk by hedging; when prices are rising they try to secure oil supplies into the future at a fixed price. Having recourse to crude oil futures markets allows oil producers, utilities, power generators, airlines and others to offset some, or indeed all, of the price risk involved. The counterparts to these hedgers are the speculators and others who are ready to assume such risk in the expectation of guessing right and making financial gains. For me one of the most important new developments is the growth in open interest at NYMEX, the largest futures exchange for oil in the world. This is representative of the growth in futures activity. In 2001 around 400 million barrels of oil were traded. In the last few weeks this has passed 1 trillion barrels of oil. This huge surge underlines the inflow of money from what I call a new investor class, composed of commodity investors, hedge funds and other financial players. There are two major commodity indices in the world, the Goldman Sachs and Dow Jones-AIG indices, which have a weighting of oil of around 30%-40%. Funds tracking these indices have grown dramatically from$8 billion in 2000 to $70 in 2005. Due to the ongoing rise in oil prices there is now a lot of "hot money" that has been doing well out of buying oil futures, thinking that the price of oil will continue to rise and thus attracting even more money. It is like a self-fulfilling prophecy. Therefore, in addition to the various reasons for the rise in oil prices I have presented, much of the increase in the last year or so is due to this influx of hot money. How much of the price is due to this phenomenon is open to question; a recent study by an analyst in the U.S. claims that it is$20/bbl plus. I am not so sure myself, but I would say conservatively that $10-$15/bbl of today's price is due to these funds.

Please not that the market in futures has a structural bias. There are more people who want to buy futures than sell them. Those buying futures are typically hedgers who are short of the commodity and wish to secure prices as they go along, such as airlines, power stations and utilities, railroads, shipping companies, etc. Some products can be hedged directly, such as gasoline and gas oil. However jet oil futures and heavy oil futures do not exist. So these companies will use the crude oil futures market to cover their positions. The demand for futures is thus always strong while the supply side is limited. The major producers in OPEC - Saudi Arabia, Iran, Iraq, Venezuela, Kuwait and Libya - do not hedge. They are therefore not in the market as suppliers of futures. For their part, the major oil companies such as BP, Shell and Chevron hedge the trading risk but do not hedge their upstream production. ExxonMobil does not hedge at all. A structural bias, where there are typically more buyers of oil futures than sellers, drives the oil price upwards.

What about 2006? We cannot expect to see a great decline in the price for this year. We have actual Dated Brent positions up to April. As of April 24, 2006 the futures market was expecting the price to rise further and to stabilize around the $75 level until the end of the year. I do not think it is that high now, but the general shape of the futures market is similar to our predictions. Our own projection expects the price of oil to stay high, reaching a plateau of around$67 until the end of the year. We expect incremental oil demand of about 1.2 mbpd for this year, but the IEA's projection is quite bullish at 1.5 mbpd. This would see prices rising to $85 or more in the coming winter. We do not believe that the IEA has got this right. On the other hand if there is more non-OPEC supply than our assumed increase of 900,000 bpd, prices could decline down to around$55 toward the end of the year. Non-OPEC supplies are a big uncertainty. Last year we had no increase in non-OPEC supplies. We had a catalogue of surprises, particularly the hurricanes in the U.S., but also severe problems in the North Sea, production problems in Australia and so on. We are hoping that this will not be repeated this year. If we get a more than reasonable year then prices are going to weaken in the second half of the year.

These projections are based on our knowledge of OPEC output from March, when OPEC output was quite weak. Iraq had a bad month and there were some other problems with OPEC. However April was much better. Production in Nigeria, one of the key problem-areas in March, has started rising again from two new fields that are compensating for the loss elsewhere in Nigeria. Also, Iraq came in with more production. Therefore, based on these latter figures for OPEC our very latest view is that toward the second half of the year we will have a weakening in the price of oil if OPEC's production continues at this higher level.

In the medium-term, when will the price of oil trend downwards? One possibility is when oil demand slows sufficiently and remains low. Another case is when non-OPEC oil supplies start picking up again, which we expect to happen from this year with Russia increasing supplies and Angolan, Brazilian and Caspian Sea production coming on-stream. Our view is that non-OPEC supplies will keep on increasing, reaching a peak in 2010. Another important factor is OPEC's spare capacity: if it rises to 5% or more - according to our analysis it should exceed 8% by 2008 - prices must weaken. So the recent run of high oil prices will not continue. There is a subsidiary issue of when refineries will be able to produce enough low-sulphur products. With many refineries now being built, mainly in the Middle East, China and India, and with a lot of diesel-producing and de-sulphurising capacity being installed, things should improve. What we cannot say will improve are the geopolitics of oil; if anything, many people believe they are going to get even worse. There is the major headache of Iran's nuclear enrichment program and the difficulties between Iran on one hand and the United Nations and the major powers on the other hand.

