George Trefgarne says there’s no need to worry about recent dramatic swings in oil prices: despite Opec production cuts, there’s ample supply for a new era of cheap energy
It must be quite boring to be a crewman on the curiously named Front Queen, an oil tanker reportedly moored off the sweltering coast of Malta. This vessel was chartered a couple of weeks ago by one of the few healthy banks in the world, JPMorgan Chase, in order to sit in the baking sun of the Mediterranean, filled with heating oil, in the hope that the price goes up.
The Front Queen is not alone. There is currently about 70 million barrels’ worth of crude, or nearly one day’s global production, bobbing about in ships around the world. That number has actually come down slightly in the last few weeks, but the point remains. Contrary to what you might hear from advocates of so-called ‘peak oil’ — the idea that we’re running out of the stuff — the world is currently awash with it. So much so, in fact, that we could be about to enter a new era of cheap and abundant energy.
The case for a high oil price is simple and goes like this: members of Opec control a third of world production. They have cut output to prop up the price — while rising demand from emerging nations is outpacing declining demand from the increasingly green-minded and recession-hit West. But the opposing case, for a low oil price, is becoming more compelling. Spare production capacity is growing all the time. Indeed, there are approximately six million barrels of spare capacity in the market, the highest level for a decade and about 7 per cent of available production. That spare-capacity number is growing all the time. Add in the effects on demand of a prolonged recession, and Opec is trying to catch a falling knife.
Sooner or later, if history is any guide, some of Opec’s revenue-deprived members won’t be able to resist cheating by letting extra supplies slip, unofficially, on to the market. In fact, the data suggests that they usually start to cheat about two years after agreeing the first cut, which this time round means we should expect the cheating to begin in September 2010. Opec is a cartel and classical economic theory holds that it contains within itself the seeds of its downfall.
According to the liberal economist Paul Krugman, the excess of storage and stocks in the world actually shows that the recent surge in the oil price from $35 to over $70 a barrel at the beginning of July was driven by speculation — unlike last year, when the even more dramatic rise to a record $147 was driven by a genuine shortage of supplies, in the face of still rising demand from China and India.
Krugman wrote a few days ago on his New York Times blog: ‘Last year I was sceptical about claims that speculation was central to the price rise, because what I considered the essential signature of a speculative price rise — physical withholding of oil from the market, in the form of high inventories — just wasn’t showing. This time, however, oil inventories are bulging, with huge amounts held in offshore tankers as well as in conventional storage. So this time there’s no question: speculation has been driving prices up.’
Politicians have pitched in too, with various attacks on speculators from Gordon Brown, President Sarkozy and Gary Gensler, the chairman of the US Commodity Futures Trading Commission, who is planning to hold hearings into how the oil market works. The US authorities are particularly concerned at the so-called ‘London loophole’, which enables large positions to be taken on the ICE exchange in the City when strict trading limits have already been reached in America. That concern was effectively reiterated in the G8 communiqué from L’Aquila last weekend.
Have you ever noticed that people only complain about speculation when prices are going up? The same evil speculators responsible for pushing the oil price higher are now pushing it down again. Almost from the very moment Krugman wrote his post last week, the price started to tumble. At the beginning of this week it was below $60 a barrel. Stephen Schork, a keenly watched analyst, reckons it could drop further. ‘Crude oil bulls are hanging on in there, albeit by the thinnest of margins. If they fail, the path toward $40 will be wide open.’
Oil is not just being stored in ships, but stockpiled in refineries and elsewhere in the system. Last week, the US Department of Energy said that gasoline stocks climbed by 1.9 million barrels to more than 213 million barrels. That means they remain about a third higher than average. Unless the economy picks up soon, that overhang is likely to grow as a slew of new oil projects, initiated during the good years, steadily comes on stream.
Last month, for instance, Saudi Arabia started pumping at its giant new Khurais field, which alone has the potential to produce nearly half as much as the entire North Sea. Even Iraqi production has risen to pre- invasion levels. Iraq has the third largest reserves in the world and its decision to open them up to international oil companies and their expertise should improve its output further.
The best place to store oil is in the ground and here supplies are also plentiful. The latest research shows that reserves equal more than 40 years of production. And that is just known reserves, ready to go. Reassuringly grizzled geologists reckon there are many less conventional resources, waiting to be exploited when new technology is developed. There have been, for instance, several major discoveries in Uganda recently which one excited US Department of Energy official was quoted as saying could rival Saudi Arabia.
Let us not forget the importance of coal and gas too. The prices for both of these abundant commodities remain in the doldrums. Natural gas, in particular, is benefiting from new technology which has opened up huge new supplies, from the untapped shale and tight gas deposits of North America to the liquefied natural gas plants of Qatar, Egypt and Indonesia. Last year, US natural gas production rose nearly 8 per cent; US gas reserves have risen 45 per cent in the last decade. As far as gas is concerned, America is the new Russia.
In the very short term, volatility in the oil price is likely to continue, especially if Opec, as expected, cuts production again. One of the wisest commentators on the oil market is Christof Ruehl, chief economist of BP. He says: ‘There is a race going on, with Opec trying to catch up with falling demand. The intention is to stabilise the price by cutting production until the world economy picks up. But what happens if the economy doesn’t pick up, or it doesn’t pick up soon enough? Demand in the US and elsewhere remains stubbornly low. Spare capacity will grow and there is the possibility of oil slipping out on to the market via the back door.’
Only one prediction can be made with absolute certainty — most forecasts about the oil price turn out to be wrong. So you would have to be a fool to say you are 100 per cent sure that the price is about to plummet. Another terrorist strike, or a faster-than-expected economic recovery, could change the picture suddenly. But short of those sorts of events, several years of cheap energy are evidently a growing possibility.
What a relief that would be. A prolonged low oil price would deliver a powerful shot in the arm to the world economy and put off the evil day when inflation returns, ignited by governments and central banks overdoing their economic stimuli. Furthermore, a per-iod of cheap energy would be a much-needed tribute to the virtues of globalisation, of free and open markets and, dare I say it, ‘speculation’. It would also be testimony to the performance of an industry in which Britain excels and which has made massive technical strides in the last few years.
But a low oil price would also be very in convenient for some. Governments (including our own) which depend on oil revenues, could find their public finances taking another turn for the worse. Chief among these would be the absurd administration of President Ahmadinejad of Iran. Despite earning half its tax revenues from oil, Iran is an economic shambles and is currently running a large budget deficit. If the oil price does head lower, Ahmadinejad might even have to cancel his nuclear programme on cost grounds. Here’s hoping.
In a low-price environment, oil companies would also find their finances under pressure: indeed, some of the many smaller players have already started to merge in a bid to transform themselves into bigger, more efficient businesses. A renewed pressure on profits could have particularly unpleasant side-effects for investors — and given the prominence of oil and gas companies in the portfolios of UK pension funds, that means you and me.
Enthusiasts for alternative energy, wind farms and the like rely on a high oil price to make their proposals attractive and would find the economics of their case seriously damaged. Indeed a celebrated oilman (and ardent George W. Bush supporter) called T. Boone Pickens has just delayed plans to pour his wealth into the world’s biggest wind farm in Texas.
Energy is a hyper-cyclical industry and the chances are that the curtailing of investment in new oil production, and indeed in low- carbon technologies, in response to the current economic downturn could already be laying the foundations of the next oil price boom, sometime in the inflationary 2010s or 2020s. That’s human nature — and markets — for you. It’s also another story.