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Shaw Capital Management Factoring: Oil Scarcity and its impact on the Global Economy

May 4, 2011 | Author Shaw Capital Management Factoring and Financings

http://www.oyetimes.com/business/44-markets/10984-oil-scarcity-and-its-impact-on-the-global-economy

TUESDAY, 03 MAY 2011 10:11

WRITTEN BY GLEN ASHER

In the latest edition of the International Monetary Fund’s World Economic Outlook publication, the IMF dedicates a chapter entitled “Oil Scarcity, Growth and Global Imbalances” to an examination of the world’s oil markets and the impact of growing oil scarcity on the world’s economy.  In this document, the IMF seeks to answer the current status of oil scarcity, how oil scarcity will impact the global economy and how oil scarcity will impact economic policies around the world.

Now that the price of both Brent and West Texas Intermediate seem solidly positioned above $100 per barrel for the first time since 2008, this is a timely study.  Demand for oil has risen and, for some major consumers such as China, consumption levels have reached new records.  Since oil is central to the world’s economy, the impact of oil price volatility is key to economic growth and security.  While oil prices have risen and fallen over the past 4 decades, it is only now that the issue of looming oil scarcity is becoming increasingly discussed.

 

The authors of the report believe that the world is, in fact, reaching a point of increasing oil scarcity.  Demand from emerging economies is acting in concert with decreasing levels of growth in supply resulting in increasing tension in the world’s oil markets.  The IMF distinguishes between an absolute drop in supply (decreasing absolute daily oil production level) and a drop in the level of oil supply growth.  If oil supply growth were to drop by one percentage point, annual global economic growth would slow by an annual rate of one-quarter of a point over the medium to long term.  On the other hand, a steady decline in absolute oil supply levels would have a much greater negative impact on the global economy even if there is an increase in substitution of other energy sources in the place of oil.  As well, the pace of the rise in oil scarcity will also affect the level of impact on the world’s economy; should there be sudden downward trends in supply, the economic impact will be far greater than if supply constraints were gradual.

 

Let’s start by looking at the concept of oil scarcity and the extent of the issue.  To put the importance of oil to the world’s economy into perspective, oil is a key factor in production and transportation and is the world’s most widely traded commodity with world exports averaging $1.8 trillion annually over the years 2007 to 2009, about 10 percent of global exports.  Oil prices generally follow the economic law of supply and demand.  When demand rises, if the supply is steady, prices will generally rise which will ultimately result in both an increase in supply and a drop in demand.  The price of oil generally reflects the opportunity cost of bringing an additional barrel of oil to the market place.  In general and over time, a high price generally implies that oil (or any other commodity) either is (or is anticipated to be) scarce while a low price generally implies abundance.  Short term market fluctuations can occur that will lead to price spikes such as those seen in the 1970s OPEC embargo or the Gulf War in 1991 when the price spiked to just over $40 per barrel from just under $10 per barrel just five years earlier.  Over the longer term, oil price changes generally appear to be relatively smooth with a gentle rise prior to the rapid rise and fall in 2008 – 2009 which reflected issues in the world’s economy rather than oil market macroeconomic factors.

 

The concept of oil scarcity is a contentious one.  Many authorities in the oil industry now acknowledge that the world may well be entering a point of supply constraints.  The decline in oil availability reflects the constraints placed by nature on the ability of the industry to profitably explore for and produce reserves.  When prices are low, the oil industry generally reduces capital expenditures which places downward pressures on supply.  On the other hand, mounting oil prices have resulted in technological advancements that have impacted industry’s ability to bring certain reserves to market, for example, the advent of both deep water drilling and multi-stage hydraulic have allowed the industry to invest in higher risk/lower productivity play types.  It is the widespread use of enhanced technology that is now depressing natural gas prices in North America where both horizontal drilling and multi-state fracking have resulted in an oversupplied natural gas market.

 

The scarcity of oil is also related to the properties of the commodity.  Oil has unique physical properties that make substitution difficult, particularly in the chemical industry where it forms the feedstock for many of the items that we use in our daily lives.  If substitutes for oil for these products were found, oil supply constraints would have less of an impact on prices since rising demand for the substitute would dampen oil price volatility.

 

One of the fundamental factors that impacts the world’s economy is the fact that oil is the world’s most important source of primary energy with over 33 percent of the world’s total with coal accounting for 28 percent and natural gas accounting for 23 percent.  In recent years, the world has experienced increased rates of growth in energy consumption, particularly from China who is now the world’s number one overall energy consumer.  For the foreseeable future, growth in China’s economy will be the primary driver of increases in global energy use.  In general, the world’s developed economies (OECD nations) expand with little increase in energy usage, however, those non-OECD nations in lower income countries have a one-to-one relationship between economic growth and energy usage.  This means that a one percent increase in real per capita GDP is accompanied by a one percent increase in per capita energy consumption as shown in this graph:

Note that the share of the world’s primary energy consumption for the United States, Europe and Japan is dropping while it is rising for India and the Middle East and rising markedly for China (blue line) as shown in this graph:

Given the one-to-one relationship noted above, the IMF forecasts that China’s energy consumption is predicted to double by 2017 and triple by 2035 in comparison to its 2008 level.  In 2000, China consumed 6 percent of the world’s overall oil consumption, this rose to nearly 11 percent in 2010 with coal accounting for 71 percent of total energy consumption and oil for 19 percent.

