Tuesday, March 18, 2008

A Complex Energy Crisis

A year ago, it was possible to debate both sides of the question, "Are we in an energy crisis?" with roughly equal vigor. There were plenty of signs for either side of the argument to cite, from the extremely tight level of global spare oil capacity to the relative indifference of US consumers to $3.00 per gallon gasoline. I think it would be a lot harder to find takers for the negative proposition, today. Much has changed, most importantly the economic context of such a crisis, and the key question is shifting from one of its existence to causation. That's more than an abstract point, because it has a great deal to say about how we might extract ourselves from this situation, with significant implications for the alternative energy sector, as well.

This is certainly not our fathers' energy crisis. The world was much simpler in the 1970s, and the step-change nature of the Arab Oil Embargo and the Iranian Revolution left our parents with little doubt that they were in a crisis. And even though it was really an oil crisis, oil's use was so pervasive across transportation and electricity that the distinction didn't matter much. Thanks to extensive fuel switching in the power sector, the impact of today's oil-driven crisis has been more narrowly confined to transportation, at least in the US. However, that doesn't mean this crisis is simpler than that of the 1970s, either in cause or solution.

A brief Internet search will turn up a variety of theories about today's oil crisis and its causes. These include the fundamentals of oil supply and demand, the interaction between the policies of the Federal Reserve, foreign exchange rates and the price of oil, and the perception or reality of Peak Oil. All of these seem to be contributing to the problem, either as direct cause-and-effect or in the way they shape the behavior of market participants. I'm particularly intrigued by the influence of the Peak Oil meme, which has spent the last few years evolving from an esoteric argument among geoscientists to a mainstream concern with some of the characteristics of the Y2K problem. So how do these disparate pieces fit together?

If we start with fundamentals, then the crisis that has been brewing is distinctly of the "boiling frog" variety, featuring a bit of drama but mostly driven by the steady growth of the large developing countries, especially the "BRICs", and the rise of resource nationalism with the resulting chronic under-investment in oil production capacity. As I argued the other day, however, the fundamentals looked just as tight a few years ago, with notably less impact on an economy that was growing strongly--even if some of that growth turned out to be a bubble. I think we must conclude that fundamentals alone haven't gotten us to this point.

Now stir in the impact of the declining dollar, the policies that contribute to its decline, and the kind of reinforcing-loop system this creates with oil prices, in which a weaker dollar drives up oil prices, which weaken the economy further, weakening the dollar more, and so on--amplified by speculation in oil as an inflation hedge and portfolio shift. This dynamic includes elements of a bubble, and it could be burst by a variety of events, including a recovery by the dollar or margin calls on speculators, requiring them to liquidate their commodity holdings to cover losses elsewhere. Every bubble has its own logic, and in addition to the weak dollar and resurgent inflation, the surge in oil prices beyond the level justified by fundamentals alone appears to be influenced by the perception that we are at or near a permanent peak in global oil output.

If there's one name that's become synonymous with Peak Oil in recent years, it is that of Matt Simmons, a renowned oil investment banker and author. Mr. Simmons's latest presentation on the risks of an oil peak makes a compelling argument that the decline of mature oil fields has equaled the rate at which we can bring on new production, globally, and that in the near future the former will overwhelm the latter. Although smart, well-informed industry experts differ on this, what matters in the near term is not whether it is an accurate description of reality, but if enough market participants accept it to convince them that $110 oil could look very cheap in a year or two. A futures market that is trading at or over $100/bbl all the way out to 2016 lends some credence to that view.

We'll eventually find out whether global oil production has truly peaked at 85 million barrels per day (MBD), as some analysts believe. The International Energy Agency sees supply increasing to 87 MBD in 2008, including the increasingly important contribution of biofuels. That growth is consistent with the view of the US Energy Information Agency, though in neither case will we know for certain until after the fact, when we see how many new projects actually started up, and factor in the actual decline of existing fields. The perception of a peak at 85 MBD might be hard to shake off until at least next year, while every inventory drop in the interim will tend to validate it. So if this is a peak-driven bubble, it could have some time to continue inflating, unless the fallout from the credit crisis pops it first. Of course, if the adherents of Peak Oil are right, then our problems have just begun.

To complicate matters further, the evolution of this energy crisis can't be separated from unrelated economic factors, which will affect our resilience to high energy prices and the resources available for investment in alternatives, or from the steps we take to address climate change. Biofuels are already having a modest impact on oil demand, and renewable electricity frees up natural gas for transportation uses. Fuel economy, energy efficiency, and old-fashioned conservation all have important roles to play, as well.

What does this mean for consumers? Is $4.00 gasoline now a certainty, along with continued inflation in any good with an energy component, including food? While that remains a strong risk, there might be some safety valves, too, though the implications for how they might kick in aren't necessarily pleasant. Demand growth has been the one constant in the last four years of this developing crisis, and slowing demand would have to take some of the steam out of it. US petroleum consumption has been flat for four years and seems likely actually to fall this year. China is experiencing inflation and a drop in its exports, and if these trends continue, its oil import growth could slow, too. The fact that June gasoline futures are currently trading at only $3/barrel over June crude oil, when that same futures differential was $10/bbl last March--ultimately averaging $25/bbl once June '07 arrived--says something about the market's view of summer demand relative to crude oil's present buoyancy.

Today's energy crisis provides a similar impression of inevitability and permanence as the 1970s' crisis. The last time around, that turned out to be unjustified, as prices collapsed within a decade of its onset. Such an outcome looks as improbable today as it did in 1981. While I don't expect that bit of history to repeat, I can't rule it out, either. But even if this tide ultimately recedes, there's no long-term return to cheap fossil energy at the consumer level, because of climate change. We're going to be using energy more efficiently in the future, and it will be coming from a much more diverse array of sources, thanks in part to the current oil crisis.

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