Supply and demand – the oil genies we need to tame

Robin Mills writes that neither of the genies offers good wishes.

The classic 1996 book by the United States economist Morry Adelman Genie Out of the Bottle describes how the Opec countries discovered they could increase oil prices by restricting supply – then overplayed their hand and triggered a price crash. Now the oil exporters have let two genies escape – and neither of them offers good wishes.

Supply and demand are the two genies, and the Opec countries and Russia unleashed them by accepting very high oil and gas prices over the past decade. Some major producers, such as Iraq, could not increase output significantly because of well-known political problems. But in many cases, countries made a deliberate choice to let their production decline, or at least increase only modestly – even in the face of rampant Chinese demand and prices that in the space of seven years soared from US$20 per barrel to $147.

The first genie is well-publicised – escaping from shale rock deep under North America. Although the technologies of shale oil and gas extraction were developed from the 1980s onwards, it was the stimulus of high oil prices that led to their rapid development and deployment. Oil output in the main US shale areas of North Dakota, South Texas and West Texas rose from less than half a million barrels per day in 2008 to more than 3 million barrels per day this year.

Shale technology continues to improve, and now that the secret is out, it will spread – inevitably, if slowly – to other countries, from Argentina to Australia.

The second genie, even more important, is invisible: the genie of oil demand that never was.

In 1998, the International Energy Agency forecast that oil demand in 2010 would be 94 million barrels per day. In fact, it was less than 88 million, the result of prices of about $80 a barrel rather than the $30 that the body had predicted.

High oil prices have destroyed demand, firstly by braking world economic growth. That growth can be made up when prices fall – but two major consuming areas, Russia and the Middle East, will actually experience lower demand as their oil-fuelled booms end, and as fiscal pressures make them reduce subsidies.

More seriously, high prices have permanently changed consumer behaviour, technology and capital stock. In most countries, oil has virtually disappeared from electricity generation, where gas and renewable energy are cheaper and cleaner.

Europe, the US and China have increased vehicle fuel efficiency standards. Countries from Morocco to India and Indonesia have raised domestic fuel prices to market levels. As oil prices fall, European countries will take the chance to raise already high taxes on petrol and diesel.

Once invented, energy-efficient technologies are not uninvented – hybrid cars are now mainstream, and electric vehicles, the ultimate threat to oil, have advanced significantly. To some extent, consumers’ oil appetite will return – US sales of new SUVs increased nearly 10 per cent in November, while purchases of lighter vehicles were down. But much of the lost demand will be permanent.

Countries with limited reserves or high production costs, such as Venezuela, Nigeria and Algeria, wished for high short-term prices. They got their desire – and now they get the consequences of lower demand and revenues. Their wish would only have been wise if they had simultaneously planned for the future – diversifying the economy and saving, as Norway has done with its $880 billion oil fund.

In the longer term, actions against climate change will bring increasing pressure to bear on oil demand. The states with low-cost fields and 50 years or more of reserves at current production rates – Saudi Arabia, Iraq, Iran, Kuwait and Abu Dhabi – need to ensure their oil remains competitive. It’s too late to put the genies back, but perhaps they can still be tamed.

Robin Mills is the head of consulting at Manaar Energy, and author of The Myth of the Oil Crisis

Follow The National's Business section on Twitter