The Producing Countries

Between Pursuing Development and Meeting Global Demand

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Composition: mingling of plastic and metal
The Producing Countries : Between Pursuing Development and Meeting Global Demand - Giacomo Luciani

Global Demand: A Dependent Variable

As we address the issue of whether OPEC investment is sufficient to create the capacity and produce enough crude oil to satisfy world demand, I believe we should consider the latter a dependent, rather than an independent variable.

Producers have frequently complained about demand uncertainty. They feel they are called to take the risk of investing in new capacity, only to discover that it is not required, because demand has not grown as expected. Producers therefore seek risk mitigation, an assurance that their capacity will be utilized, if they invest in creating it.

But should we assume that demand growth is exogenous and that producers must simply conform to it? Are we taking demand for sacrosanct, even if not entirely predictable? Or shall we discuss desirable demand trends?

Inevitably, we shall need to question demand patterns. A first major reason for this is the impact on the environment and emissions of greenhouse gases: the danger of climate change is serious enough and needs to be addressed urgently. A further reason is that even if we were able to capture and master greenhouse gas emissions, the fact remains that our model of consumption of fossil fuels is unsustainable in the long run.

The per capita primary energy consumption of the United States (at 277 million BTU per head) is 60 percent higher than that of the European Union and Japan (at 174 million BTU per head). This gap is not mirrored by an equivalent gap in the standard of living or per capita income1: it simply reflects the absence of a serious effort at saving energy, and especially transportation fuel. In fact, even the pattern of consumption, which is characteristic of the EU or Japan, may not be sustainable, in the sense that it could not become universal.

The major component of demand growth today originates from China (which consumes 30 million BTU per head, 1/10 of the US consumption level) and India (12 million BTU per head, or less than 1/20 of the US level), two very large and rapidly developing countries, which aspire to bridging the gap that separates them from the industrial countries. This will require huge and essentially unstoppable fossil fuels demand growth: should this be met only through increased capacity and production, or also through a measure of containment, if not decline, in the demand growth of the industrial countries?

Resources are scarce: creating capacity to meet a rapidly growing demand requires huge investment, large and scarce human resources, and time. What we see at present is competition among net importers to acquire their needed supplies, leading to upward pressure on prices. It may be convenient to blame the OPEC producers that are not increasing capacity fast enough, but perhaps we should move more decisively to contain the industrial countries’ demand.

I believe OPEC should not simply accommodate any demand growth, but factor in and anticipate a policy of demand restraint on the part of the industrial importing countries - simply because this is rational and necessary in order to achieve a demand pattern that is sustainable in the long run. Accommodating demand only temporarily hides the nature of the problem, but does not solve it.

Should Producer Anticipate Global Demand?

From the producers’ point of view, is it advisable to anticipate or accommodate demand? It would seem that the best course is rather to trail demand growth somewhat – i.e. not to the point of creating serious scarcity or prices rising beyond control. A condition of relatively tight supplies and gently rising prices seems to be what is required to send the right message to the world: demand should be restrained and non-conventional supplies expanded.

Is there a danger that prices may become “too high”? OPEC of course is influenced by the historical memory of the early 1980s, when the group’s market share was eroded and the system of posted prices had to be abandoned. However, conditions today are profoundly different: there is no major province coming on stream with such prolific supplies so as to marginalize OPEC by compensating for the declining production of an ever longer list of mature basins.

There will be fuels originating from non-conventional sources, such as the bitumen and heavy oils of Venezuela, or the tar sands of Canada; from natural gas (gas-to-liquids) or coal; and even from agriculture (corn, rapeseed, sugar cane and many more). But all of these require very large investment and long lead times before they generate a stream of products: they are, so to speak, long seen in coming.

We are talking of a different time scale from projects in the major oil producing countries, which can add hundreds of thousands or even more than a million barrels per day in five years or less. Hence, the major producers will have plenty of advance notice and will be able to influence prices in order to make sure that their capacity is not left underutilized.

Generally, major oil producers have preached against the development of non-conventional fuels and have tended to see them as a danger: here I am proposing exactly the opposite. It is in the interest of the major producers to “encourage” some development of non-conventional fuels and to manage prices so that this development does not become too rapid (a very unlikely occurrence). The “long-term equilibrium” price of crude oil is one that allows for development of alternative energy sources at a pace compatible with the producers’ preference for the pace of their reserves’ draw down. Hence in a sense it is up to the producers to establish their long-term production policy based on their preferences for reserves’ life; and to let the price encourage alternative fuels sufficient to fill the likely gap.

Are Price Too High?

Can we say that prices today are high, or even too high? The evidence is less clear-cut than it might appear at first sight.

