Storm, The (11 page)

There has been, overall, a remarkable increase in frugality in the world’s use of oil over the last three decades. The gas-guzzling
USA has halved its oil intensity (measured as tons of oil in relation to real GDP). So have Europe and Japan, from a lower
starting point to an even lower level. China has made even more spectacular advances, mainly because of the movement away
from the extraordinary inefficiency of the Stalinist heavy industry favoured in the 1950s and 1960s.

In parallel, there was a rapid growth in non-OPEC production. Higher prices made oil exploitation and production highly profitable
for the first time in many years. The main stimulus to production was in the USA, especially in Alaska and, later, the Gulf
of Mexico, and in Mexico itself and the North Sea, but oil companies went looking for oil and found it in commercial quantities
in Malaysia, Gabon, Angola, Egypt, Oman and China. OPEC was as a consequence forced to make the difficult choice between holding
back production to support the price and maximizing revenue for development, leading to growing tension between the richer,
low-population members, which could exercise restraint, and the poorer, higher-population countries. As oil prices plummeted
in the mid-1980s, the oil producers desperately cut back their production, to 17 million barrels / day in 1985 – barely half
of production capacity – in order to support the price. Budget pressures then forced them to increase production, driving
prices down further. These were OPEC’s darkest hours. The decision of Saddam Hussein to invade Kuwait in 1990 had much to
do with a growing sense of financial desperation and tension between OPEC countries.

The upshot is that OPEC, despite having the lion’s share of world reserves and almost all the world’s low-cost oil, has not
increased production, of around 32 million barrels /day, in an expanding world market, since a third of a century ago, before
the first oil shock. The entire increment in production now comes from outside the OPEC countries. Back in 1973, OPEC produced
over half of all the world’s crude oil, but now it produces barely one third (32 million barrels /day out of 84 million barrels
/day, in 2007).

Oil optimists cite this experience of diversifying production as proof of the ability of the oil industry to respond positively
to ‘scarcity’ and higher prices. They expect to see the trick repeated again in the future, with non-conventional oils in
Canada, through deep-sea exploration, and in new zones such as the Arctic and countries in Africa, Asia, Latin America and
the former USSR which have not been intensively explored. Recent big finds on the
Brazilian continental shelf reinforce that optimism. Pessimists worry that production is falling behind demand growth and
has peaked in those countries willing to produce more, leaving a greater dependence on the OPEC countries. They believe, furthermore,
that OPEC has an incentive not to produce more but to let scarcity drive up the price, increasing the value of oil kept in
the ground.

This background is important in order to understand what has been happening in this century. Until the oil market crashed
in the latter part of 2008, there had been a steady upward climb. This can be traced back to the day in December 1998, when
oil prices fell to $10 per barrel, following a decade of low prices that had left the industry worrying that oil was becoming,
as in the 1950s and 1960s, just another superabundant primary commodity, like coffee – not worth prospecting for in a world
where production costs in difficult offshore fields and other ‘new-frontier’ exploration areas could be as much as $30–40
per barrel. Oil prices then started moving discernibly upwards from just over $25 in mid-2003 and broke through to $40 in
May 2004. Newspaper stories started to appear about ‘the next great oil shock’ (
Financial Times
, 17 May 2004) and ‘world braced for oil shock’ (
Observer
, 11 May 2004). Prices continued remorselessly upwards ever since until the crash at the end of 2008.

