There are only two factors driving up oil prices: supply and demand. Supply is restricted as oil becomes harder to find, and demand is growing due to the rise of China, which is now one of the world’s largest users of oil.
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Analysts are predicting that global demand for oil could exceed supply by as soon as 2015. However, the situation is not quite as simple as the newspapers make out. First, the world isn’t running out of oil; it’s running out of cheap oil. Canada alone has an estimated 180 billion barrels of recoverable oil, enough to meet global demand for the next century or so.
The problem is, you can’t run your car off oil in the ground. The global oil shortage is a refining problem, not a lack of resources. As oil becomes harder to extract, it becomes more expensive. As oil becomes more expensive, major oil users will look elsewhere for energy, or simply reduce their energy use. Oil will remain a major global energy source for the foreseeable future, but only where there is no economic alternative.
Much of the oil currently used in China is squandered; Chinese industries are often crude and inefficient, and much of the energy from the fuel simply goes up the chimney. These wasteful habits will drop away as oil prices rise.
The Chinese government is working hard to drop China’s dependence on oil. Coal-fired plants may be crude and dirty, but they’re cheaper to run than oil-fired plants and China is building them by the dozen. China is also investing heavily in nuclear energy, largely to break its dependence on oil.
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By GlobalDataSo will demand exceed supply in 2015? Probably not. There’s a dubious assumption underlying most predictions of a continuing oil shortage: that China’s economy (and therefore its oil needs) will continue to grow at present rates.
Much of China’s hunger for the world’s commodities is being driven by sales of manufactured goods to America. A flood of easy money, courtesy of the America Federal Reserve, is behind much of America’s spending spree in China.
Former U.S. Federal Reserve chairman Alan Greenspan had only one solution to economic difficulty: flood the market with more money at low interest rates. This worked in 1987, when the U.S. stockmarket lost 22% of its value in a single hour, it worked again during the Asian financial crisis of 1997, but eventually easy money became Greenspan’s answer to all financial problems. After the dotcom bubble burst in 2001, Greenspan’s solution was to flood the market with more money at low interest rates.
The easy availability of money at low interest rates fuelled a boom in housing and domestic spending in America, as homeowners borrowed against the rising value of their houses. This boom flowed through to China as American homeowners, flush with borrowed money, bought desirable consumer items like flatscreen televisions. When the Chinese electronic factory got more orders for flatscreen televisions, it needed more employees and more energy. Thus, the Chinese economy boomed, along with its need for oil.
There’s always a time in an economic boom when it seems natural and inevitable that it will go on forever. People with easy money in their pockets assume the boom will be permanent, because they’d like it to be so. Historically, it’s always around this time, when the booming market seems to be an unstoppable force, that it suddenly corrects, taking the dreams of its investors with it.
Many people believe that Greenspan’s boom is now over: the US housing market is on the way down, along with many of the mortgage companies that made loans to people who couldn’t pay. The most likely outcome of these difficulties is a sudden reality check for the American consumer sometime soon. When you’re having trouble meeting mortgage repayments you’re quite likely to defer buying a new flatscreen television from Walmart. When Walmart starts selling fewer televisions, they order fewer televisions from China. When the Chinese electronic factory gets fewer orders, it needs fewer employees and less energy. Thus, the Chinese economy cools, along with its need for oil.
Rather more troubling is the Chinese stockmarket. In the eighteen months from January of 2006 it grew 248%. Chinese brokers are reportedly opening 350,000 new accounts per day, as factory workers and schoolteachers make easy money from the bubble. Right now the Chinese stockmarket can do no wrong, but it’s still basically a house of cards, certain to come tumbling down soon.
Here’s how American economics writer Steven Goldberg described it: “Chinese stocks aren’t much like U.S. stocks. The [Chinese] government owns big stakes in almost all the companies. The kind of reporting and accounting transparency we’re accustomed to in the U.S. and other developed nations is absent in mainland China. If you own [some] of these [shares], I suggest you sell now.”
Like much of the Chinese economy, the Chinese stockmarket is in bubble mode, and the one inescapable economic reality is that every bubble must eventually burst. We talked to an accountant who has extensive dealings with China. These were his words of caution:
“It frightens me that Westerners are so gullible where China is concerned. They take Chinese government economic statistics as gospel, then they arrive starry-eyed in Shanghai and get a guided tour of a few select businesses and believe that these businesses represent the strength of new China.”
China’s business base is a lot shakier than Westerners believe, he adds. “In my estimation anywhere up to 40% of new Chinese businesses are bubble companies – that is, they can exist only in boomtimes and will probably not survive a downturn.”
