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 mbpd, that is 3.2%, in the three months through Jan. 2011, compared to the same three months a year earlier. Although this is a high number, it is not unprecedented. In the twelve years to 1972, world oil consumption increased by 30 mbpd, representing 150% demand growth over the period and 2.5 mbpd average annual growth in volume terms.
And demand increased by 7-8 mbpd 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 mbpd / 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% and 5.1% 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 mbpd in the three months through Jan. 2011, compared to the same period a year earlier. Non-OPEC liquids contributed 1 mbpd to this, consisting primarily of the US (+0.4 mbpd), 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 mbpd and crude a lowly 0.2 mbpd.
Still, over the period, supply lagged demand by 635,000 barrels per day 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 mbpd 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 mbpd range for 2011 and 2012 seems more likely.
The chart below shows the difference between the EIA’s and our 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 similar to the 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 mbpd, with peak demand hitting 92 mbpd in some months.
World Oil and Liquid Fuels Consumption 2009-2012
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 mbpd 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 mbpd 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 mbpd-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. If we apply this same metric to Saudi’s stated production reserves today, its excess capacity could be only 3 mbpd, or perhaps a bit less.
How will the Kingdom commit this reserve? Many observers believe that Saudi will never pump more than 10 mbpd-only 1.4 mbpd more than its produces today. This belief is based on history: Saudi production has never sustained above 10 mbpd. 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 a 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 oblige. So both the Kingdom’s long term view and expected oil prices may encourage it to limit production.
Is then, Saudi Arabia’s nominal spare capacity to be taken at face value? No one, probably not even the Saudis, knows for sure. However, for policy purposes, a conservative approach would assume that the Saudis will not exceed 10 mbpd, and that based on history, an effective capacity of more than 11 mbpd should not be assumed.
As a result, effective spare capacity in the global system should be considered 1.4 – 2.4 mbpd less than the 4.65 mbpd currently reported by the EIA. Consequently, it may not be more than 2.25 – 3.25 mbpd, in essence as much as global growth in demand last year. This is not much.
Surplus Crude Oil Production Capacity 2009-2012
EIA STEO Feb. 2011 and Douglas-Westwood Analysis
Further, if we pair reduced spare capacity with our forecast for 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 mbpd, or even less, if the Saudis decide to limit production at 10 mpbd. 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 barrels per day, 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.