The simple and obvious explanation for this prolonged rise is that the world economy has been growing very strongly in this
century, faster than ever previously recorded. Specifically, there has been remarkably rapid growth in China, with 8–10 per
cent annual expansion (Chinese numbers are not totally reliable, but few dispute this broad order of magnitude and the visible
transformation of the country that has resulted from it). India is growing rapidly from a lower base. This expansion has fed
into energy demand as industrialization has advanced and living standards have risen. Quite understandably, Chinese and Indian
families wish to turn their increased income into the higher quality of life most of us take for granted: greater mobility,
deriving
from the ownership of vehicles; improved public transport and aviation; and comfortable levels of domestic heating, for example.
China currently has around 40 million motor vehicles, less than the USA in 1949 and less than one fifth of the current US
level (which stands at 250 million). India’s launch of a family car costing less than $2000 speaks to a similar ambition in
that country. In the first seven years of this century China and India accounted for 50 per cent of the increase in the world’s
primary energy demand (approximately 45 per cent from China alone), and 35 per cent of the increase in oil demand. With the
slowing down of the main Western economies in the last two years, a substantial majority of the incremental demand for oil
is coming from these countries, especially China. In the years from 2005 to 2007 inclusive, world demand grew by approximately
1.5 million barrels / day on average, and of that 1.3 million barrels / day came from non-OECD countries, led by China.

World oil supply, while growing, did not keep pace. We shall explore later whether this was the consequence of a fundamental
long-term problem or of a series of conjunctural factors: under investment following a period of low prices; the Iraq War,
following a decade of sanctions, which left production at around 2.5 million barrels / day, less than half the estimated potential;
violence in oil-producing regions of Nigeria, causing substantial under production; US sanctions which have inhibited Iranian
production, and Iran’s own willingness to cut production to make a political point; disruption of production in Venezuela;
and production falls in Russia. Much as in the early 1970s, steadily expanding demand, outstripping supply, ate away at spare
capacity (much of which is in Saudi Arabia). From over 5 per cent of production in 2002 spare capacity fell to 2.5 per cent
in 2004, and then to just over 1 per cent (1 million barrels / day). Saudi Arabia has expressed an intention to increase production
capacity through a large investment programme, though this will be slow to come through. Any system operating on such wafer-thin
cap acity margins was dangerously poised for an extreme price
reaction, which is what we have seen, just as we did in 1973. Yet the spike of prices in 2008 has passed. Prices crashed to
$40 per barrel as increased production met falling demand due to the global recession. This was a world far removed from the
prediction of a $200 ‘super-spike’, as Goldman Sachs analyst Arjun Murti proposed recently, which was reflected in the option
contracts on oil at $200 per barrel. But this is a market that never stands still for long. By September 2009, crude prices
had revived to $70 per barrel following production cutbacks and news of tentative economic recovery.

This volatility prompts a series of questions. First, how much of the recent ‘spike’ can be attributed to ‘speculation’ rather
than underlying supply and demand factors? Second, while an oil price shock represents a huge shift in relative prices and
a cross-border redistribution of wealth (from countries that are not oil consumers to net oil exporters), what difference
does it actually make to the world economy and its prospects for growth? Third, is it realistic to expect a repetition of
the strong response, both in supply and demand, that occurred in the 1980s, driving oil prices further back down. Or is there
now something fundamentally different about the oil world, as ‘peak oil’ theorists claim, which makes it inevitable that from
now on oil prices will remain high when a recovering world economy encounters falling world production.

As prices soared towards $140 per barrel, scapegoats had to be found. The idea emerged that responsibility did not lie primarily
with consumers for consuming ‘too much’ relative to supply, or with producers for producing ‘too little’ relative to demand
(though consumers are blamed in oil-producing countries and producers in oil-consuming countries). Rather, the fault lay with
‘speculators’. Oil consumers and producers have agreed on the pernicious role of speculators, if little else. There were,
at one time, a dozen bills in the US Congress designed to deal with these malign forces of darkness. European leaders have
been equally imaginative in coming up with wheezes to punish them: taxes
on speculators, closing down markets in which they operate, unleashing criminal prosecutors against them.