“The luxury businesses will be the first to go – those Shanghai vodka bars where a single drink costs the average weekly wage, or car dealers who sell only Mercedes and Rolls-Royces.” However, that won’t be the end of it, he says: “Next to go will be the manufacturers whose business model is based on ever-growing turnover. These companies have massive American contracts to supply things like cheap televisions, and their profit margin on each set is probably two or three percent. These businesses are currently thriving because they sell more sets each month, but if there’s the slightest hiccup they’ll collapse overnight.”
Any setback in the Chinese economy will hurt the whole world. February’s 9% slide on the Shanghai Composite Index prompted a massive drop in stockmarkets around the globe. What damage would a 30% drop do to the world’s economy, and its demand for oil?
What if the Chinese stockmarket drops 248%?
Lastly, it’s worth remembering that China doesn’t need oil in the same way that America does: America’s economy, from the mountains to the sea, is built around cheap oil. As far as America is concerned, cheap energy is not so much a luxury as a right. You basically can’t get around America without a car or a plane. You can’t run the average American farm without vast amounts of petrochemicals. You can’t run air conditioning in 100 million homes without lots of cheap oil to power the electricity plants. Although America’s attitude to energy is very slowly changing, it will take quite a jolt to shake many Americans out of economic habits built around a century of cheap oil.
By comparison, it’s easy to get around China without a car; in fact most private cars in China are sold as semi-luxury items – proof of economic success in a country where the average wage is around US$1500 per year. Any severe economic downturn in China is likely to see its domestic car market decimated as consumers stop buying luxuries, and existing car buyers default on hire purchase loans.
The Chinese may crave economic growth, but they are a nation of hardworking survivors and pragmatists. If times go bad they will simply revert to more conventional forms of commerce, transport and farming. It’s difficult to see large numbers of Americans swapping their cars for bicycles anytime soon, yet many Chinese are still using the bicycles they grew up with. It would not take much of an economic shock to switch Chinese car owners back to two wheels.
If China can avoid disintegrating internally after an economic crash, it will eventually recover, but the Chinese people, once burned, will be twice shy. China’s second economic boom is likely to be far slower and more sustainable, with less of an emphasis on vodka bars and Mercedes Benzes.
All of these factors point to a lowering of the global demand for oil and therefore a lowering of the price. But there’s one factor that no one can control: terrorism. Islamic extremists who want the West to collapse have a powerful tool in oil.
Any interruption to the processing and delivery of oil can have catastrophic effects, even if it’s only for a short time. For example, Hurricane Katrina wiped out 25% of America’s domestic production, causing crude oil prices to leap to US$70 a barrel.
High oil prices, even if they only stay high for a short time, can have a devastating effect on a country’s economy. Not only does the country suddenly have to find more money to import crude oil, but high oil prices also tend to cause rampant inflation; virtually everything in the modern world relies on oil for much of its existence so high oil prices ripple through the economy – trucking firms put up their prices because their fuel costs more. Supermarkets put up their prices because their transport costs have gone up. Workers demand higher wages to pay for higher fuel and grocery prices, and so on.
This is well understood by economists, of course, which is why even the threat of an interruption to supply is likely to trigger a sudden rise in the price of oil, even though it’s only a threat.
If terrorists knocked out one major refinery, the effect would be immediate and drastic. Not only would the price of oil rocket because a major source of processed oil had suddenly dried up, but the threat of further attacks would probably trigger a further price panic out of all proportion to the actual interruption to supply.
This is well understood by both governments and terrorists, and a great deal of effort has gone in on both sides to thwart each other. To date the governments have won and there have been few major terrorist attacks to significantly affect oil supplies, but the threat is an ever-present one that will not really go away until either the terrorists are eliminated or alternatives to oil are found.
Oil installations in the Middle East are like war zones, with a massive military employed at all times to keep the refineries and pumping stations safe. Less safe are the installations outside the Middle East. Although American oil refineries are also protected, they are highly vulnerable to attack by a suicide bomber in a truck or aircraft. The Alaskan oil pipeline, when all’s said and done, is nothing more than a large metal tube running a few metres above thousands of miles of empty tundra. A single stick of dynamite would shut it down.
So where does this leave the world’s oil prices? That’s anyone’s guess, but it seems likely that a slowly tipping seesaw is the most likely scenario.
Oil prices will stay high while China’s bubble stays high, and fall along with the Chinese and American economies. Terrorism will endanger global oil supplies and may drive prices back up again, not in a sustained pattern, but in a series of spikes, followed by equally dramatic drops as the threat diminishes.
In the longer term the ingenious human mind will find alternative ways of gaining sustainable energy. In the shorter term we can expect an uneasy seesawing of oil prices; uncertainty seems set to be normal.
By Clive Matthew-Wilson, editor, The Dog & Lemon Guide
