Monday, February 21, 2011

If Libya's Oil is Shut Down, Oil Could Hit $142/bbl.

There is some concern right now that because of the potential imminent collapse of the Libyan government, the country may have to temporarily shut down oil production.  This would be a major issue, because Libya is currently the world's 11th largest oil exporter.

To get right to the punchline, if Libya were to shut down all of their oil production, the price of oil could spike to $142 per barrel.  There's a 20% chance it will happen, and if it does, the US economy could loose $335 Billion in GDP.

Muammar Gaddafi
Using the short run price elasticity of demand, it is possible to calculate the impact of the secession of Libyan oil production on world oil prices.  There are a number of estimates of the short run price elasticity of demand for crude oil from a number of leading journals.  They range from -0.034 to -0.05 to -0.077.  Based on this range, -0.05 should be a good enough estimate for the purposes of this post.  As I stated in my video two weeks ago, there are reasons to believe that the short-run elasticities of both supply and demand are far more inelastic than most economists believe, but for simplicities sake, -0.05 is an adequate estimate.  Assuming the adjustment to the supply and demand curves will come entirely from the demand side, we can use the following equation to estimate the change in price:  Short Run Elasticity of Demand = % change in quantity supplied / % change in price.  I believe this is a fair assumption, given the fact that recent Wikileaks releases, which I discuss in another post, have shown us that the available spare production capacity of Saudi Arabia may be grossly overstated, resulting in a far smaller cushion of spare oil capacity available to reduce the effect of a shock like this.  Any price improvement from slack taken up by spare production capacity may be lost in the trading frenzy that would follow an event like this.

Current World Oil Production = 84,388,895 barrels per day
Current Libyan Oil Production =  1,789,155 barrels per day
% Change in World Oil Production if Libyan crude production is halted = ((84,388,895-1,789,155)-84,388,895)/84,388,895 = -2.12%
-.05 = -2.12% / % change in price
% change in price = -2.12%/-.05
% change in price = 42.4% increase
Brent crude price before Libyan unrest = $100 / bbl
Brent crude price if Libyan crude production is halted = 100*1.424 = $142/bbl

If all of Libya's crude oil production was taken offline, we could see the price of oil spike to $142 per barrel.

The actual Brent crude price today was $108 / bbl - an increase of $8 since last week, when the Libyan collapse started.  This means that the increase in the oil price as a percent of the $42 increase potential is 8 / 42 = 0.19047619.  So the $8 increase in oil price since the Libyan collapse began is signaling that the market believes that there's about a 20% chance that Libya will halt all oil production.

If the price of oil gets much higher, we will be running dangerously close to the point where demand destruction will cause the world economy to sink back into a recession.  This paper uses the short run oil price elasticity of GDP to find that for every 1% increase in the price of oil, the US economy looses .05% of its GDP.  To put it another way, with a $14.5 Trillion economy and with oil at $100/bbl, for every $1 increase in the price of oil, our economy looses $7.3 Billion of GDP.  With today's $5 oil price increase, the United States lost $36 Billion in GDP.  If Libya's crude oil production is taken offline, and the oil price spikes to $142/bbl, the US economy would loose $335 Billion in GDP - a 2.3% decline that would push the US economy back into a recession.

For more information on how to protect yourself from this possible oil price spike, please read my other posts Demand Destruction from Peak Oil and Profit from Peak Oil's Bumpy Plateau.

Thursday, February 17, 2011

Wikileaks Confirms Fears of Saudi Peak Oil - An Analysis

Last week, Wikileaks released four diplomatic cables which had been sent from the US embassy and consulates in Saudi Arabia to the U.S. Department of State.  The main headline from these cables was the fact that the US government privately believes that Saudi Arabia may be overstating their oil reserves by 40%.

Coincidentally, the night before the leak I posted a video in which I discussed a few of the reasons why most experts believe that Saudi Arabia and other OPEC members are overstating their reserves and I discussed that the main implication of this is in the short run, we're likely to see an oil price spike within the next two years.

Today, I'd like to put the leaked cables into context with an analysis of the issues discussed in the cables and the possible repercussions of those issues.

The first cable was sent to the US Department of Energy via the US State Department on December 10th, 2007 by Consul General John Kincannon with the subject line "FORMER ARAMCO INSIDER SPECULATES SAUDIS WILL MISS 12.5 MBD IN 2009".  Consul General Kincannon is headquartered out of Dhahran, Saudi Arabia - a city of only 11,000 people on the Persian Gulf coast of Saudi Arabia.  What's important about Dhahran is that for the past 78 years, it's been the home of the headquarters for Saudi Aramco - the largest oil company in the world.  The consulate in Dhahran is one of the most important posts of any US diplomat, as the information brought back from their relationships at Saudi Aramco have wide-reaching implications for the military and economic security of the United States.

