Record oil prices have captured public attention for the past several months. The persistent rise has only been temporarily interrupted by some good news, China’s decision to increase retail fuel prices, and Saudi Arabia’s announcement that it would increase its daily oil production. However, these positives were soon overshadowed by underlying market expectations. We think underlying fundamentals of global supply and demand, and the resulting outlook, are driving the persistent increase in oil prices, rather than pure speculation.
The specific case of the oil-surplus GCC shows that domestic demand growth has exceeded supply growth, and as a result the exportable surplus of oil has fallen in 2007. With record economic growth reflected in rising energy demand, the shrinking exportable surplus is likely to stoke oil prices. Hence, having once been the swing producer of oil, the GCC may no longer be able to play a role in rectifying the global imbalance.
Easing oil production growth from the GCC is reflected in the slowdown in global production. While OPEC has been successful in stabilising oil prices (with Saudi Arabia being the swing producer), its ability to do so has faded significantly in recent years. Other members of the GCC have stayed close to their production capacity, which has increased somewhat since the beginning of the oil boom in 2003.
Saudi Arabia
Saudi’s ability to step into the void, as it had in the past, has been missing in recent years. For example, after Iranian oil stopped flowing into the market in 1979 as the Iranian revolution was playing out, Saudi Arabia increased its daily production by 1.3 million barrels; when Kuwait’s production stopped after Iraq’s invasion in 1990, Saudi stepped in with an additional 1.5 million during the year; and, to fill the gap when Iraqi production collapsed in 1991 after the first Gulf War, Saudi Arabia again increased its daily production by a further 1.7 million. This track record has justified its status as the swing producer and created expectations that Saudi Arabia will again come to the world’s rescue. However, unlike when Saudi production was well below its capacity, now it simply cannot step in as it had in the past.
Making too strong a point about this is also harmful, as it would reaffirm market concerns that Saudi can no longer play the role of swing producer. However, with all eyes on the world’s largest oil exporter, Saudi Arabia called an unusual meeting of the largest consumers and producers of oil on 22 June, with a specific agenda to show that it too was concerned about the sharp increase in oil prices. But its promise to increase production by 200,000 bpd was a bit disappointing; this means Saudi production will reach 9.7 million bpd from July 2008, which is well below its peak production of 11.1 million in 2005. Other members of the GCC (Kuwait, Qatar and the UAE) did not commit to an increase; although they didn’t explain why not, the fact is that these countries are already producing at full capacity.
The special relationship that the US has with Saudi Arabia is contingent on an uninterrupted supply of oil at a reasonable price. In exchange for this, we believe the US maintains a security umbrella on the GCC, which explains why it acted so swiftly after Iraq invaded Kuwait in 1990.
While supply from the GCC has been increasing in recent years (albeit a little slower than demand), the issue of price has now become a sore point for the US and the rest of the OECD. Under these circumstances, we believe Saudi Arabia would have done as much as possible to calm prices to maintain its special relationship.
Furthermore, as OPEC seems less united (Iran and Venezuela are opposing supply increases), this in our view should only increase the urgency for Saudi Arabia to flex its supply muscle. Yet, this has not happened. In our view, Saudi’s meager increase is a reflection of its desire to cool the market and yet retain a minimum amount of space capacity to protect the market against supply shocks. If Saudi increased production further by eating away its spare capacity, its ability to step in in the event of a supply shock would be very limited.
Hence, if these are more supply disruptions in Nigeria, or Israel attacks Iran’s nuclear sites, Saudi Arabia will be unable to calm global markets. In such a scenario, the price of oil could jump into uncharted territory.
With non-Saudi production almost at capacity, it is clear that, despite the increase in proven reserves and the rise in domestic consumption, there has been insufficient investment to increase production capacity.4 This could be linked to the oil glut during the 1980s and 1990s but, with prices increasing since 2003, we view the lack of growth in production capacity as disappointing.
Reserves
Hydrocarbon reserves are a finite resource, with two characteristics: one, all producing fields experience a peak production level; and two, even after the peak, oil production continues, albeit at a slower pace.