True, the prices of WTI and Brent have increased substantially, recently passing the $60 per barrel threshold – about five times the level they were five years ago. However, neither WTI nor Brent are representative of the average crude oil, and they do not play the role of marginal supply equalizing global demand and supply.

The quality differentials between light and sweet crude oils, as both WTI and Brent are, and the heavier and sourer streams that constitute the bulk of global supplies –certainly of marginal global supplies – has considerably widened. Hence on average the price of crude oil has not increased as much as the price of WTI and Brent.

Secondly, we should distinguish between nominal and real prices – a price of $60 per barrel in today’s dollars remains below the peak historical price of $32 per barrel in 1980 dollars. In addition, for quite some time the dollar has been depreciating relative to other currencies, notably the euro: it is only in recent weeks - at the time of writing - that this tendency has reversed. The European consumer is therefore feeling the added burden of the depreciation of the euro (meaning that effectively in recent weeks the price of crude oil to the average global consumer has increased more than the nominal price in dollars would indicate).

Finally, in Europe and Japan taxation creates a huge wedge between the price of crude oil and the price of products to the consumer: for every euro spent on gasoline, 75 cents go to the taxman and only 25 pay for the product.

The huge incidence of taxation has two unwelcome consequences. Firstly, it “buffers” the consumer from proportionate product price increases, as the tax is at least in part computed as a fixed-sum excise rather than as ad-valorem proportional to the industrial price of the product. Secondly, and possibly more importantly, it indicates that the final consumer is willing to pay much more than the industrial price of the product – meaning that the “market value” of the product is well above the cost of buying crude oil at the current high prices, and refining it. The high level of taxation, in other words, is a constant reminder to OPEC that consumers are willing to pay a lot more for the convenience of using fossil fuels.

Nevertheless, the private car remains the cheapest mode of transport - even in Europe, where it is most heavily taxed. It is normally cheaper than regularly scheduled air transport, and even in many cases cheaper than travel by train, notwithstanding the fact that whoever travels by car pays a lot of taxes and supports the government in the process, while generally public transport passengers are net beneficiaries of government subsidies.

A lot has been said to decry the American habit of driving SUVs, but the latter have become increasingly popular in Europe as well, notwithstanding the much higher gasoline and diesel prices. We have a technology that can provide the same comfort and driving experience with much reduced consumption: the hybrid engine. But do we see a dash to buy hybrid cars, or more fuel efficient ones? One can hardly detect a trend. In short, the consumer may complain about the increasing price of fuel, but he/she is hardly changing his/her habits or preferences.

It is possible that we cannot yet see a demand response because it will react with some delay. If the demand response is retarded, it is possible that prices may overshoot the “equilibrium” level. Yet changes in demand patterns take time and are visible at the margin well before they can make a huge difference on the average. Hence, producers will be able to monitor the symptoms of a change in demand behaviour well before it bites: they just need to be flexible and prudent – as they failed to be in the early 1980s.

In this sense, producers have an interest in price “stability”, i.e. in avoiding sudden and large increases in prices, which might trigger an unpredictable delayed response from the system – demand and supply. In this sense, prices have increased too rapidly for comfort in the past five years, and producers should strive, as they are doing, to contain or even somewhat reverse the increase. A period of, say, five years of price stability is required before we can say with certainty what the response to higher prices might be. It is however not clear that the market will allow for that.

Should Producers Maximize Production?

A further point, which needs to be discussed, is whether it is in the best interest of the producing countries to produce more, i.e. draw down their available resources more rapidly in order to accommodate rising global demand.

It has become fashionable to repeat that the Stone Age did not end because of a dearth of stones, or the coal age because of the exhaustion of coal deposits. What these statements imply is that the oil age might end because oil is made irrelevant by some fundamental discovery, which will provide an alternative source of energy, cheaper and more convenient.

However, no such leap is anywhere in sight, and scientists called to discuss the potential for it have concluded that oil will remain relevant for the foreseeable future. Any fundamental discovery would require long lead times before it becomes commercial, and even longer lead times before its use becomes widespread. By the way, the age of coal has in fact not ended at all: coal remains very much in use to this day.

The opposite preoccupation – that oil resources might be exploited too rapidly, before the country possessing them has had a serious chance to develop and diversify its economy – is much more serious. Development is not bought in brightly coloured packages from the supermarket shelves: it is increasingly associated with the accumulation of human capital, and the latter requires generations to be achieved.

The official Saudi strategy presently envisages reaching a capacity of 15 million barrels per day and maintaining it for 50 years: should we conclude that this is too conservative? I do not think so. In the end, it is a question of whether the producing country would have good use to make of the additional money in case it produced more – assuming that it would increase its revenue by increasing production, which is far from certain.