Consul General John Kincannon
In the leaked cable, Consul General Kincannon describes a meeting he and the consulate's economic officer had with Dr. Sadad al-Husseini on November 20th, 2007.  Dr. al-Husseini served as the Executive Vice President for Exploration and Production at Saudi Aramco from 1992 to 2004 and was a member of the Saudi Aramco board of directors from 1996 to 2004.  In these positions, he had complete access to all of the information on all of Saudi Arabia's oil fields.  He had complete data from each oil field, including the field's total size, the amount of oil which has been extracted, the amount of oil left, and, most importantly, what the peak production capacity of each field is from an economic and geophysical perspective.  During the meeting, Dr. al-Husseini told the consulate general that Saudi Arabia "has oversold its ability to increase production and will be unable to reach the stated goal of 12.5 million b/d of sustainable capacity".  Additionally, he stated that "sustaining 12 million b/d output will only be possible for a limited period of time, and even then, only with a massive investment program."  He stated that "new oil discoveries are insufficient relative to the decline of the super-fields, such as Ghawar, that have long been the lynchpin of the global market."  He goes on to say that "once 50 percent depletion of original proven reserves has been reached...a slow but steady output decline will ensue and no amount of effort will be able to stop it."
Essentially, Dr. al-Husseini told the US that Saudi Arabia's oil production would peak at 12 million barrels per day and would decline thereafter.

Dr. Sadad al-Husseini
He further stated that "approximately 116 billion barrels of oil have been produced by Saudi Arabia, meaning only 64 billion barrels remain before reaching this crucial point of inflection. At 12 million b/d production, this inflection point will arrive in 14 years."

Given that the meeting was held in 2007, 14 years from the date of the meeting puts the peak year in 2021.  If Dr. al-Husseini is correct, we will see a Saudi peak within the next 10 years.

What most of the news media missed in the analysis of this leaked cable is that Sadad al-Husseini has been publicly warning people about the Saudi peak for a number of years.  In 2004, three years before this meeting took place, al-Husseini did an interview for UK's Channel 4, in which he gave the same warnings about rising oil prices and a future Saudi peak.  After his Channel 4 interview, al-Husseini did interviews for the New York Times and the Energy Bulletin in 2005, for writer David Strahan in 2007 and for CNBC in 2008.  In 2008 he also met with influential investors like George Soros and T. Boone Pickens in an effort to further raise awareness of the issue.  So it certainly wasn't private knowledge that Sadad al-Husseini believed that Saudi Arabia was overstating their reserves.  What is important about the leaked cable, therefore, is not the fact that Sadad al-Husseini is predicting a Saudi peak in the next 10 years, but that the US government is privately acknowledging it while publicly saying nothing about peak oil.

The cable brings up the point that one of the factors limiting the addition of new oil production capacity is the lack of skilled workers in the oil industry.  Because the price of oil collapsed in the early 1980's and remained low for nearly two decades, thousands of experienced workers were laid off and thousands more who would've entered the industry went on to work in other industries.  As a vast amount of the workers who remained in the industry through this bear market are now beginning to retire, they are taking their years of industry knowledge with them and further exacerbating the skilled labor problem.  This factor has been discussed recently, as the lack of skilled workers may have contributed to last summer's gulf of mexico oil spill.  From the peak oil perspective, the lack of skilled workers is making it harder to bring more oil production online, which could make it difficult to slow the decline once we've reached peak oil.

The cable also discusses the oil price increases in 2007, saying "considering the rapidly growing global demand for energy - led by China, India and internal growth in oil-exporting countries - and in light of the above mentioned constraints on expanding current capacity, al-Husseini believes that the recent oil price increases are not market distortions but instead reflect the underlying reality that demand has met supply".  In my video that I put up the night before Wikileaks released this cable, I go into much more depth on this issue.  The main conclusion that I reach is that our world's oil supply is beginning to reach a wall and at the same time the world's demand for oil is growing rapidly and becoming far more inelastic.  These factors will combine to cause a price spike in the short run and higher oil prices in the long run.

With respect to the motives for Saudi Arabia to overstate their reserves, the cable states that "al-Husseini believes that Saudi officials overstate capabilities in the interest of spurring foreign investment".  This is part of the motivation, but it is not the whole picture.  The reasons for overstating reserves are both economic and political.