The US in 1972 (when it produced 11.2 million bpd); Indonesia peaked in 1991 (at 1.7 million bpd); Brent (UK and Norway) peaked in 1999 at 6.0 million bpd; and Mexico in 2004 at 3.8 million bpd. All together, these countries peaked in 1997.
The promising non-OPEC suppliers are Russia, Canada, Brazil and Kazakhstan. The slump that started in 1989 can be traced to the breakup of the Soviet Union, which reduced Russia’s supply until the mid-1990s. However, the increase by Canada and Kazakhstan since 2000 has been heartening, especially since they are net exporters. In overall terms, however, the rate of growth of these non-OPEC producers is falling, which suggests capacity constraints. There are some concerns that Russian production levels in the second half of the 1980s may no longer be attainable because the rapid production after the oil companies were privatised could have damaged some of its fields.
In terms of actual production, OPEC remains the leader. With Angola joining OPEC in early 2007, more than three quarters of African production is now part of the cartel. In our view, global attention will remain on OPEC because of its massive proven reserves. As of 2007, the 12 members of OPEC accounted for 75.5 per cent of global oil reserves, with the GCC 4 accounting for almost 40 per cent – Saudi Arabia, alone, represents over 21 per cent of the world’s oil reserves.
The manner in which proven oil reserves have increased in the 1980s, and the fact that on-going production has done little to deplete these reserves, is a bit odd. It almost seems as if OPEC members were competing to increase their reserves.
The stability of proven reserves has raised some doubts about the veracity of these numbers.6 An increase in proven reserves can result from any of the following: (1) the discovery of new oil fields; (2) the use of better drilling technology to increase the efficiency of extraction; and/or (3) a change in the price of oil which impacts the volume that can be commercially extracted. We believe only the discovery of new fields could justify a lumpy increase; better technology and oil price fluctuations should impact all producers, which means correlated volatility.
A comparison of OPEC producers with more transparent countries, like Norway, UK, the US and Indonesia, is particularly interesting. In the latter group, annual oil production in these countries is at least somewhat correlated with remaining proven reserves. In our view, the seemingly ad hoc increase in OPEC’s reserves, and the lack of follow through to production capacity, has raised some doubt about OPEC’s ability to increase production. With limited spare capacity within the cartel, we believe OPEC’s ability to stabilize oil prices could well be over.
Inflation
With rising retail fuel prices, some reduction in demand is expected. However, in this period of record inflation in the GCC, the question is whether policymakers in the region will increase retail fuel prices – in our view, this is unlikely. Since policymakers have committed to use subsidies to keep prices from rising, it makes little sense to increase retail fuel prices that have strong spill-over effects; hence, we expect retail fuel prices (and utility rates) to remain fixed until inflation in the region has started easing.
Now that the GCC is the fastest growing region in the world, the growth in energy demand is significant. Although the region clearly meets its domestic energy needs, a growing share of energy production is now being consumed locally, which means less is available for export. While the US, China and India have access to other sources of energy (nuclear, coal, hydel), all the GCC’s energy needs must come from oil. This explains why the GCC is not only showing the fastest increase in per capita oil consumption in the 21st century, but also the highest consumption level in the world.
In quantum terms, the picture is just as unsettling. Even with the strong economic growth in India, which has been triggered by a booming middle class purchasing consumer durables, the GCC 4 consumed 8 per cent more oil than India in 2007, despite only having a population that is 2 per cent of India’s. The point to make is that, with the strong economic growth fuelled by oil prices, the GCC states are more dependent on oil than almost any other country in the world.
Gas
Furthermore, unlike the Asian giants that have increased retail fuel prices to ease demand and reduce fuel subsidies, the GCC has no such compulsion. This means that if the GCC growth momentum continues as we expect it to do; domestic oil consumption will continue to grow.
There has been some discussion about shifting power generation in the GCC from oil to natural gas, so as to free up oil for export. However, as seen from the oil consumption data, so far this has not been enough to dent domestic consumption in the region. There are two simple reasons for this: (1) producers know that exporting oil is much easier than gas, and hence have already been using gas for power generation; and (2) there is a shortage of natural gas in the GCC.
