Wednesday, June 11, 2008

Oil Shock

For those of us that (just about) remember the early 1970s, the headlines over the past few months are acquiring a dismally familiar look.

Although much has changed in nearly forty years, the fact is that despite the two oil shocks of the 1970s, the industrialised world did not take the opportunity to wean itself from unsustainable dependence on oil. All through the 1970s there was much discussion concerning energy efficiency and conservation. In the end though, as the oil price began to fall, not only were conservation measures blunted, there was even a return to extravagance and profligacy- how else to explain the advent of the Hummer?

Oil prices have been rising steadily for some years now, as the market began to factor in the dramatic increase in demand from newly emergent economies of China and India. In a sense, the transfer of manufacturing production from America and Europe to Asia has brought a slightly unforeseen consequence- these economies are dramatically less energy efficient per unit of production than the Western factories that they replaced- the result has been a much faster increase in CO2 emissions and of course a faster growth in demand for energy.

Now the knock-on effects of higher energy costs is causing serious problems across the world. In an attempt to reduce dependence on fossil fuels, the United States, especially, has shifted corn production towards bio-fuels. The consequences of that move has increased the squeeze on supply of cereals, at a time when prices were already moving up as the result of increasing energy costs. Food prices across the world have thus run sharply ahead of the general increase in prices- hitting the World's poorest disproportionately .

Meanwhile the Oil market itself has also been squeezed by bottlenecks in capacity. Both Venezuela and Russia have seen drops in production, as their decision to exclude international E & P firms has resulted in a drop in investment in new production. Russia, despite discovering significant provable reserves has not actually opened a single new oil field since the fall of the USSR. The debate continues to rage about whether we have reached the plateau of "peak oil" or whether such a concept even has meaning; however there is a fear that overall supply can no longer keep pace with demand. The result has been a dramatic increase in speculative trading of oil derivatives. The tension in the Middle east- the continuing war in Iraq and the growing sense that Iran is set to defy the world and develop nuclear weapons- is meat and drink to the speculators.

Now we have a debate about whether oil could rise to $200/bbl or could it even double to $260/bbl.

Frankly, the height of the spike is a rather academic debate, because with oil at anything like that level much new production will be brought on stream, including the difficult to access fields west of the Shetland Isles and more tar sands in Australia and Canada- notwithstanding their higher CO2 content. Furthermore, it is clear that the unfinished work of the 1970s- creating sustainable power generation and transport- may now finally be completed.

However, the increase in supply and the changes in technology will take time to come through. In the short term, the oil price will fall based on a more simple and brutal equation: the stagflation that the oil spike is causing will choke off demand efficiently and quickly. The oil price of $140/bbl is already causing a dramatic fall in economic activity- $200/bbl will be an even sterner test.

Those of us who remember the first two oil shocks know what to expect from this one: A dramatic fall in global economic activity. The great boom that has lasted since 1991 is over. All we can do is wait fearfully to see how the credit crunch and the oil shock conspire to do their worst.

The coming decade could be every bit as bad as the 1970s.

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