On the economic side, because Saudi Arabia is part of the OPEC cartel they have a huge economic incentive to overstate their reserves.  In game theory, this is the classic “prisoner’s dilemma” situation.  Each member of the cartel is allowed to produce oil based on the amount of reserves they claim to have.  Since the actual exploration and production data that proves these reserve numbers are state secrets, there are no repercussions for lying about them, since it is impossible for the other cartel members to force you to prove them.  By overstating their reserves, Saudi Arabia is able to make more profit by producing more oil while the cartel keeps the market price high.

The other economic incentive is one which Sadad al-Husseini brings up - that by overstating reserves, Saudi Arabia is making the economic future of their country look brighter than it really is, thereby encouraging more foreign investment in their country.

In addition to the economic incentive to lie about their oil reserves, Saudi Arabia has huge political incentives to do so as well.  They may wish to overstate their oil reserves in order to make themselves seem more important than they really are to international economic and military partners.  Countries like the United States are heavily dependent on foreign oil and are therefore most likely to make economic and military alliances with countries that can supply them with oil well into the future.  Saudi Arabia is in a very unstable area of the world, surrounded by hostile neighbors like Iran and Yemen, so the incentive to overstate reserves in order to secure these international military partnerships is enormous.

Politically, it may actually be more important for the Saudi government to overstate reserves in order to quell political turmoil within their own country.  Oil is the number one source of current and future wealth production in Saudi Arabia and by overstating their reserves, Saudi Arabia makes the future look brighter for their citizens.  If the citizens suddenly realized (as they may be realizing right now) that the future that's been promised to them by the royal family won't be there, the population may become restless and overthrow the dictatorship.

As we are seeing right now with governments in Tunisia and Egypt being overthrown, the dictators in these Middle Eastern countries often have a tenuous hold on political power.

Saudi Arabia is currently experiencing a birth explosion, with the population doubling within the last 20 years to over 25 million people today.  This huge youth bulge means that the median age in Saudi Arabia is only 24.9 years old.  More than half the population is under the age of 20.  At the same time, the sex ratio in Saudi Arabia is skewed worse than almost any other country on earth, with 1.29 men for every woman between the ages of 15 and 64.  Since the wealthiest men often take more than one wife and it is illegal for men to meet women unless they're accompanied by a chaperone, it can safely be assumed that there are a lot of frustrated young men in Saudi Arabia.  The unemployment rate is high for everyone in Saudi Arabia, but it is particularly bad for the youth.  The unemployment rate for males between the ages of 20 and 24 is nearly 50%.

Saudi Arabia is the world's largest oil producer but the vast majority of the oil wealth only makes it into the hands of the royal family.  It's estimated that there are more than 10,000 princes in Saudi Arabia.  The average Saudi sees these princes driving around in Ferraris and living in lavish mansions, but yet 40% of the population lives below the poverty line.  By almost all measures, Saudi Arabia has some of the worst income inequality of any country on earth.

Worse still, it was revealed in another leaked cable that, in one of the most religiously conservative countries on the planet, where the punishment for drinking liquor is public lashing, the princes routinely throw outlandish parties with liquor, prostitutes and drugs.  Over the past decade, as the internet and satellite television have begun to permeate the country, more and more average citizens are getting a true picture of those in charge.

Saudi Arabia is home to the two holiest sites in Islam - Mecca and Medina.  Ever since the 1979 seizure of the Grand Mosque in Mecca by Islamist radicals, the islamic religious leaders in Saudi Arabia have had tremendous political power in areas of social policy.  Since 1979, they've set up a madrasah-style education system around Saudi Arabia which teaches these impressionable youth a fundamentalist form of Wahhabi Islam.

So when you combine all of the factors I've described above, Saudi Arabia has a lot of frustrated, unmarried, religiously fundamentalist, unemployed young men, who see most of the oil revenue going to a select few royalty that seem to flaunt all of the religious rules which they diligently follow.  It certainly sounds like a recipe for a revolution if you ask me.

Clearly, this social unrest puts another pressure on the government to overstate their reserves in order to paint a rosy picture for the proletariat of a brighter future ahead.  If the general public begins to realize that the country's oil wealth won't be growing in the future at the rate it has been growing thusfar, the youth may choose to overthrow the government in order to spread the wealth around while it still remains.

