Oil price shock; you ain't seen nothing yet

The most common cause of a spiking oil price is supply shock. We may be seeing just such a phenonenon right now with the effective shut down of Libyan oil. But sometimes it’s excessive demand that does the damage.

Forget the present turbulence, which may or may not be temporary. You don’t have to look far into the future, perhaps as little as a year to 18 months, to see that a major demand challenge is looming which even assuming no further disruption to existing production, will challenge the present supply base to breaking point.

As it is, it’s fair to assume the world is closer to full capacity than producers care to admit. Rewind to the last oil price shock in the summer of 2008, and Saudi Arabia, pumping out oil at the rate of around 9.5 million barrels a day, was having to draw on inventories to meet demand. It’s therefore reasonable to assume that 9.5 million bpd then represented maximum capacity.

Since then, the Saudis have brought a further two fields on stream with a capacity of around 2 million bpd, bringing total capacity up to some 11.5 million bpd. But there is generally reckoned to be an attrition rate of around 6pc per annum on existing fields, taking us back to square one in terms of maximum daily output. This is perilously close to what the Saudis are already producing, and makes the assumed buffer of Saudi spare capacity considerably smaller than the Saudis claim. There’s not much slack anywhere else either.

Now look at growth in demand, virtually all of which is coming from China and other emerging markets. Chinese demand at around 10 million bpd annually is already around half that of the world’s biggest oil consumer, the US. But unlike the US, where demand is in gentle decline, in China it’s rising like a rocket. Last year Chinese demand rose by close to 1 million bpd. It’ll probably be a bit lower this year, but not much. More cars are now being bought in China than the US, and they’ve got to run on something.

Nobody believes that Chinese GDP will grow by as little as 3 per cent per annum over the five years, but in order for as much nominal GDP to to be added to the Chinese economy over the next five years as occurred in the last five, that’s in fact all that needs to occur. In reality, growth is likely to be much higher.

Do the math. Almost regardless of what happens to supply, demand will soon be outpacing the world’s capacity to meet it. The economic effect of such a mismatch is to drive up prices to a level where they eventually ration demand. Output will fall to a point which brings demand back into balance with supply. That’s called a recession.

That may be where we are heading this time. Or it may be that the world economy can tolerate rather higher oil prices than it has in the past. We’ll see. But either way, high prices serve an important purpose. One is to stimulate investment in further sources of supply. And as Chris Huhne, the UK Energy and Climate Change Secretary, pointed out in a speech this week, another is to make alternative energy sources economic. By Mr Huhne’s estimation, $100m oil is the point at which clean and green energy become cheaper for the UK consumer than hydrocarbons.

The UK is only 2 per of global demand for oil, so what happens here isn’t going to make a whole lot of difference to the overall picture. But what the US chooses, or is forced to do, most certainly will. Per capita consumption of oil in the US is about twice the European level. The solution to the looming demand problem for oil is therefore to get the US to reform its bad behaviour and consume less of the stuff. This is much easier said than done.

The whole US economy is built around cheap oil, and there is certainly an argument for saying the US cannot physically consume less without taking a big hit to GDP. On the other hand it also means that there is huge scope for efficiency improvements. Relatively small changes in behaviour which need not necessarily be damaging to output – such as automobile sharing or simply using public transport more frequently – could have a big effect on consumption.

In any event, high oil prices are here to stay. In 2008, the price at which US consumers stopped spending was $147 a barrel. It may be a bit higher this time around, but it’s not going to be far off.