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UK at greatest risk from oil’s twin peaks

Image: Michael

Among the biggest “green” myths of recent times was the wildly outlandish claim that we had reached “peak oil demand.”  The economists promised us that as increasing numbers switched to renewable energy, electric cars and digital working, so an ever larger part of the world’s remaining oil would be left in the ground.  That, of course, was four years ago following the economic slowdown that corresponded to the temporary boom in US fracking production.  In 2018, things are looking a lot less rosy.

I hardly need to tell those of my British readers who drive that fuel prices have risen dramatically in the last few months.  At the end of September, the average UK price of petrol was £1.31 per litre ($7.87 per gallon) and diesel was £1.35 per litre ($8.10 per gallon) causing another dent in already stretched household budgets.  And the bad news is that things are likely to get worse – possibly a lot worse.  This is because global demand for oil has continued to increase despite rising prices; recently hitting the psychological 100 million barrels per day mark according to the International Energy Agency (IEA):

“Both global oil demand and supply are now close to new, historically significant peaks at 100 mb/d, and neither show signs of ceasing to grow any time soon. Fifteen years ago, forecasts of peak supply were all the rage, with production from non-OPEC countries supposed to have started declining by now. In fact, production has surged, led by the US shale revolution, and supported by big increases in Brazil, Canada and elsewhere. In future, a lot of potential supply could come to the market from places like Iran, Iraq, Libya, Nigeria and Venezuela, if their various challenges can be overcome. There is no peak in sight for demand either.”

The growth in supply is to be expected as prices rise toward that other psychological mark of $100 per barrel.  This is simply because the oil industry already has reserves that would not have been economically viable in 2015 when the price was less than $40 per barrel, but which are now worth bringing into production.  Nevertheless, the world has long since exhausted its supply of large deposits of easy sweet crude, and is increasingly turning to difficult and unconventional sources that cost more to produce and must, therefore, attract a higher price to remain worthwhile.

It is worth noting at this point that the rise in demand that has allowed the increase in both production and price has occurred in the face of a Herculean effort to deploy renewable energy technologies, to develop alternative fuels and to electrify transport and industry.  The main reason why these efforts have failed even to dent global demand concerns what is called “marginal utility” in the developing countries.  To understand this, imagine the price of oil doubled.  The result in advanced countries like the USA and UK would be a shift in spending by (among others) motorists.  Spending on discretionary items would be cut back, while car usage patterns would shift to essential travel only.  Moreover, some of the cost would be transferred into the vehicle sales market as new purchases shifted away from large gas-guzzling vehicles in favour of small, high-mileage ones.  Now consider the impact on an aspiring Chinese factory worker who currently struggles to get around on foot or by bicycle.  Even though that Chinese worker is never going to do the kind of frivolous happy motoring that our lifestyles were built around, the improvement in quality of life that comes simply from having a car to commute more than outweighs the higher cost of fuel.  The same is true for the farmer in sub-Saharan Africa when purchasing a motorcycle to take crops to market, or buying a small tractor to expand production.  Again, the benefits far outweigh the additional cost of fuel.  The broader point is that the majority of the global population (and especially the global youth) are in those developing regions where $100 or even $200 oil is still worth buying.

The added immediate problem in the oil study is the prospect of artificial shortages brought about by US sanctions on Iran and Venezuela.  These are expected to remove 500,000 barrels per day from the world market; driving prices even higher than they are today.  Indeed, this loss of supply would be enough to drive prices to $100 per barrel; possibly more.

This is a particular problem for the UK, whose North Sea production is just a third of its peak in 2000.   The UK became a net importer of oil in 2004; and in 2018 also depends on imported gas and electricity to keep its economy running.  According to Sam Meredith at CNBC:

“The prospect of an abrupt supply shock in the energy market is making investors increasingly nervous about the possibility of oil prices soaring above $100 a barrel before year-end.  Oil prices have surged more than 25 percent this year, prompting investors to bet that a return to triple-digits could be just around the corner…

“’The countries that stand to lose from higher oil prices have historically been much more systemically important to the global economy and financial markets than oil exporters,’ said Bank of America Merrill Lynch’s Ethan Harris and Aditya Bhave.

“This means that – while the U.S. has become better protected by a recent shale boom, the euro area, Japan, China and India would ‘stand to lose significantly from a spike in oil prices.’”

Higher prices might lead to some of the remaining small and difficult pockets of oil in the North Sea and the North Atlantic west of Shetland being developed, but these will barely dent Britain’s need for imported oil.  Indeed, since almost all of the North Sea deposits are well past their peaks, new production will struggle to offset the decline.

Ultimately, oil demand will fall and oil prices will crash; just as it did in 2014.  But it would be wrong to assume that this will happen straight away.  This is because for most businesses and households, oil is a non-discretionary item.  People will simply absorb the price increases by transferring spending from discretionary items; accelerating Britain’s growing retail apocalypse.  The danger, however, is that rising oil prices will cause a temporary increase in inflation while spending patterns adjust.  Mainstream economics textbooks erroneously claim that in such circumstances central banks should seek to offset inflation by raising interest rates.  If they do so, then businesses and households will have even more reason to cut what remains of their discretionary spending in order to fund their debt servicing costs.  Such a move would also have a chilling effect on new borrowing – the primary means by which new currency enters the economy.  In this way, just at the point where businesses and households are struggling with rising non-discretionary costs, the money supply itself will be shrinking.

This is more or less what happened prior to the 2008 crash.  We can only wait with baited breath to see whether bankers, economists and politicians learned any lessons from that crisis.  If they have not, then the UK may well witness its own “peak oil demand”… but not in the way the economists promised.

As you made it to the end…

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