The second cable was sent to the US Department of Energy via the US State Department on May 7th, 2008 by the Riyadh Deputy Chief of Mission (chargé d’affaires) Michael Gfoeller with the subject line "PRINCE ABDULAZIZ ON ENERGY MARKETS, OPEC LAWSUITS".  In the cable, Mr. Gfoeller describes a meeting he and the Energy Attaché had on May 6th, 2008 with the Assistant Minister of Petroleum Prince Abdulaziz bin Salman bin Abdulaziz Al-Saud.  In the meeting, the Prince told the US deputy chief that he was "extremely worried about demand destruction in the U.S."  He said "We are extremely worried about demand destruction, like in the early 1980s. Aramco is trying to sell more, but frankly there are no buyers. We are discounting crudes, now we're at a $10 differential between West Texas Intermediate (WTI) and Dubai Light, sometimes as much as a $12-$13 differential. Our buyers still bought less in April than they did in March."  To put the meeting in context, on May 6th, 2008 the WTI oil price had just broken $120 per barrel for the first time in history.  Exactly 60 days from this meeting, the oil price would spike up to $147 per barrel, causing extreme demand destruction and triggering the worst recession since the great depression.  Over the next 5 months, the price would fall from $147 per barrel to just $30 per barrel.

In my video that I put up the night before Wikileaks released this cable, I explain this demand destruction in more depth.  There are two types of demand destruction.  The primary demand destruction occurs as the price of gasoline at the pump rises and people and companies begin to curtail their gasoline consumption.  The second, and more economically damaging, demand destruction occurs because oil is used as an input in almost everything we consume in our modern lives.  As the price of oil goes up, the price of all other goods goes up.  Because wages don’t increase along with the price of goods, consumers have to spend more of their income on the necessities in life such as the gasoline needed to drive to work or the food on their dinner table.  This leaves the average consumer with less discretionary income to spend on other consumer goods.  When you aggregate this across the whole society, the demand for all goods goes down – thereby further decreasing the demand for oil but also causing the economy to tip into a recession.  This is exactly what we saw occur less than a year after this cable was sent.

The third cable was sent to the US Department of Energy via the US State Department on June 3rd, 2008 by the Riyadh Deputy Chief of Mission (chargé d’affaires) Michael Gfoeller with the subject line "PRINCE ABDULAZIZ ON ENERGY MARKETS, OPEC LAWSUITS".

In the cable, Mr. Gfoeller summarizes the analysis of Brad Bourland, the Chief Economist of Saudi-based Jadwa Investments, explaining that "while crude has increased by nearly 6 times in the last four years, gasoline prices in the U.S. have at most tripled. While consumers complain vociferously about rising pump prices, nonetheless they are not absorbing the full brunt of rising input prices. The refining sector is absorbing the growing pricing differentials between crude and finished products, leading to plummeting refining utilization rates in the U.S.".

As oil prices spike, refineries find it difficult to send the full cost increase on to their customers, leading to a narrower differential between the crude oil price and the refined product price (this is known as the "crack spread").  Oil refineries that are not vertically integrated with oil producers get "squeezed out", which lowers overall refinery utilization, leading to a reduction in available refined fuels like gasoline and diesel, which pushes prices for these products up even further.  

This is just one more factor which can accelerate an oil price spike.  Since the last recession began and the oil price fell, many of the remaining independent oil refineries like Big West and Flying J have gone bankrupt and have closed down.  On top of these factors, at the end of 2010, the EPA announced it would begin regulating greenhouse gas emissions from refineries within the next two years.  If these new regulations aren't shot down in congress, it would be just another headwind against independent refineries.  Because of the closure of these independent refineries, the available refining capacity in the US has been getting tighter since the last oil price spike.  This means that as oil prices spike again, the increase costs will be passed on to the consumer more quickly - potentially accelerating the speed of the spike and the speed of the demand destruction crash which will follow it.

Mr. Gfoeller further states that "widespread petrol subsidies in China, India, and the Middle East ensure price feedback mechanisms are broken; they therefore predict crude demand will continue to rise there. Governments are abandoning plans to roll back petrol subsidies in the face of escalating food inflation...Essentially there is no price signaling, "go slow" sign in the form of higher prices for consumers as crude rises...we will continue to see unrestrained demand growth, especially in the Middle East and China."  Gfoeller goes on to say that "Bourland was not optimistic about prospects for encouraging greater price elasticity in the world energy markets. Inflation, particularly food inflation, recently has become a front-burner issue for many nations. Pressed consumers in many nations have recently found themselves on a knife's edge regarding food security, and are not likely to peacefully accept the rolling back of petrol subsidies which have become effectively institutionalized. Bourland also cautioned that Saudi Arabia's domestic consumption of crude continues to grow by about 100,000 bpd annually, ensuring a tight global market for the foreseeable future."

