Oil Shock II

As OPEC's members and friends meet in Algeria to agree on deeper cuts in oil output, the effectiveness of their actions will depend greatly on the nature of the demand slump to which they are responding. If it proves to be merely a dip in the long-term growth trend, similar to the one associated with the Asian Financial Crisis of the late 1990s, then their current decline in revenue will likely be short-lived. If, on the other hand, the response in consuming countries is similar to that following the energy crisis of the 1970s and early 1980s, then OPEC and indeed all oil producers face protracted problems. In that case, they might have to hope that the chief economist of the International Energy Agency is correct in his new assessment that the credit crisis will hasten an expected peak in global oil production, perhaps sending oil prices beyond their summer 2008 highs within a few years.

Although the narrative concerning the present financial crisis and global recession is bound up in the collapse of the US housing market and the vast global debt bubble that fueled it--a bubble that had to burst sooner or later--it seems remarkably coincidental that it would begin to deflate just as oil prices raced past their previous inflation-adjusted peak of around $90 per barrel. Because that price rise took place over several years and was driven as much by demand as by supply constraints, the resulting oil shock wasn't as sharp or obvious as the one triggered by the Arab Oil Embargo of 1973 or the Iranian Revolution of 1979. But between 2003 and 2007, the US net oil import bill rose from around $100 billion per year to $300 billion, based on refiner acquisition costs. It crested at an annualized rate of $500 B per year in July. This added significantly to the US trade deficit, and the resulting sustained double-digit inflation in consumer energy costs helped push the annualized consumer-price inflation rate past 5% this summer. With the energy spike having folded, the November 2008 annualized CPI rate has fallen to 1.1%.

If in retrospect these indicators describe a true oil price shock, then what might OPEC and other oil producers expect in the years ahead? Well, in the aftermath of the last oil crisis, from 1979-83 global oil demand fell by 10%, the current equivalent of over 8 million barrels per day (MBD), based on last year's global consumption of 85.8 MBD. It didn't reach its 1979 level again until 1989. The effect on OPEC was devastating. With demand lower and non-OPEC output expanding steadily, OPEC's oil was squeezed out, losing a third of its former market share. Oil prices remained low for another fifteen years, contributing to the growth of the exurbs and the SUV fad.

History rarely repeats exactly, and it would be simplistic to think that we're likely to replicate the oil price environment of the mid-to-late 1980s. There's no tidal wave of non-OPEC conventional oil coming from places like the North Slope and North Sea, which looked technically challenging at the time but seem relatively easy, compared to today's opportunities. Biofuels have added the equivalent of around 0.5 MBD in the last several years, and Canadian oilsands a similar amount, but production in most non-OPEC countries is peaking or in decline, notably in Mexico and Russia. And as the IEA's Dr. Birol notes, tight credit and low prices will slow additions to supply from all sources, while natural decline erodes today's base production. That makes demand the crucial factor, particularly the behavioral elements of demand. Although rarely discussed in these terms, vehicle fuel economy faces diminishing returns. Boosting US fleet average miles per gallon from 13 to 25 under the original CAFE standard in the 1970s and '80s saved three times more fuel per mile than the mandated increase to 35 mpg will--in fact more than moving the entire fleet to 100 mpg plug-in hybrids would. Vehicle miles traveled have recently declined in the US. Along with the appetite of Asian consumers for their first cars, this will have as much impact as fuel economy on total oil consumption, and thus on prices.

Although the oil price shock of the last several years can't be blamed for the full extent of the mess we're in, it is at least a plausible candidate for the trigger that caused the debt bubble to pop now, rather than a few years from now. That has important implications, because current conditions may be setting the stage for another, possibly sharper oil shock shortly after the economy begins to recover. Although we face a drastically altered set of energy concerns going into 2009, energy policies that promote both conservation and increased supply look just as essential as they did a year ago.