There is a purist view – which I don’t hold – that says that competitive markets will always be efficient even if they are
volatile, since the price simply reflects the information available to market participants. I have noted in earlier chapters
– in relation to housing, for example – that it is possible to have highly inefficient markets if prices are largely based
on expectations of future price changes, especially in long-life assets. There is a separate argument, from the same ideological
stable and with the same practical consequences, that speculators are inherently stabilizing in their influence on markets
since they (collectively) only make a profit if they correctly anticipate the trends and turning points in the markets. In
other words, they sell appreciating assets before markets peak, pushing down the price when it is soaring, or buy before markets
hit rock bottom, pushing up the price. In practice, however, there are many examples of destabilizing speculation in the panics
and crashes experienced in financial and commodity markets.

Was the recent spike a product of such ‘destabilizing’ speculation? It is perfectly reasonable to argue that in certain circumstances
those who speculate in a commodity – in this case oil – can destabilize markets in an inefficient way. There was an example
during the oil shocks of the 1970s. Motorists queued in ‘gas lines’, as they were called in the USA, to keep their tanks topped
up, believing that scarcity would become worse and that prices would rise further. The consequential increase in stock levels
held in tanks increased demand, and pushed up the price even further. Much oil was also wasted by motorists queuing at the
pumps with their engines running. There were also reports of oil companies, industrial users, utilities and distributors hoarding
stocks, or buying beyond expected consumption, in anticipation of higher prices to come. It was estimated that, in 1979–80,
speculative accumulation of inventories by companies and consumers added 3 million barrels / day of demand above consumption,
a
larger amount than the actual shortage of production that caused the crisis. When the inventories were sold off in the falling
market that followed, or motorists ran on lower tanks when prices fell, the ‘speculators’ lost money, but their losses did
not provoke a lament from those who had earlier denounced speculative greed.

What evidence is there that speculation has been a major factor at work in the oil shock that we have recently experienced?
No hard evidence has been put forward that there was systematic hoarding by companies or individuals. Perhaps because there
has been no major supply disruption, people have not hoarded. Instead of increasing demand in response to price increases,
which is the effect of speculative hoarding, oil users have generally curbed demand, helping markets to stabilize.

A more subtle argument relates to forward markets. Investors buy or sell agreements forward, for future delivery. If they
believe oil prices will rise in six months’ time, they will enter into agreements now to buy oil at the current – ‘spot’ –
price, and then sell at a profit in six months’ time. This activity naturally affects today’s spot price for those buying
and selling oil in the spot market – but not any long-term contractual price for real oil already agreed between suppliers
and refineries. In the example I have given, investors will push up the price today, but push it down relative to what it
would otherwise have been in six months’ time (since in six months’ time they are contracted to sell oil). Depending on whether
the overall position of those trading in futures markets is a net purchase of long-term positions (‘net long’) or a net sale
(‘net short’), this will drive today’s price up or down. There is no doubt that substantial movements in spot prices are achieved
in this way, but it is difficult to see evidence that the market has been pushed by speculative activity systematically in
one direction. If there were, it would be reflected in the accumulation of inventories, as commitments to buy now in order
to sell later are realized.

Critics try to make a distinction between regular traders in the real oil market, who close their positions by acquiring or
disposing of real oil when their futures market contract expires, and those who are simply interested in speculating in ‘paper
oil’. They point to the big increase in money invested in commodity funds whose managers, in turn, invest in futures markets
on their clients’ behalf. It is claimed by Senator Joe Lieberman in the USA that the amount of money invested in ‘index funds’,
which track commodity prices, has risen from $13 billion to $260 billion in five years, and that much of that money is in
oil, perhaps accounting for 80 per cent of the commodities price index. While this latter is a large sum, it is only one half
of one per cent of oil market transactions in a year. And, for the reasons given, there is little evidence of hoarding of
real oil. There have also been falling prices in other industries where there are active commodity markets (such as nickel),
and rising prices where there are not (such as rice). Attempts to blame high oil prices on financial speculators therefore
seem wide of the mark, even though they contribute to short-term volatility. Perhaps the need for a scapegoat stems from the
sense of impotence in seemingly powerful countries like the USA and Germany, which feel that they are essentially passive
price takers in a market dominated by China on the demand side and Gulf Arab (OPEC) states on the supply side.