This cable again relays the warning about the factors affecting the inelasticity of of demand that I discussed in my video last week.  Another important point which is brought up is the increasing amount of export cannibalization from the rapidly rising oil demand within Saudi Arabia.  The population of Saudi Arabia has exploded over the past two decades, and because energy is heavily subsidized within the country, the demand growth for oil within the country continues to grow year-over-year.  The best way to think about export cannibalization in oil exporting nations is through the "Export Land Model", developed by Dallas geologist Jeffrey Brown.  Essentially the model predicts that as a country's oil production peaks and begins to decline, the internal demand for the nation's oil continues to rise, cannibalizing exports and accelerating the decline in oil production.  Currently, about 40% of the production increases every year in Saudi Arabia are offset by increased oil demand within the country itself.  In the years ahead, this will continue to grow until Saudi Arabia is no longer a net exporter of oil.  We have seen this happen in every single oil exporting nation from the United States to Egypt.

This third leaked cable again reiterates the United States' concern over Saudi Arabia's peak production with Mr. Gfoeller stating that "it appears unlikely Saudi Aramco could muster the million or more barrels which appear to be needed to make a dent in the normally upwards price trajectory.  Saudi Aramco's ability to sustain such a production increase for a year or more raises serious questions. A series of major project delays and accidents XXXXXXXXXXXX over the last couple of years is evidence that Saudi Aramco is having to run harder to stay in place - to replace the decline in existing production. Additional production would likely come from increasingly heavy crude which the world lacks sufficient capacity to easily refine. The Saudis appear dis-inclined to discount its heavy crude sufficiently, so the market is dis-inclined to purchase it."

Ironically, after laying out a seven page case for Saudi peak oil, Mr. Gfoeller ends his cable by clarifying that he is "far from embracing doomsday "Peak Oil" theorists".  It's fascinating to see that while it's publicly taboo for US government officials to discuss peak oil, it seems to be privately discouraged as well.

The fourth cable was sent to the office of the Coordinator for International Energy Affairs at the US State Department on November 11th, 2009 by the US Embassy in Riyadh with the subject line "SCENESETTER FOR VISIT OF DOE DEPUTY SECRETARY PONEMAN TO SAUDI ARABIA".  In the cable, the embassy discusses a few of the efforts made to increase the Saudi oil production capacity, including "projects to bring non-conventional oil on line to meet the evolving needs of the international market and expand reserves, such as Saudi Arabian Chevron's project in the Partioned Neutral Zone with Kuwait to steam flood heavy oil in limestone cavities".

Enhanced oil recovery methods like steam injection are incredibly capital intensive and require tremendous amounts of energy to operate.  These enhanced oil recovery methods have a much lower energy return on energy invested (EROEI) than traditional oil drilling, and are usually only undertaken on light crude fields once the field has peaked an on heavy crude fields once all of the "easy oil" is gone.

The embassy goes on to explain that Saudi Arabia's "electricity demand is growing at 8-10% per year". The tremendous recent increase in electricity demand and discusses a number of efforts which Saudi Arabia is undertaking from renewable energy to nuclear energy.  The embassy states that "Saudi Arabia is actively considering the development of a civilian nuclear program, which a number of analysts believe is the only possibility the Kingdom has to generate sufficient electricity to meet projected demand from economic and population growth and increasing affluence without wastefully burning large quantities of fuel oil."

Politically, it might be difficult to set up nuclear reactors in a country which produced 15 of the 19 September 11th hijackers.  There could obviously be a lot of international political push-back to a Saudi Arabian nuclear program, given the fact that the country is a hotbed for Islamist extremists who are keen on overthrowing the dictatorship.  The cable notes that "in May 2008, the Secretary of State and the Saudi Interior Minister signed an agreement creating the Office of Program Management - Ministry of Interior (OPM-MOI). OPM-MOI is a State-led interagency effort to assist the Saudi MOI with protection of critical infrastructure, including Aramco's petroleum production and transport facilities, which were the subject of a terrorist attack on the Abqaiq production facilities in Dhahran in 2004."  Clearly the US government is extremely worried about terrorists attacking key infrastructure targets in Saudi Arabia.  Given this level of concern about terrorist attacks on traditional energy infrastructure, constructing and protecting nuclear infrastructure may be logistically risky and politically impossible.  If the embassy is correct that without nuclear power, Saudi Arabia will only be able to meet the domestic electricity demand by burning more and more oil, it would fit well with the export cannibalization model I described earlier.

