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As nations and corporations consider their energy strategies for the future, their beliefs about the sources of the current recession will prove critical in strategy formulation.
Was the current recession the result of a normal business cycle? If so, life will return to normal as asset and commodity bubbles are squeezed out of the economy.
The price of oil will remain manageable, US consumers will begin looking for ever more powerful SUVs, and governments can afford to ignore fossil fuels in formulating policy.
|US GDP under three scenarios: Predicted assuming no recession;|
based on effect of oil prices; and as actually observed. (Source: Prof. James Hamilton, University of California at San Diego)
Or was the recession primarily a consequence of peak oil? If it was the latter, the world is on notice that oil has entered its twilight years and fundamentally new approaches to transportation will be required to maintain accustomed standards of living.
In the absence of new solutions in the short to medium term, periods of prosperity will likely be punctuated by recurring oil price shocks and painful recessions as the world adjusts to a shortage of oil.
Just a recession
|World oil demand assuming maximum 100 MMb/d oil supply: 2005-2030 Note: This chart calculates with 100 MMb/d for illustrative purposes. (Source: Douglas-Westwood analysis based on EIA data)|
The dominant view is that this recession was caused primarily by a housing price bubble tied to excess leverage. When the bubble popped, mortgage quality deteriorated, leading ultimately to a banking crisis unparalleled since the Great Depression.
Analysis by economist James Hamilton, however, tends to support a more nuanced view. Hamilton, well known for his macroeconomic analysis of oil markets, can attribute a substantial portion of the current recession to oil prices. In August 2008, oil prices could explain the entire downturn. Subsequently, oil prices would have led to a shallow recession, but clearly other factors — possibly the bankruptcy of Lehman Brothers — look to have deepened and possibly prolonged the recession. In many ways, this recession, like many before, can be attributed at least in part to oil prices.
But was it a peak oil recession or merely a boom-bust cycle seen so many times before in the oil and gas industry? In a typical boom cycle, supply increases, but not as fast as demand, and scarcity pricing emerges. Prices continue to rise until consumers and lenders are no longer willing to underwrite price levels, and the bubble pops. For key sectors of the economy — for example, oil and housing — a bursting bubble is accompanied by a general collapse in demand, which cools prices and restores market balance. Even as demand is collapsing, long lead-time investments are coming online, and supply is surging, exacerbating the situation.
Such a description does, in fact, apply to the natural gas sector, which has seen not only a fall in demand but new technologies and applications that have greatly increased supply. As a result, the natural gas sector is currently in the bust phase of the cycle, with rig counts down and sector companies looking to work off record-high inventory levels.
The role of oil
|US oil consumption: Actual and forecast by EIA; predicted, owing to oil supply constraints. (Source: EIA and EIA Short-term Energy Outlook (July 2009) and Douglas-Westwood analysis)|
Oil is another matter. Today, there are no “bulls” in oil. History helps shed light on the industry’s restrained mood.
Until late 2004, oil supply had grown apace with economic activity, and prices had fluctuated at relatively low levels. However, in Q3 2004, the oil supply stalled and remained entirely flat through 2007, achieving only modest growth through the first half of 2008. Over nearly four years, the oil supply had grown only 2%. By the first half of 2008, a volume equal to the entire production of Saudi Arabia was missing compared to the quantity anticipated based on observed GDP growth, even allowing for normal efficiency gains.
And recent developments have not been particularly comforting. Peak global petroleum liquids (including unconventional and biofuels) production of 85 MMb/d set in May 2005 has been exceeded only in two months subsequently. Non-OPEC production peaked in May 2005 and has not seen that level again.
Looking forward, there are few optimists. Some analysts believe the July 2008 production number of 86.7 MMb/d will represent “practical peak oil,” arguing that, given the adverse impact of the recession on oil production, by the time the oil industry ramps up production again, accelerating production decline rates from existing wells will dominate new production additions.
Others, including the EIA, some oil companies, and Douglas-Westwood, take a somewhat more positive view and do not discount the potential for the oil supply (including unconventional and biofuels) to grow to around 100 MMb/d at peak. The EIA, in particular, sees the oil supply at 106 MMb/d in 2030, although one might note that the EIA has progressively reduced its forecast from 118 MMb/d in the last three years.
Demand, on the other hand, has enormous potential. China alone could increase its demand from around 8 MMb/d to nearly 45 MMb/d by 2030 if it follows the path of South Korea at similar stages of development. Other countries — notably India and Brazil — could see their consumption increased by 12 MMb/d over 2005 levels. And importantly, if invisibly, the other non-OECD countries could increase their consumption by nearly 28 MMb/d. This may be surprising, but the “other non-OECD” comprises many countries with a population of 2.5 billion, including all of Africa and the Middle East; all of South America excluding Brazil; and places like Pakistan, Indonesia, the Philippines, Vietnam, and the rest of Indo-China. The oil demand of these countries rarely merits individual comment in the press, but collectively they represent a population almost as large as China and India combined and the lion’s share of population growth to 2030. Even if the advanced countries were assumed to hold consumption flat over the period, global oil demand might be expected to nearly double and approach 160 MMb/d by 2030, assuming the oil supply was available at affordable prices.