As stated by a senior executive who works on energy projects in the GCC, “There are two issues: first, there is a shortage of gas in the GCC; and second, power generation will have to compete with petrochemicals to get the gas allocations. While governments recognise the “cleanliness” of gas, they also understand that they need to create jobs and the petrochemical industry is better placed to deliver these jobs.”
The shortage of natural gas may seem counter-intuitive for the oil-rich GCC, but except for Qatar’s long-term sales commitments, there is no unencumbered gas for domestic consumption. The amounts of gas that have been produced so far have already been used for power generation.
Kuwait and Saudi Arabia relied on natural gas for power generation, but with the gas shortage these countries have shifted their generation units to crude oil. We believe the gas shortage in the GCC will persist until at least 2011, and thus the region’s dependency on oil will only grow.
Although production from the GCC 4 is just off its record high of 2006, rising consumption is eating into the exportable surplus. We believe this is the first time oil exports from the region have fallen without an intentional effort to reduce supply. With oil prices where they are, we do not see OPEC reducing production; the issue is whether current production levels are enough to increase the exportable surplus of oil. In the case of the GCC, we see the exportable surplus falling in the coming years.
This creates an interesting reversal in causality: while rising oil prices triggered strong economic growth in the GCC, we believe this relationship is no longer in play; instead, we think strong GCC growth may now be playing a role in pushing oil prices higher.
In the global context, Middle Eastern consumption is significant. The incremental increase in oil demand from China and the Middle East, accounted for 84 per cent of the global increase in consumption in 2006, and 58 per cent in 2007.
In our view, the OECD and Asia Pacific have become marginal players in the demand picture. Hence, while net oil exports from the GCC 4 have tapered, Chinese demand continues to grow. Although we expect a degree of demand destruction in China, we do not expect its demand to be as responsive as the OECD for the following reasons: (1) China’s growth is not just energy dependent, but the growth itself is increasing demand for oil; (2) the consumer boom in China is still at its initial stages, which means appetite will remain strong; and (3) with a growing income divide in China, we expect oil demand to be relatively inelastic. Looking at India, it is not as much a problem as people think.
Constrained demand
Since China and the Middle East are driving oil consumption, the only way to ease global demand is for sufficient demand destruction in the OECD. Furthermore, with oil production almost at full capacity in OPEC – and Saudi being forced to use up its spare capacity – possible supply shocks (Nigeria, Iran-Israel) are likely to have an exaggerated impact on oil prices. Also, insufficient investment in oil production and the absence of large oil discoveries in the GCC point to only modest supply increases.
Looking specifically at the GCC, we see constrained production, but little to ease growing demand. Rising oil prices will continue to drive these economies, while subsidised fuel will add to domestic demand for oil. As we have shown, 2007 was the first year that the exportable surplus of oil fell in the GCC. We expect this to fall further as member countries first satisfy domestic demand – oil consumption in the GCC has been growing at about 7.4 per cent per annum since 2003. With a shortage of gas in the region, domestic demand for oil will continue eating into the exportable surplus.
In terms of a longer-term outlook, expectations that supply must increase from the GCC are not misplaced. The sheer size of the region’s proven reserves invites such attention. With growing domestic demand, and Saudi’s effort to remain the swing producer, we expect significant investment to enhance production capacity – and not just refining capacity.
Related to this is the need for greater transparency about the giant oil fields in the region; this is required to properly gauge whether Saudi Arabia can indeed increase its production capacity to 20 million bpd, as assumed by oil analysts. If credible information (and investment) is not forthcoming, concerns that
Saudi production may have peaked will continue to gain acceptance.
How could this global shortage materialise so suddenly? The suddenness is only partially accurate; oil prices have been increasing consistently since January 2007, while China and the GCC have been booming since 2003. However, in our view, the supply side has been ignored, and this is where the sense of panic may have come from.
Despite rising oil reserves, the large OPEC producers have done little to increase production capacity. We do not think this is intentional, as it undermines the GCC’s special relationship with the US; triggers global resentment; and could accelerate the search for alternative fuels. In our view, analysts have not tracked production and refining capacities as closely as they should; perhaps the reluctance of the GCC to discuss their oil sectors is partially responsible. Now that the price of oil has become unreasonable, supply details are required to settle the market.
Mushtaq Khan is an economist at Citi in London