IS THIS JUST ANOTHER BLIP?
Given how often runups in the price of energy have been followed by rundowns, might the high energy prices of 2006–2007 be just a temporary increase? During almost all of the previous energy price hikes, it certainly seemed that higher energy prices were here to stay. For that matter, when energy prices subsequently fell, few thought prices would rise again. As a glance at Table 2.1 suggests, however, price cycles, with their ups and downs, appear to be an inescapable part of the world’s economic energy life.
The way economics works, it is to be expected that almost all economists would insist that energy price cycles are inescapable. Energy markets can be likened to the corn-hog cycle that economists teach to their students. When corn is scarce corn prices rise, which makes it too expensive for many farmers to breed hogs. So they kill their hogs, which reduces the demand for corn. This precipitates a drop in corn prices, which makes it cheaper to breed hogs so the demand and the price of corn rise. In much the same way, although you can not grow or kill oil wells like you can breed or slaughter hogs, when energy prices rise, energy becomes too expensive for some users who then look for substitutes or cut back. Not only are there fewer buyers (less demand) at higher prices, but the higher prices stimulate suppliers to offer more for sale. They want to sell more not only to earn a higher profit but also because the higher prices make it profitable to develop substitutes or to open up marginal sources of supply where heretofore the costs were too high to operate profitably.
While the supply and demand process needs no human organizer or controller to make it work, the Saudis have traditionally sought to ensure that swings in the price of petroleum were not too extreme. Consequently, when crude oil prices fall too low, they lobby the other members of OPEC to reduce output in order to tighten supplies and nudge up prices. On occasion, they have acted unilaterally. Similarly, when prices climb too high, the Saudis use their standby capacity to increase output because too great a price rise would stimulate the search for substitute fuels and conservation, measures that could prove hard to undo.
The rapid growth in prices in the early 2000s induced just such a Saudi reaction. After skyrocketing from $15 a barrel in 1998, to $77 a barrel in July, 2006, oil prices leveled off and for a time in early 2007 fell to slightly under $50. At that point the Saudis responded by curbing production by almost 1 million barrels a day (50 million tons) to prevent a further slide in prices.41 But since the Soviet Ministry of Petroleum and now the Russian oil companies are not part of OPEC, Soviet and then Russian producers have traditionally tried to take advantage of Saudi and OPEC cutbacks by doing just the opposite. When OPEC has reduced output the Russians usually have increased theirs. That explains why in late 2006 when the Saudis reduced their output, Russia once again became the world’s largest producer of petroleum.
In post-1998, however, there was something different about the way energy producers and consumers reacted. Producers did increase and reduce output in tandem with price increases and decreases (at least OPEC producers did), and the higher prices did revive interest in and production of renewable biofuel energy substitutes such as ethanol. Yet as prices approached the $100 a barrel mark, there seemed to be a new factor pushing prices to that level. There seemed to be less and less slack in the market. According to calculations of Fatih Birol, the chief economist at the International Energy Agency, the world needs 5 million barrels a day (250 million tons) of spare oil production capacity to avoid energy disruption.42 That is equivalent to almost half of Russia’s annual production. In 2005, there was only 1.5 million barrels (75 million tons) spare capacity.43 Paolo Scaroni, CEO of the Italian energy company Eni, estimates that as of 2006 the world’s spare petroleum capacity had fallen from 15 percent of world consumption to 2–3 percent.44 That suggests that energy prices are unlikely to drop in the near future. What remains to be seen is what sources of supply that before were too marginal will now become profitable and how extensive such new projects will prove to be.
THE NEW DEMAND EQUATION
Equally important, not only did there seem to be less spare capacity but energy consumption seemed to be increasing faster than normal. According to an estimate by Edward Morse, chief energy economist at Lehman Brothers, the investment banking firm, overall world energy demand rose by 10 million barrels a day (500 million tons) from 2000 to 2006.45 Subsequently, the high petroleum price in 2006 precipitated a drop in consumption of 100,000 barrels a day within countries that belong to the Organization for Economic Cooperation and Development (OECD), especially the United States. But as we noted earlier, demand in the developing countries, especially in China and India, rose faster than elsewhere thus offsetting that drop. While petroleum consumption in the United States has risen by 17 percent since 1995 to a massive 20.7 million barrels a day, the comparable figures in India were a 57 percent increase to 2.5 million barrels a day and for China, now the world’s second largest consumer of petroleum, there was a 106 percent increase to 7 million barrels a day.46
It is always risky to predict the future, especially when it comes to the discovery of new energy supplies and energy prices, but the recent very rapid growth in demand within the developing world is unlikely to abate. As the GDP continues to rise rapidly in countries like India and China, their energy consumption is likely to grow even faster as their new wealth brings an even faster demand for energy intensive products such as automobiles, refrigerators, and air conditioners. Because all three items are considered to be icons of the middle class, demand for such products is especially strong. Given that each Chinese consumes the equivalent of two barrels of oil a year and that each American consumes twenty-six barrels, the odds are that even with higher prices, China will substantially increase its energy per capita consumption; this means that future worldwide energy demand will continue to increase rapidly and outpace discovery of new energy supplies.47 It is this demand and supply dynamic that enhances the financial and political clout of energy-rich Russia. Undoubtedly, as is in the past, sometimes there will be an increase in supply and a slowing of demand growth (and even occasionally a decline), but it is the coming of affluence to India and China that changes the equation. As their demand for energy continues to grow, this will provide enormous economic and political opportunity for Russia.