The issue of what to do with the money should not be belittled, and is one that the importing countries must recognize if they wish to encourage the major exporters to produce more. An increase in oil revenue is a potent temptation to also increase expenditure: however, the danger that by so doing the government will set off the infamous “Dutch disease”2 and damage diversification is very real indeed.

In the 1970s and earlier, governments massively invested in infrastructure and in industry. Recent research confirms that such investment, if well directed, may serve to cure or prevent the Dutch disease. Due to the weakness of the private sector, governments felt they were required to step in directly.

However, development requires a strong private sector. In fact, private business enterprises have grown much more capable in the past 30 years in many major producing countries (though certainly not in all) and today the government must refrain from decisions which might “crowd out” the private sector – not from the sources of financing, but from profitable investment opportunities. Private enterprises are constantly claiming for new investment opportunities and complaining that the government is subtracting opportunities from them. In infrastructure, industry, and public services, governments are advised to leave investment to private enterprise and to privatize companies that were established by the state. Hence, governments in turn find fewer opportunities in which it is justified for them to step in and invest directly.

Accumulating financial assets in order to invest internationally – that is, creating a “reserve” or “stabilization” fund along the lines adopted by a growing number of producing countries and advocated by the World Bank and IMF – is a possibility, but raises the question of assets management. Unfortunately, money can also be lost in the management of these funds: a consideration that points in the direction of very conservative investment, i.e. primarily government paper from the major industrial countries – the US first and foremost. But to what extent does it make sense to extract more oil and increase revenue only to lend it to the US government to finance the federal budget deficit? One is left to wonder.

The stereotype, according to which the governments of the producing countries need larger and larger oil revenues in order to satisfy the expectations of their rapidly growing populations, implicitly assumes that these countries are unable to diversify their economies or spend wisely. In many cases, it is a very poor approximation of reality.

Add/Optimize Value

Rather than necessarily maximizing crude oil production, the major exporting countries should focus their attention on adding value to crude oil and optimizing value creation downstream. Refining returns have become much better in recent times. Indeed, the shortage of conversion capacity globally is considered to be one of the causes of higher Brent and WTI prices and is also one of the reasons why increasing the supply of heavier and sour crude oils does not necessarily help easing them. Producers are, therefore, announcing ambitious plans to invest in refining and petrochemicals, and they are very wise to do so.

The development of refineries and petrochemical plants in huge industrial estates in conjunction with power generation, water desalination, aluminum smelting and other energy-intensive industries (including gas liquefaction or transformation into liquid fuels, and the production of hydrogen for export, whenever a demand for it will emerge) will create conditions ideal for the capture and sequestration of CO2 in the same oil and gas fields. The technology for doing this exists – it just needs to be combined and applied on a scale that is unheard of for the time being. It is a direction in which the producing countries should massively invest rather than just sinking more wells in the ground.

We should, in other words, possibly shift our focus from the availability of crude oil to the availability of the required final products – fuel and non-fuel. The required fuel products may be new, as in the case of hydrogen, or old – gasoline, kerosene, diesel etc. They may be produced out of crude oil distillation and conversion, or out of coal, gas or agriculture. We shall need to revise our vocabulary: I deliberately avoid using the term “petroleum products,” because they may not come out of petroleum at all.

In a world in which the required fuels are produced from a variety of sources through a variety of technologies – all well established and mostly commercial at current prices – we may progressively see an increase in the relative importance of final products, and a decline of the weight of crude oil in international trade. This, I would suggest, would be a welcome development.

At present, the price of crude oil is the major factor determining the price of products. However the “fundamental” demand is for the latter: crude oil prices are determined by a market structure whose defects have been underlined and extensively documented, and which is affected more by financials than by fundamentals. A world in which the production of fuels is more diversified, and trade in fuels is more important, may be one in which final demand plays more of a role, and the price of crude oil is more responsive to market conditions for fuels, rather than vice versa.

Notes

1 Each dollar of US GDP requires close to 11 thousand BTU, against 7 thousand BTU for each dollar of Western European GDP and 5 thousand BTU for each dollar of Japanese GDP; all figures are taken from the EIA’s International Energy Outlook 2004 and refer to 2001.

2 This term, coined in 1977 by the Economist to describe the decline of the manufacturing sector in the Netherlands after the discovery of natural gas in the 1960s, is a concept that tries to explain the apparent relationship between the exploitation of natural resources and a decline in the competitiveness of the manufacturing industry.

Giacomo Luciani is professor of political economy and co-editor of the Mediterranean Program at the University Institute. He frequently lectures at the Bologna Center. Most recently he co-authored and co-edited Regime Change in Iraq: The Transatlantic and Regional Dimensions.