Invitation to an Energy Crisis

One has only to examine the recent past to see why market fundamentals matter in determining oil prcies. And, as OPEC’s crude oil exports decline, rising consumption in the oil-producing countries forces international oil companies to invest in high-cost areas with small reserves, and global demand continues to grow, we could be witnessing an energy crisis in the making.

DALLAS – As rising consumption and nationalism in OPEC countries pushes down their crude-oil exports and forces international oil companies to invest in high-cost areas with small reserves as global demand continues to grow, oil prices might ultimately shatter the record set in 2008. In the short run, heightened volatility will be the rule, owing to economic, political, natural, and technical factors. One has only to examine the recent past to see why.

While speculators can affect prices in the short run and increase price volatility, market fundamentals and government actions explain the spectacular rise in oil prices between 2003 and mid-2008. During this period, world oil demand increased, mostly in developing countries, while production remained relatively flat from 2005 to 2008. The only way to meet growing demand was to use OPEC’s spare capacity and commercial inventories. Once spare capacity vanished and commercial inventories declined to critical levels relative to estimated future demand, oil prices started to break record after record.

Let us consider some details. First, world crude-oil production declined by 266,000 barrels per day in 2006 and 460,000 b/d in 2007. Meanwhile, world oil demand increased by 1.2 mb/d in 2006 and 937,000 b/d in 2007.

Second, the difference between actual output and what the markets expected magnified the impact of falling production. For example, forecasts at the end of 2006 predicted an increase in world oil production of 1.8 million b/d in 2007, but production actually decreased by 460,000 b/d. The market factored in the missing increase and thus reacted to a decline of 2.26 million b/d, not the actual decline of 460,000 b/d.

Third, OPEC’s crude-oil production fell by about 280,000 b/d in 2006 and 381,000 b/d in 2007, with a profound impact on prices. Most models, including those of the International Energy Agency, the US Energy Information Administration, and OPEC itself, employ behavioral variables to forecast world oil demand and non-OPEC production. However, they do not apply the same method to estimate OPEC production. Instead, they simply assume that OPEC will supply the difference between estimated world oil demand and non-OPEC supply, despite the fact that OPEC can no longer compensate for a decline in non-OPEC production or for higher-than-predicted demand.

Fourth, lower production and increased domestic consumption drove down OPEC’s net oil exports by about 1.8 million b/d in 2006 and 2007, after increasing by about 4.8 million b/d between 2002 and 2005. Indeed, top oil producers are joining the top oil consumers with annual oil consumption growth rates above 5%.

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Fifth, in the long run, a weaker dollar decreases supply and increases demand. However, it seems that in the short run, the inverse relationship between oil prices and the dollar exists only under very specific circumstances, such as a crash in real-estate prices and volatile financial markets.

Looking forward, in the short run, speculators will continue to fuel oil-price volatility as bullish and bearish factors steer them one way or the other. Economic recovery, a further decline in the dollar, low interest rates, weaker investment in 2009, and various political factors are among the most frequently cited bullish factors, whereas weak and sluggish economic recovery, spare production capacity, and high inventories are among the most cited bearish factors.

Market fundamentals will continue to determine the long-term trend in oil prices, and point to a tight market in which supply cannot keep pace with demand. As more poor countries join the club of emerging economies, and many subsidized renewable-energy projects fail in the developed and emerging economies, demand for oil will continue to grow. Oil exports of most oil-producing countries are expected to decline relative to their production as young populations, higher incomes, urbanization, and power shortages continue to boost domestic consumption.

Moreover, as oil-consuming countries aim for energy independence, producing countries will try to shield themselves by building energy-intensive industries so they can export oil embedded in industrial products. If the dollar continues to decline, it will exacerbate the situation, reducing world oil supply and increasing demand in countries with appreciating currencies.

When it comes to the price of oil, production does not matter. Exports do. The fear is that OPEC exports will decline at a time when the leaders of the major consuming countries fail to deliver the promised “green” economies. Under this scenario, we could be witnessing an energy crisis in the making.