As for global oil production, the pessimists argue that we are reaching peak production, a view they base on a few well-chosen arguments. They argue that major producer Saudi Arabia's oil fields have peaked, which I consider to be an exaggeration. It is true that the world depends on a few gigantic but geriatric oilfields. The largest 14 fields, with an average age of 44 years, account for over 20% of oil production. It is also true that oilfields are not as prolific and discovery costs are rising slowly. This is indeed a fact; however, it should not come as a surprise, because even if you drilled at random for oil you are bound to find the larger oil fields first. This can be shown mathematically. Furthermore, when you discover a field you do not know how much oil the field contains; however, over time more is learned about the field and it tends to have far more oil than predicted. This is called growth in oil reserves and is a key consideration.

If you add up all the oilfield discoveries in the last few decades, they yield peak production of 7.2 million barrels per day. So, to argue that we have not been finding large oilfields in the last few decades is not true. A case in point is the Tenghiz field, discovered in Kazakhstan in 1979. Although a super-giant field, it has a planned peak production rate of only 0.5 mbpd, because it produces a lot of hydrogen along with the oil and is thus considered a technically difficult oilfield. If a Western oil company had been given full access to oil production in Kazakhstan that field would have been producing 1 mbpd or more. Another monster field is the Cantarell field in Mexico, discovered in 1976, which accounts for two-thirds of Mexican oil production, or 2 mbpd. The Azadegan field in Iran, discovered in 1999, is a field where the Iranians are going to be producing at maximum 400,000 bpd. If a Western company had been involved, Azadegan would have been producing 800,000-900,000 bpd. So, things are not as bad as people are saying.

To conclude, oil prices are at current levels because of tight short-term market conditions. The world's spare oil production capacity is below 3% of oil demand and the industry's ability to produce middle distillates with low levels of sulphur is severely constrained. This will not continue for too long. If the economic system is given enough freedom it is able to solve these problems; it is a question of investment. What is certain is that the world is not running out of conventional oil. On the basis of my work and of others, we think that the world has 3 trillion barrels of ultimately recoverable conventional crude oil and that we shall pass the 50% stage of recovery - or "peak oil" - some time after 2020. If we count as oil the Canadian tar sands, of which we have about 170 billion barrels, and the Venezuelan heavy oils, of which we have about 300 billion barrels of recoverable reserves, then the picture is much, much better.

