Economics, Demography & Oil

1
Economics, Demography Oil

• Whats Going On?

10/14/04
2
Oil and the Middle EastFour Possible Questions

• Does 9-11 explain recent oil market moves?
• Do the current problems in Iraq explain the oil
  market?
• Is the world going to be more dependent upon
  Middle Eastern oil?
• What will this mean for U.S. Middle East
  Policies?

3
1999 Year of Change
4
A Closer Look Weekly 2002-2004
5
Moving into the 40s
6
Oil is different because it is Strategic

• Modern economies require oil
• Modern military power requires oil
• States intervene when dealing with oil because
  price volatility creates distrust of markets and
  politicians like to claim solutions

7
Historical Notes

• Churchill and Admiral Fisherdont depend on coal
  and the politics of coaling stations
• GB Invests in the DArcy ConcessionAnglo Persian
  Oil (now BP) is formed
• Lawrence overturns the Mid East in WWI and oil
  becomes the currency of Middle East Geopolitics

8
Oil and the Cold WarThe Dark Side of Cheap Oil

• U.S. begins from a position of independence,
  but gradually becomes a significant importer of
  oil (after 1971)
• The Soviet Unions interests in the Middle East
  during the Cold War become the context for
  resource nationalism. (Libya) US loses its
  absolute control over Middle East Oil, but not
  its interest in a stable oil supply
• OPEC tries to regulate oil prices but the cartel
  is unstable in the face of burgeoning non-OPEC
  supplies. Saudi Arabia then imposes
  discipline, and oil falls below 10/barrel in
  1986 undermining longer term reserve development
• The Soviet oil industry collapses under the price
  pressure and revenue losses hasten the collapse
  of the entire Soviet state
• Energy Independence in the U.S. falls by the
  wayside but lingers as a continuing political
  theme

9
The Post Cold War Oil Market

• From the end of the first Iraq War until 1996,
  crude oil rises from about 20 to over 25 with a
  pit stop at 15 in 1993
• The US economic boom begins after the Mexican
  Crisis (1994) and oil moves above 25
• With the Asian Crisis of 1997, falling world
  aggregate demand conditions push oil downward
  toward 12/barrel, again undermining new capacity
  expansion.
• After the Russian default (September 1998), oil
  essentially triples to an unsustainable
  37/barrel during the Tech Boom
• In the Bust of 2001, oil collapses once again,
  climaxing with the 9-11 attack driving down
  consumption, but the US recovery in 2002 moves
  oil up again, this time over 50

10
Government or Markets?Understanding Recurrent
Themes

• Oil demand is price inelastic and for fast
  growing economies, highly income elastic
• Over time, new sources of oil become harder to
  find and more costly to develop
• If oil were strictly a market commodity, oil
  supply would be far more responsive to expanded
  demand conditions, but oil is a strategic
  resource
• Sources of cheap reserves are under government
  control, making it virtually impossible for
  private companies to ignore governmental policies
  regarding oil supply development
• The SPR undermines private incentives to hold
  private inventories (the law of unintended
  consequences) creating conditions for even more
  price volatility

11
Crude Oil isnt the Only Thingpetroleum products
are the inflammables

• Crisis not only about crude supply but about
  the supply of refined products. Can have
  adequate crude and inadequate product supply, but
  high product prices invite bad policy
• Refined product supply very affected by NIMBY
  sentiment
• Balkanization of gasoline supply reflects our
  Federal system
• The US has insufficient cracking capacity to
  use cheaper heavy, sour barrels. Why is refining
  an area of underinvestment?
• US energy policy is political parochialism in
  extremis. Supply expansion or demand
  restriction? Which party wins in November?
• Only a crisis will stimulate political
  cooperation but usually the wrong policies are
  chosen

12
Demographics of New Oil Demand

• New Sources of oil demand growth include China
  and India
• See next slide
• China is responsible for some 40-50 of
  additional demand
• Other Asian Demand is also rising (India, Korea,
  etc)
• Oil demands include transportation fuels and
  space heating (or power generation). Oil demand
  in the emerging markets is highly income elastic
  and petroleum products are used less efficiently
  than in the developed countries
• These sources of new demand are likely to
  continue rising
• Oil price instability leads these governments to
  adopt State-run oil reserve holding (adding to
  demand) but undermining a market based solution

13
New Demands
14
Why Cant the Market do the Job?Vicious Circles!

• Private Inventory Holding and the SPR
• New Government strategic reserves
• The financialization of oil markets
• Risk sharing and uncertainty
• Government can create uncertainty and undermine
  markets by state reserve-holding
• Financialization plus insufficient excess
  capacity produces additional price volatility
• Price volatility produces more political
  intervention

15
Why Are Prices More Volatile This Time?

• economists no spare capacity
• prices have upside volatility when excess
  capacity drops below a critical value (3mb/d).
  See slides 16-17-18.
• financialization futures are heavily influenced
  by traders and the marginal barrel is priced this
  way
• Financial optics attract bad politics

16
Excess Capacity Problem
17
Spare Capacity and Pricing
18
DESPITE DEBATES PROBLEMS WILL REMAIN
19
New Oil Supply is a long run proposition subject
to politics(all politics are local)

• Alaskan North Slope
• Gulf of Mexico
• Territories of the Former Soviet Union
• West Africa
• Venezuela
• Brazil
• Libya
• PG countries including Iraq, Iran and Saudi
  Arabia
• Global Warming and the Green Movement

20
Oil and the Middle EastFour Possible Answers

• 9-11 heightened fears of terrorism, creating
  uncertainty but not fundamental
• Only superficially. Key is expanding capacity
• Yes, because it is the cheapest barrel and the
  reserves are known
• Inevitably, the geopolitics of energy cannot be
  avoided

• Does 9-11 explain recent oil market moves?
• Do the current problems in Iraq explain the oil
  market?
• Is the world going to be more dependent upon
  Middle Eastern oil?
• What will this mean for U.S. Middle East
  Policies?

21
oil is a greasy businessCalouste Gulbenkian as
quoted in The Seven Sisters

• Calouste Gulbenkian Mr. Five Percent, long ago
  discovered a basic truth about oil. Oil
  generates a great deal of money. The pen may be
  mightier than the sword, but money trumps the
  pen!
• Jessups Law politicians cant handle the truth
  because they fear their electorates. The result
  is almost always an inferior solution to an
  energy dilemma
• The CRICcycle (courtesy of Robert Feldman)
  applies to Energy Policy in the US
• Crisis
• Response
• Improvement
• Complacency