To summarize, these four leaked cables are significant not because of the information they contain, but because they reveal that the US government is extremely worried about a peak in Saudi Arabian oil production.  Nearly 1/4 of the world's oil exports come from Saudi Arabia, and when the country reaches peak oil, it's almost guaranteed that the rest of the world has reached a peak as well.  These cables reveal that Saudi Arabian peak oil could occur much sooner than most people anticipate.  The main factors which are accelerating the approach of this peak are:

  • Overstated Saudi reserve estimates due to economic and political pressures
  • Large decline rates in most Saudi fields
  • Difficulty in adding additional production capacity to offset these declines
  • Export cannibalization from rising internal oil demand
Because of the rising, inelastic oil demand from the developing world, the approach of a Saudi peak will likely be met with a series of oil price spikes followed by demand-destruction-induced recessions.  This process is known as the "Bumpy Plateau"; if you're interested in reading more, please see my post Profit from Peak Oil's Bumpy Plateau.

Monday, February 7, 2011

Oil Supply and Demand and the Next Oil Price Spike

I gave this presentation to my energy economics class at Cornell last week.  In the presentation I describe how the supply and demand of the world oil industry have changed recently and use this analysis to argue that we will see an oil price spike within the next two years.  Enjoy.

Video Transcript:

"Hi this is Will Martin from and today I’m going to be explaining how the next oil price spike will occur by analyzing the supply and demand of the oil industry.  I gave this presentation to my energy economics class at Cornell last week and I thought it would be good to put it online so that others better understand how the next oil price spike will play out.

This is the traditional economic view of the short-run supply and demand in the oil market.
As supply shifts to the left, for example from a supply disruption like terrorists blowing up a pipeline, the price will increase slightly, and demand will shift to create a new equilibrium.  Likewise, if demand shifted out to the right, perhaps as we moved into the summer driving season, price would increase and supply would shift out to meet it at a new equilibrium.
Many traditional economists believe that the supply and demand curves in the oil market are approximately linear and relatively inelastic with short-run price elasticities of supply and demand at .04 and -.04, respectively.

I, however, respectfully disagree with this traditional view.  When you look at the real world data of world oil production during the last oil price spike in 2008, we see that the actual short-run elasticity of supply was only .0075.
This means that the short-run elasticity of supply is far more inelastic than we would expect.  As oil prices went up significantly in 2008, the market failed to bring significant additional oil production online.
I will argue later in this presentation that in addition to the inelasticity of supply, the short-run demand curve is far more inelastic than most economists believe.

So with demand being more inelastic than expected, the real elephant in the room is the question of OPEC’s spare capacity.  For the last thirty years, OPEC has been one of the few players in the world oil market with the ability to pump more oil at a moment’s notice.  During the last oil price spike, many people questioned this spare capacity, asking, “Is OPEC tapped out?”
Obviously there are a number of reasons for OPEC to lie to the world about their available spare capacity.  Firstly, each OPEC country individually has an economic incentive to overstate their reserves.  In game theory, this is the classic “prisoner’s dilemma” situation.  Each member of the cartel is allowed to produce oil based on the amount of reserves they claim to have.  Since the actual exploration and production data that proves these reserve numbers are state secrets, there are no repercussions for lying about them, since it is impossible for the other cartel members to force you to prove them.  By overstating their reserves, a country is able to make more profit by producing more oil while the cartel keeps the market price high.
In addition to the economic incentive to lie about their oil reserves, OPEC members have huge political incentives to do so as well.  Countries may wish to overstate their oil reserves in order to make themselves seem more important than they really are to international economic and military partners.  Countries like the United States are heavily dependent on foreign oil and are therefore most likely to make economic and military alliances with countries that can supply them oil well into the future.  Many OPEC countries are in unstable areas of the world, surrounded by potentially hostile neighbors, so the incentive to overstate reserves in order to secure these international military partnerships is enormous.
It is also possibly beneficial to overstate reserves in order to quell political turmoil within one’s own country.

But when we look at the data during the last price spike, we see that OPEC’s spare production capacity worked largely as we would have expected it to.  The short-run elasticity of supply of OPEC oil was .048 – on par with what most economists would expect.  This means that, at least for now, the economic and political incentives for OPEC countries to lie about their spare capacity availability is not the driving force in causing the short-run global supply of oil to be more inelastic than expected.
So if OPEC is still able to pump oil on demand, why did we get the oil price spike in 2008?
Then answer is that OPEC’s spare capacity simply wasn’t enough to make the whole world’s supply more elastic.  The rest of the world’s oil producing countries are running full-tilt, producing as much oil as they possibly can as quickly as they possibly can.  There simply isn’t any additional spare capacity elsewhere on the world market.
In addition to this, there is the possibility that we’ve already hit the worldwide global peak in oil production and, outside of OPEC, the world’s available daily production capacity has already started to decline.  This is up for debate.  It will take a number of years before we can determine is this has actually happened, but what is obvious is that the world as a whole simply doesn’t have the additional spare capacity to increase supply as the price of oil spikes.

