Storm, The (12 page)

This is not to say that oil markets are in any sense normal or working well. Prices should approximate to the cost of producing
an extra unit – the long-run marginal cost, variously estimated at $10–60 or $70 per barrel, depending on where the extra
unit is ($10 in Iraq or Saudi Arabia, $60 or $70 in the Arctic or Canadian tar sands). The world price rose a lot higher than
even the highest estimate of marginal cost. There was, in that broad sense, a speculative ‘bubble’. The difference – the ‘rent’
in the language of economists – was accruing to producer countries that were not allowing these extra units to be produced.
This could be seen as a calculated and speculative punt by the producers on the fact that future oil would be worth a lot
more than present oil. If so, they badly miscalculated, because the price
slumped to a level well below that which almost all producing countries regard as the minimum necessary for their domestic
requirements, though it has since recovered to $70.

If there were clear evidence that speculative behaviour in futures markets was badly and systematically distorting the price
in an upward direction, governments could counter it by releasing government-held strategic stocks so as temporarily to flood
the market and punish the speculators. The US stock alone is 680 million barrels, the equivalent of 4 million barrels / day
for almost eighteen months. So far, the judgement has been made that there is no justification for using this stock as a buffer
to counter market trends rather than as a strategic stock to counter a possible embargo. The judgement has been vindicated
by the fact that the market fell sharply without any intervention.

The increase in oil prices to $140 per barrel was a major ingredient in the witches’ brew of economic toxins that contributed
to the crisis of 2008. First, a big increase in oil prices operates like an indirect tax on the world economy. It is simultaneously
inflationary – it pushes up prices – and deflationary – it reduces consumer purchasing power. Much then depends on how major
consuming countries react to this mixture of inflation and deflation. During the 1978 shock the leading governments and central
banks were preoccupied with virulent inflation and the dangers of a wage– price spiral and sharply increased interest rates
– at one point the US prime rate reached 21.5 per cent. There was a recession, and this recession was transmitted to the developing
world via falling commodity prices and the impact of high interest rates on their debt. In the most recent oil shock, oil-consuming
countries have engineered both recession and inflation, but the emphasis shifted to fighting recession via interest rate cuts.
That, however, is not the end of the story. The OPEC countries act like a tax-gathering government and spend their revenue.
During the first and second
oil shocks this process provided an initially slow but growing offset to the forces of recession, and it is doing so again.

The OPEC countries, moreover, do not require oil-importing countries to send them goods and services to balance their transactions.
They accept future claims in the form of financial securities, property or other investments. This process – ‘recycling’ –
was the subject of much agonizing and analysis in the late 1970s, but now it simply happens. To work, it requires a degree
of trust by the oil exporters that their investments will be safe and remunerative, and a willingness by oil-importing countries
to accept OPEC claims – be they rich foreigners buying expensive property and football clubs, or companies (or banks such
as Barclays) being taken over, in whole or part, by sovereign wealth funds or rich individuals.

The efficiency of recycling has been one factor blunting the economic impact of an oil shock on oil-consuming countries. Another
is that in the three and a half decades since the oil shocks of the 1970s Western economies have become much less oil-dependent.
Deindustrialization, switching fuels and energy conservation have all played a part in reducing the amount of oil consumed
as a proportion of GDP by over 50 per cent. The factors that dragged down the world economy a third of a century ago have
been less in evidence. Indeed, the world economy continued to grow strongly up to and including 2007, despite the steady increase
in oil prices. One major reason was the ease with which the banking system, until its collapse, acted as a financial intermediary,
transferring the surpluses of oil exporters back into the economies of oil-importing countries. Goldman Sachs has estimated
that $1.8 trillion was being transferred from oil consumers to oil producers in 2008. The oil producers saved in aggregate
around half of their windfall and spent the rest. The $1 trillion a year of excess savings was being accommodated by the oil-importing
world in the form of capital inflows. The capital inflows financed large current
account deficits in some oil-importing developed countries (the USA, UK, Spain, Poland) and emerging economies (South Africa,
Pakistan, Turkey). Despite the efficiency of this financial recycling, the oil shock none the less added an extra destabilizing
load to an already unbalanced world economy.

