by David C. Grabbe
August 14, 2012
As the driving season kicks into high gear, the cost of gasoline is again on the minds of many. Of course, the price at the pump largely rises and falls according to the price of oil. What has caused oil prices to rise so much in the last decade? Is this simply a matter of supply and demand—with increased demand from the developing world and supplies running out?
For decades, conventional wisdom has held that the world's fossil fuels are drying up, and soon the world as we know it will grind to a halt as the oil disappears. This idea is largely attributable to the work and analyses of Marion King Hubbert (1903-1989), who is distinguished in the term "Hubbert's Peak"—better known as "peak oil." In 1956, after rigorous analysis, he predicted that U.S. oil production would hit its peak between 1965-70. In 1970, U.S. oil production did in fact hit its high point and began to decline, and three years later, the nation suffered the shock of the oil embargo. Hubbert's credentials were then beyond reproach, and he continued to predict that children born in 1965 would see the depletion of all the world's oil, and that mankind was entering "a period of non-growth." His disciples have continued to speculate that the world is perpetually ready to fall off the oil mountain; it is now a mainstay among much of Western culture.
Though Hubbert correctly forecast the future of U.S. oil in his day, the oil industry is not static. According to "There Will Be Oil" by Daniel Yergin (The Wall Street Journal, September 17, 2011), since 1978, the world's oil production has increased by 30%. Just between 2007-2009, for every barrel of oil produced in the world, 1.6 barrels of new reserves were added, either through new discoveries or through developing techniques to extract even more oil from existing fields.
Currently, an estimated 1.4 trillion barrels of oil are technically and economically accessible—out of 5 trillion total barrels in the ground. Truly, the world can be said to be awash in oil. Not only are new fields continuing to be discovered, but the technology continues to advance, allowing for previously impossible extraction and production. This is not to suggest, however, that the world's current rate of consumption could be indefinitely sustained.
Thus, oil scarcity does not account for the present price of oil. Nor is it price-fixing by the OPEC cartel, which today produces only about a third of the world's oil. Instead, several other factors make up this complex equation.
As Chevron Chairman and CEO David O'Reilly wrote in an open letter in 2005, "One thing is clear: the era of easy oil is over." According to a 2010 review by the International Energy Agency, the world's largest producing oil fields—the "easy oil"—are expected to lose three-quarters of their production over the next few decades. The "tough oil"—though there is apparently a large volume of it, in deep-water fields, tar sands, and the Arctic—requires tens or even hundreds of billions of dollars invested in infrastructure and new technology to get the oil from the ground into a usable form for refining. Because of the hefty upfront cost, many of the recently discovered fields will not be profitable unless the price of oil remains above $90/barrel.
Who pays the billions of dollars in upfront expenses? The majority of the capital comes from the oil companies themselves, which depend on hefty profits to fund new projects. A large percentage comes from non-oil-industry investors simply looking for a return on investment. In the last 12 years, these investors have grown to account for 40% of the oil market. They tend to trade based on confidence and rumor, and the news of the day can bring wide variations—whether Iran sounds belligerent or a surging oil price attracts investors trying to catch an upswing. Thus, the "open market" of oil is a double-edged sword: It allows anyone to invest—and is generally a safe investment given the demand for oil—and such investment allows for the "tough oil" to be brought to market. Conversely, the more people invest in a commodity, the higher its price.
That nearly all the world's economies are increasing their money supply via fiat currency compounds the effect. Since 2005, the global money supply has more than doubled. As more money is created, more finds its way into investments (especially oil), looking for a return, and the more money in the system, the higher the price of oil. In the 2008 stock market crash, a huge amount of fiat "wealth" was destroyed, and within six months, the oil price fell from $145 to $36 per barrel.
Wherever big money can be made, politics comes into play, and oil is certainly no exception. A geopolitical drama is unfolding in the eastern Mediterranean due to the 2010 discovery off Israel's coast of an estimated 1.7 billion barrels of recoverable oil and 122 trillion cubic feet of recoverable gas. The U.S. Geological Survey calculates that the eastern Mediterranean contains 3.4 billion barrels of oil and 345 trillion cubic feet of natural gas—the decade's largest natural gas discovery. Already tensions have risen. Lebanon is making its case to the United Nations that part of the gas field (named "Leviathan") lies in its territorial waters. Israel, though, will not simply acquiesce. Its current domestic natural gas production is already winding down, and existing supplies could run out within a few years. It needs the new fields for its energy—and thus national—security.
The Israeli discovery prompted its neighbors to do their own exploration, and significant deposits of oil and natural gas were found in the Aegean Sea near Greece—enough that Tulane University oil expert David Hynes claims that Greece could potentially solve its debt crisis by developing the fields. Athens may never see this potential realized, however. For starters, the IMF and EU are demanding that Greece sell off its public companies (including its state oil companies) to pay its public debt. In addition, Greece has not declared an Exclusive Economic Zone around its coast, which would give it international recognition of mineral rights. Moreover, Turkey has previously stated that if Greece drills any further into the Aegean, it would consider it an act of war.
In the present economic and political environment, tensions are already high in the Middle East and Europe. This new discovery of "black gold" has the potential to intensify the friction in one of the most volatile places on earth.