Just as the supply of oil is far more inelastic than we expected, the worldwide demand for oil has also changed recently to become far more inelastic and at the same time, the world demand for oil continues to increase, shifting the demand curve to the right.
The inelasticity of demand is largely due to the developing world.  In the developed world, oil is purchased by corporations and consumed by people like you and me.  We all need to make the business case for purchasing oil at higher prices.  If we can’t justify the benefit of purchasing more oil at $150 a barrel, we will simply use less oil.  This is why demand in the developed world isn’t extremely inelastic.
Most of the worldwide economic growth in the past decade, however, has come from developing countries, where oil is often purchased by the government and consumed by government-owned companies.  These government-controlled buyers don’t necessarily have to make the business case for purchasing oil at high prices.   As long as buying the oil will help their economy grow, these government agencies will purchase oil no matter how high the price is.  In other words, their demand is far more inelastic than in developing countries.  Because these developing countries as growing so rapidly and becoming such huge players in the world market, this is making the overall global short-run demand for oil far more inelastic.
The key player in all of this is China.  China has been experiencing rapid economic growth for the past decade.  Their GDP grew 10% just last year.  Last year China exceeded Japan as the second largest economy while at the same time exceeding the United States as the world’s largest consumer of energy.  Much of China’s growing demand for oil comes from the rising middle class, who are now beginning to reach a more western standard of living and many are beginning to purchase the ultimate symbol of western life: the automobile.  Car sales in china have been exploding recently.  In fact last year more cars were sold in China than in any other country at any other time in history.  If the number of cars per capita in China were to reach the level we have in the US, China would singlehandedly use all of the current world oil production.

China has an enormous demand for energy and has been importing more and more oil lately.  When we look at China’s oil consumption during the last oil price spike, we would have expected, based on the standard economic model that China would have decreased their oil consumption.  What we see, however is that instead of an expected short-run elasticity of demand of -.04, the elasticity of demand was actually slightly positive.  China continued to increase oil consumption, even during the spike, meaning their demand for oil is almost completely inelastic.
It wasn’t until the stock market crash in the US, and the corresponding reduction in demand for Chinese exports, that their oil consumption fell.  But I’ll talk about oil shock-induced demand destruction a little later.

So just to recap, the standard economist’s view of the supply and demand in the oil market is wrong.  What we see during the last oil shock is a far more inelastic supply of oil and a far more inelastic (and growing) demand for oil.  As you can see from this chart, Chinese oil demand continues to increase and as the US begins to exit the current recession, we see the US demand for oil beginning to return to its historic levels.  These two sources of demand will combine to shift the demand curve to the right and cause the oil price spike in the next few years.

Here’s what the supply and demand chart for oil actually looks like.  As you can see, the supply curve is not linear, but in fact runs into a wall of an upper limit on available spare capacity at around 87 million barrels per day of global oil production.  As the demand shifts to the right, as the developing world continues to demand more oil and as the US recovers from the recession, we see a spike in the oil price.  The production shifts out a little bit, but the price shifts up a lot.  This is the economic mechanism for an oil price spike.

Now the traditional economist’s view of the oil price spike is that we shouldn’t be worried because the high price will bring more production online and cause consumers to be more careful with their consumption.  Many economists believe that the oil price spike didn’t have a significant role in the 2008 economic crash.
But when we look at the data, we see that an oil price spike preceded almost every single economic downturn in almost every region of the world.  Clearly oil price spikes are damaging to our economy.

Why are oil price spikes so damaging?   The answer is that the use of oil permeates every aspect of our economic lives.  The primary use for oil, of course, is as a transportation fuel.  We use it as a fuel in our cars to get us to and from work, to get us out to dinner with friends, to get us to the mall to shop, etc.  About 9% of our oil consumption goes to jet fuel.  This allows us to take a vacation to see our relatives, but it also transports all kinds of “just in time goods” that we use on a daily basis – everything from sushi to flowers.  About a quarter of the oil we use goes to diesel fuel to truck around all of the other goods we consume and to bunker crude to ship all of our goods over the oceans to America.
The remaining 19% of the oil we consume goes into the products we use on a daily basis as a direct input.  All plastics are made directly from oil.  The asphalt roads we drive on are made from oil.  Many people still heat their homes with oil.  Oil is used for paints and pharmaceuticals and explosives and even the synthetic rubber in our car’s tires.
And then, of course, a lot of oil goes into the production of the foods we eat – from the oil-based pesticides and fertilizers used to grow the food, to the tractors and semi-trucks that plow, plant, harvest and deliver our food.
Everything you see around you is either directly made of oil or has been transported there by oil. 