 

The IMF study also examined the elasticity of oil.  Elasticity is defined as “…the ratio of the percent change in one variable to the percent change in another variable. It is a tool for measuring the responsiveness of a function to changes in parameters in a unitless way…”  The IMF found that an oil price increase of 10 percent leads to only a 0.2 percent reduction in demand (low elasticity).  Over a longer term of 20 years, that 10 percent price increase reduces demand by only 0.7 percent, a very insignificant amount.  When looking at oil demand based on income, over the short-term, a 1 percent increase in income results in a 0.68 percent increase in oil demand; this drops to 0.29 percent over the longer term.  This is far lower than the increase in demand for total energy consumption meaning that as incomes rise, over the short-term, people increase their demand for oil but over the longer term, while their demand for all energy sources increases, they substitute other fuels for oil.  It is interesting to note that the demand for oil among the developed nations of the OECD changes very little when the price of oil rises when compared to the demand of non-OECD nations.  This is likely because during the oil price shocks of the 1970s and 1980s, nations such as the United States and France switched from oil to other means of power generation such as coal and nuclear.  The economies of the more developed nations are somewhat more immune from increases in the price of oil since their power generation does not require the use of oil.  The same cannot yet be said for those nations with less mature economies who still rely more heavily on oil.

 

What impact will increasing oil scarcity have on the global economy?  Strong and increasing oil demand is expected from emerging market economies where rapid income growth is being experienced.  Since oil production appears to have reached a plateau over the past decade, supply and demand could well fall out of balance.  As I noted above, even a drop in the average growth rate of oil production (not a drop in the absolute level of oil production) will have an impact on the world economy.  To put the following scenarios into perspective, oil production has grown at a historical rate of 1.8 percent annually.

 

Now let’s look at two of the IMF oil scarcity scenarios:

 

1.) Oil production growth drops by a persistent 1 percent annual growth rate: In this case, an immediate oil price spike of 60 percent is predicted by the IMF models.  Over a 20 year period, a 200 percent increase in the price of oil is predicted.  This will result in a massive wealth transfer from consuming nations to exporting nations and will result in a much lower GDP for oil importers that is at least partially offset by a higher GDP for oil exporting nations.  On the upside, increased demand for goods from oil importers results in increased exports of these goods by the wealthier oil exporting nations.  Overall, the IMF feels that global economic growth is slowed by less than one-quarter of a percent annually over the medium and long term if oil production growth slows gradually.

 

2.) Oil production growth drops by a persistent 3.8 percent annual growth rate: This scenario is more closely related to scenario anticipated by the proponents of “peak oil”. In this case, an immediate oil price spike of 200 percent is predicted by the IMF models.  Over a 20 year period, an 800 percent increase in the price of oil is predicted.  Price changes of this magnitude have never been experienced by the world’s economy and the impact would make it very difficult to carry out monetary policy.  The economies of emerging Asia would be highly impacted since their economic growth is at a one-to-one ratio with energy usage.  As well, the economies of those nations that have weak links to oil exporting nations, such as the United States, would be highly impacted.  It is likely that if oil output decreased substantially, oil exporting nations might well reserve an increasing share of their production for domestic use, shrinking the amount of oil available for the world’s oil markets.  This could have the ultimate result of shrinking the world’s supply of oil far faster than would normally be anticipated.  A persistent decline in oil production growth of this size would result in larger current account imbalances (exports minus imports) among nations with oil importing nations experiencing a 6 to 8 percentage point drop in GDP over the long term.

 

The state of oil scarcity can be mitigated by changes in government policy toward the development of sustainable sources of energy, particularly among nations that are net importers of oil.  Changes in policy will also be required for nations that use subsidies to keep energy costs reasonable for their citizens.  As oil scarcity results in higher prices, the fiscal cost of fuel subsidies could overwhelm the fiscal situation of these governments.  Removing such subsidies has often resulted in civil unrest, however, on the other hand, the reduction in subsidies would also allow market forces to work their way through the system to reduce demand as prices rise.  In place of subsidies, these governments will need to implement an enhanced social safety network to ensure that their citizens do not face increased poverty.

 

Governments around the world face a conundrum; by ignoring the issue now, the world’s addiction to oil continues to rise unabated.  By acting too soon to curtail oil consumption through the use of policy interventions, the world’s economy could be thrown into a premature economic malaise.  Since the scarcity of oil is a global problem, it is critical that governments throughout the world act in a cooperative manner to ensure that the ultimate outcome is one that is advantageous to all of us.  The sooner that action is taken, the better for everyone.


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