As I have described above, the world was able to cope with the oil shocks of the 1970s by recycling oil producers’ surpluses
in the short run, and in the longer term by a process of adjustment through the response of demand and supply to price signals.
The evidence from the past suggests that both demand and supply do respond, given time. Some modelling by Nobel laureate Gary
Becker at the University of Chicago suggests that in the developed world oil consumption drops by only 2 to 9 per cent in
response to a doubling of oil prices, within a space of five years; but over longer time periods consumption drops by 60 per
cent. On the same assumptions, supply grows by only 4 per cent within five years, but by 35 per cent in the longer term. The
story behind these figures is not difficult to put together. In the short term, consumption may not respond quickly to higher
prices (unless there is also a fall in income and purchasing power). It takes time for individuals to change their make of
car, for manufacturers to produce new, fuel-efficient, cars, for people to move so as to reduce their dependence on car commuting,
for electricity generators to change their feedstock, or for new materials to appear that are not oil-based. But once these
adjustments are made, their effects can be far-reaching.

It is now the response of the developing, rather than the developed, countries that matters, much more than in the 1970s.
One major factor slowing response in the short run – but not the long run – is the existence of government subsidies for oil
products (or a reluctance to tax them as much as in some rich countries). China has lower petrol prices (around 75 cents per
litre) than the USA ($1 per litre), and a third to a half of those in Britain or Germany.
It may be understandable why oil-rich Saudi Arabia or Venezuela should decide to make petrol available to their people for
a few cents a litre. But Indonesia, Mexico and Malaysia have many other claims on public resources, and oil subsidies are
unaffordable (at 7 per cent of GDP in Malaysia, and 3 per cent in Indonesia, before recent price increases). India’s oil subsidies
have been running at around 2 per cent of GDP, a major contributor to an unsustainable budget deficit (9 per cent of GDP and
rising). Governments are naturally reluctant to take on protesting objectors, but few doubt that they will have to, and are
already doing so.

It is the supply response that is more controversial. World oil production grew, over thirty years, from 55 million barrels
/ day in 1983 to 80 million barrels / day in 2007, an increase of roughly 1 million barrels / day each year. If demand growth
continues at trends established before the recent crisis and recession, production will have to grow to 140 million barrels
/ day by 2030 to keep prices broadly stable. There are wildly divergent views as to whether this is a feasible objective (even
if it were desirable).

There are basically two theories about the future of oil. One is the theory of ‘super cycles’. On this view, we shall lurch
from current scarcity and high prices to superabundance and low prices, and then back again, as has occurred over the last
few decades. Cycles operate as they do in – and may be correlated with – financial markets. The other is ‘peak oil’ theory,
that we have finally reached the limits of production: that it is downhill all the way for production (and uphill all the
way for prices). The outcome of this controversy is crucial for the world economy. There are ideological overtones – ‘greens’
versus ‘brown’ oil interests – and psychological ones too – pessimists versus optimists. But the key difference is over a
set of facts, as interpreted by geologists and economists.

‘Peak oil’ theory has recently enjoyed considerable prestige and a strongly sympathetic, fashionable literature, though the
collapse in prices in late 2008 is an inconvenient twist in the story. In one, obvious, logical sense, ‘peak oil’ theory must
be right: oil is a finite resource and production must peak at some point. But the ‘peak oil’ theorists say that that point
is now, or at least imminent. Even if new oil is discovered, they argue, it can do no more than offset the falling output
of known fields. There is no prospect, they maintain, of substantially raising production on the scale required by current
demand growth and as confidently predicted by the International Economic Association, the official intergovernmental voice
of oil-consuming countries (and ‘optimists’), which bases its judgements in significant part on the US Geological Survey.

The ‘peak oil’ argument, considerably oversimplified, is this: there is a history of peaking in established, known fields.
Most famously, M. King Hubbert was a Shell geologist who correctly predicted in the mid-1950s, in the face of some scepticism,
that US oil production would peak around 1970 and then decline. It did (though Alaska emerged subsequently, and there have
been recent major discoveries deep offshore in the Gulf of Mexico, albeit with offshore drilling constrained by environmental
legislation). The North Sea has passed through the same peaking process – indeed, it peaked ten years later than ‘peak oil’
forecasts claimed it would – and it is estimated that eighteen individual countries, accounting for around 30 per cent of
production, have passed their peak.