What this all means is that as we endure an oil price spike, we have two types of demand destruction.
The primary demand destruction is what most economists talk about when they use the term “demand destruction”.  That is, as the price of oil goes up, the price of gasoline at the pump rises and people and companies begin to curtail their gasoline consumption.  Demand for oil is directly destroyed.
But at the same time, there is a second, and far more economically damaging, form of demand destruction taking place.  The secondary demand destruction comes from the increase in the price of all goods as the price of oil spikes.  Because oil is used as an input in almost everything we consume in our modern lives, as the price of oil increases, the price of all other goods goes up.  Everything from plastics to beef gets more expensive.
It’s been estimated that it takes 6 barrels of oil to raise one steer.  At $100 per barrel, this works out to about $1 per pound of beef.
So during an oil shock, the price of oil moves up quickly and at the same time, the price of almost every other good increases along with it.  Because wages don’t increase along with the price of goods, consumers have to spend more of their income on the necessities in life such as the gasoline needed to drive to work or the food on their dinner table.  This leaves the average consumer with less discretionary income to spend on other consumer goods, so when you aggregate this across the whole society, the demand for all goods goes down – thereby further decreasing the demand for oil.  This is what people are referring to when they say that high oil prices are a “drag on our economy”.

So why is there this secondary demand destruction and why is it so damaging to our economy?
The simple answer is that the average American is already on a tight budget.  75% of Americans live paycheck-to-paycheck and the majority are being squeezed by significant debt.  Because wages don’t increase along with the rapid increase of the price of goods during an oil shock, people simply have even less disposable income during an oil shock.  Because people are spending more of their budget on gasoline or food, they have less money to spend on clothes or DVDs or vacations.
Because 70% of the US economy is dependent on consumer spending, when consumers start spending less money on the non-essentials, the economy goes into a recession.  We see that the situation is similar in the UK, Germany and most other developed countries.  China has an economy that is less dependent on consumer spending, but because their economy is dependent on exporting goods to consumers in developed countries, when that demand goes away, they also enter a recession.
This is why oil price spikes are usually followed by global recessions.

There’s one caveat to my prediction of an oil price spike within the next two years.  There’s a very real possibility that the current economic recovery could fall back into a double-dip recession.  This would preempt an oil price spike by halting the increase in oil demand.
There are a lot of threats that could push us back into a recession.  In the United States we currently have about 10% unemployment and over 16% underemployment.  Our national debt has reached completely unsustainable levels and is not even being funded by China any more.  In fact China has recently become a net SELLER of treasury securities.  The Fed now purchases more government debt than every other foreign government combined.
The state and municipal debts are no better.  We could see a wave a municipal bond defaults which could push the market back into a recession.  Many state budgets are worse than our federal budget.  We could see a wave of state bankruptcies, and many state legislatures are currently debating changing their state constitutions to allow this.
Housing prices have also recently begun to double dip, which could push the market down as it did in 2008.
The situation in Europe is no better.  Governments like Portugal, Ireland and Greece are completely bankrupt.  There’s the possibility that this crisis could spread to Spain, which is too big of an economy for the EU to bail out – it’s essentially too big to fail – and it could bring down the Euro with it.
China has been growing so rapidly and pumping so much money into their economy that there’s a possibility that they’ve created a real estate bubble and a credit bubble.  We could see a repeat of the American credit crisis occur in China.

But assuming all of that doesn’t happen and assuming that we continue to grow out of this recession, I believe we will see an oil price spike within the next two years.
The million dollar question is: “can consumers handle oil over $100 per barrel”.  As we saw during the last oil price spike, there seems to be a ceiling of oil prices that the consumer simply can’t handle.
The current price of oil has already gone up 40% in the last 6 months.  We’ve seen Brent Crude oil break $100 per barrel last week and the US economy hasn’t even fully recovered yet!  Because the United States uses a quarter of the world’s oil, as we exit this recession, it will shift the demand curve to the right, causing an oil price spike.  We saw Dow reach 12,000 just last week – if economy continues to recover at this pace, we could see a price spike much sooner than expected.

So that’s how the oil supply and demand picture really looks, and why we’re probably going to see an oil price spike within the next two years.  If you want to read more, you can go to"