Consequently, by any reasonable measure, demand is likely to outstrip supply be a wide margin.
How will the world cope? Understanding how the world has compensated since oil production stalled in 2004 provides a clue. Price rises averaging 25% per year dampened demand. In addition, through much of 2007 and 2008, demand was being sustained by continued draws on inventories, which fell to critically low levels.
But increasingly, emerging countries began bidding oil away from the advanced economies.
And this is visible in the statistics. For example, European consumption peaked in mid-2006 but began falling soon thereafter. Japanese consumption started falling even earlier but was falling in earnest by mid-2006. US demand peaked in 2005 but did not start falling appreciably until late 2007. In fact, by late 2007, through their own conservation, the advanced economies were contributing almost 1.5 MMb/d to the emerging world. The primary source of new supply for the emerging economies had become not the oil-producing states but advanced consumer economies.
This, then, may be the pattern to be anticipated in an era of peak oil, a time when increases in supply may not be sufficient to power the aspirations of all nations.
When this happens, prices will rise as the fast growing economies bid away the existing supplies of the incumbent users.
How might this look in practice? Oil supply growth to 2030 is uncertain, with estimates ranging from about 93 to 106 MMb/d. Clearly, demand will have to adjust to available supply. By 2030, China will be most of the way through its “motorization” process, and we project that China’s per capita oil consumption at that time would roughly equal three-quarters of South Korea’s and about half of US per capita consumption today. If the countries’ per capita consumption is further adjusted for forecast populations, we would expect China’s oil consumption to be about twice that of the US in 2030. However, given that available supply will be less than desired, consumption for China, the US, and the rest of the world will have to be allocated pro-rata into a limited supply of perhaps 100 MMb/d. This implies that the consumption of advanced countries must fall, just as it did after 2006.
From its peak of near 21 MMb/d in 2005, US consumption is anticipated to decline by about one-third, to 14 MMb/d by 2030, representing a 1.5% reduction per annum.
If we accept the notion that the US will have to reduce consumption at this rate to make room for growing economies like China and India, we can look at the experience in the period after the oil supply stalled in late 2004 to see how demand might evolve in the future. Demand did not fall smoothly and continuously.
Despite high and rising prices, US consumption was little changed until the recession actually hit in late 2007.
To all appearances, a sharp and traumatic recession was required to bring consumption levels in line with predictions, and then the entire requirement and more was achieved in just a few months. This suggests one model of demand accommodation in the era of peak oil: global GDP growth — primarily in the developing world — continues for several years; the oil supply/demand balance becomes increasingly tight as incumbent consumers resist changes to accustomed behaviors, and oil prices rise.
When oil consumption exceeds the recession threshold, which we estimate at the cost equivalent of 4% of GDP in the US, a recession ensues, and developed economies shed large shares of oil demand rapidly. By rights, this share of oil should be quickly seized by the emerging economies during and immediately following the recession. As a consequence, developed countries should anticipate being “locked out” at lower levels of consumption. The model predicts, for example, that US consumption will top out at 19.0 to 19.5 MMb/d, about 5% to 7% below earlier peaks, and will never see levels achieved in 2007 again.
The lockout can happen by two mechanisms. In one instance, emerging economies can recover before developed ones, leading to oil consumption increases in emerging economies and increasing the price of oil to levels exceeding the tolerance of developed countries. Douglas-Westwood research indicates that the US economy cannot tolerate oil above US $80. In fact, before the recession, European oil consumption began to fall at $70/bbl; the US, at $75. Therefore, given that oil has been trading in the $70 range recently, the prospect of a “lock out” appears quite plausible.
Alternatively, advanced economies could experience “peak demand.” In peak demand, consumers abandon oil because they lose faith in its reliability and look for alternatives. This would appear less likely, as there are few alternatives to gasoline and diesel-powered vehicles.
In either event, the conclusions are sobering.
If events go to form, the constraint on US recovery and growth by mid-2010 is likely not to be financial stability but rather the oil price. The oil price may well rise above $80, preventing a material recovery of the economy or sending the US back into recession. Government and the private sector need to consider the very real possibility than US consumption will never return to previous levels. Heavy users of oil-based fuels, like airlines, are unlikely to recover their peak passenger volumes. US downstream oil operations could be in a declining industry even as the upstream business booms. As for the government, the time is ripe to consider finding new fuels for transportation, fuels that make economic sense and can be brought into play in short order.
In the end, the recession of 2008 was about more than oil. But oil played a material part. For the first time in history, spare oil production capacity simply ran out. At the same time, advanced country consumers resisted yielding oil consumption levels to fast-growing emerging economies, not for months but for years. Only a severe recession induced the mature economies to reduce their consumption, and when they did, consumption fell at a pace not seen since the oil crises of the 1970s. In the era of peak oil, therefore, sharp and painful recessions may prove the chief means by which oil consumption in transferred from the rich to the poor. If so, this is the first peak oil recession, and surely more will follow.