So with so much oil discovered already or still waiting to be found at a cost far below $60 per barrel, oil prices in a rational world should not remain at these high levels over the medium term. Our projected prices go down to$35 per barrel by 2012 or 2013, and then they start rising again. However, oil in the ground needs investment to become accessible. Thereafter, having developed the capacity, you need the will - in other words I am talking about OPEC now - to produce the oil. Most of this oil is in the OPEC countries. The investment sums are not very large. To increase OPEC spare capacity by 16 million barrels a day, which is what will be needed by 2020, we are talking about $100 billion. Considering that per annum spending on its upstream by ExxonMobil is$15 billion, by Shell $30 billion and by BP$14 billion, $100 billion spending for the OPEC countries is not an excessive amount. Western oil companies would be quite happy to invest these sums of money, but the political situation is not helpful. Oil companies are not invited to come in and are not really wanted. Having started with President Chavez in Venezuela, resource nationalism is building up a head of steam and has now spread to Bolivia; we also see it in Iran, Saudi Arabia and the other Gulf countries. So, we do not have a lack of oil in the world, we have a lack of investment. ### Questions and Answers Q: In the previous oil crises price elasticity was low in the short term, but in the longer run it was substantial. How can we assess the correct oil elasticity? A: We know, many years after the 1970s oil crises, that oil demand is not elastic, it is not above one, but is 0.8 in the long run. This is high enough because, for example, a 100% increase in prices in the long run leads to an 80% decline - a big effect. However, we had to wait until the 1990s to do the analysis and see this. We are in the same position again now. People say prices are very high, demand is not reacting, and we will continue like this. However, as I showed you, demand has already reacted, although a period of strong economic growth makes it difficult for the price effect to have an impact in the short run. In the 1970s and early 1980 the elasticity of oil demand was higher, because there was a lot of demand for heavy fuel oil, which is more elastic than gasoline - in fact, fuel oil's elasticity was 1.4. As soon as the price of oil rose very high users backed out of fuel oil rapidly. Now, this highly elastic component of oil demand has all but gone. We are still left with long-run gasoline and diesel demand elasticities of around 0.6; in the short run these elasticities are nearer 0.2. Gasoline-electric hybrids are beginning to have an effect, with sales rising by 40%-50% per annum in the U.S. On current trends, by 2030 the hybrid fleet in the U.S. will have a penetration rate of 60%. So at that point the demand for gasoline, for example, will be completely static, if not declining. So give it enough time and you will see what happens, as happened in the 1980s, but for slightly different reasons. Q: What do you think of non-OPEC supply, especially in terms of Russia? A: It is very difficult to have a clear picture, because non-OPEC supply of oil is an elaborate situation, dealing with discovery rates, additions to reserves, many other factors, and technological effects that we cannot predict. However we believe that non-OPEC supplies should tend to carry on increasing until about 2012, when they will reach a plateau. Of course, a lot depends on Russia, on Russian policies and the former Soviet Union as a whole, because that is one of the key countries where supplies will keep on rising until 2013 or 2014. So far we have had some problems, with the YUKOS affair having two repercussions. One is to slow down completely foreign investment in the oil industry in Russia. The second has involved the state taking ever-increasing sums from the oil industry through export taxes, implying that companies operating in Russia are investing less than previously in the oil fields. Incremental supplies from Russia have therefore stopped growing at the impressive rates we saw before. They are investing again, but not at the previous rates, so Russia is worrying us a little bit. But then we have Angola, Brazil and many other non-OPEC countries. Q: How do you view the level of global spare capacity and will Saudi Arabia continue to play a swing producer's role in terms of carrying the cost of spare capacity? A: The 2006 position is not very encouraging, because we have only about 600,000 bpd of additional OPEC capacity coming on stream this year. If plans go as predicted then the increase from 2007, 2008 and 2009 will be more than 4 mbpd, although of course oil demand will have also grown by then. I think the cost of drill pipes and labor and so on is a short run phenomenon; when you suddenly demand much more from a system you get very big price increases. There are not enough engineers, drill hands, drilling rigs and so on to go around. There are many drilling rigs being built in Norway now because of high daily drilling rates - around$250,000 per day - which offers much encouragement to the manufacturers of drilling rigs, semi-submersibles and so on. So that problem will be solved quickly, within two or three years.

The problem is that these plans need OPEC to invest. Until recently Saudi Arabia had excess capacity that was considered a big cost. Who will carry the cost of this excess capacity henceforth? There is a nice way of putting it. It is called the lose-lose versus the win-win situation. OPEC right now thinks it is in a lose-lose situation. If its members invest, they lose in terms of having to spend money and then two to three years down the line there is more capacity, so oil prices start falling and they lose again. Whereas they think it is preferable to be in a win-win situation in which they do not invest much, keep capacity tight, keep oil prices rising and they win because they hold on to their financial reserves and because oil prices are high.

This policy is fine if you have short horizons, but these countries have to think about the future as well, not just five years from now but 20 years and beyond. Given the uncertainty in the world and science progressing the way it does, we do not know what will happen in the next 20 or 30 years. Some big scientific breakthrough might result in oil being left in the ground, losing Saudi Arabia a wonderful opportunity to prepare its economy for the post-oil world. This is something that Dubai, for example, is doing right now; it has prepared very well for the post-oil era, providing general services, tourism, financial services etc.

Saudi Arabia has to think very carefully about what it is doing and for whom. The king and his half brothers are in their 70s and 80s and their time horizons are short. When you have that short a horizon, what do you care about what happens next? Yet, you have to care about your country and the longer term; this is why the policy of win-win versus lose-lose must be rethought. For Saudi Arabia to be able to influence the market in the way it wants it must have spare capacity. OPEC, without spare capacity, has no control over the market. Without Saudi Arabia OPEC is finished. Within OPEC, Saudi Arabia has to think about re-establishing some kind of influence on the market.

Saudi Arabia has spare capacity of about 1.5 mbpd at present, but it is for heavy, sour oil. The Saudis could sell more of this oil tomorrow if they wanted to; however, since they price their crude off spot markets they need to increase their price differentials. They could sell more oil to Japan if they gave bigger discounts on their heavy oil, but they are not doing that. They are not very willing to sell more oil, because they believe it will go straight into storage. This is what is keeping the oil market tight and prices high; nobody wants to take the first step.

*This summary was compiled by RIETI Editorial staff.