Oil: A New Pricing Mechanism and the Coming Crunch

Clingendael has released an interesting report regarding the coming oil crisis. (No, we are not quite there yet.) The crisis or crunch is slated for 2010, around the beginning of the next decade, five years earlier than the IEA predicted in 2007 (cf World Energy Outlook 2007).

That crunch will occur, despite some demand destruction and despite weak global economic growth. Perhaps only a severe and prolonged global recession will contain energy prices somewhat.

Compounding our difficulty is the fact that alternate energy sources are not mature enough to provide us the energy we need for continued growth. Indeed, they will not be plentiful soon enough for us to avoid real hardship.

All of the above strikes this writer as old hat, a familiar and depressing old hat at that. What is interesting is how the report deals with the recent spike–along with its subsequent fluctuations.

The writers see a struggle between two modes in establishing the price of oil.

a) The cost of the marginal barrel of supply as determined by the most expensive barrel plus a margin for supply/demand fundamentals and geopolitical risks, driven by open markets in an OECD economic framework and

b) The real User Value of oil–determined by increasingly closed markets (for new reserve exploitation; for bilateral oil trade flows; for refined products), as supported by several of the major OPEC countries and Russia.

The first is how oil has been traditionally priced. Given production, refinery, and transportation costs–each stage tacking on some reasonable profit–, we arrive at the final price, which the writers put at about $110.

However, with a crunch in the making and with growing global demand, a new way of pricing oil is coming into play.

“Ok, oil-lovers, what is it worth to you?”

Such a question is possible when oil markets are increasingly closed. Additionally and importantly, there are more buyers for that oil–and, of course, fewer sellers.

This new pricing regime will mean that oil producers can meet their “income requirements” through price, not volume. Additionally, oil that can be stored in the ground will only gain in value as we approach crunch time.

What we are watching, then, is a transition period between the two pricing structures: first one dominates; then the other. The recent high prices were, in effect, testing User Value; after all, “weak globalization” has doubled “the consumer base to 1.5. to 2 billion people in a period of less 15 years.” Yet, if globalization were to take deep hold, i.e., China and India’s billions start owning cars, then we would see an impossible strain on present oil production. Oil producers are fully aware of this fact. Another reason a new pricing structure can be tested.

According to the writers, the next IEA report will assert that for 2030, “a new supply/demand outlook” will be “around 100-105 million b/d,” in contrast to the 2007 production of “116 million b/d.” Demand destruction in the U.S. will, of necessity, be around 50-75%.

Despite the Arctic prospect or fields off Brazil–whatever–, present discoveries are not keeping pace with oil fields in decline. The writers go so far as saying there will be “demand rationing” in the U.S.

In newly emerging markets such as China, there is the problem of oil subsidies. Relaxing their subsidies too much–or even beginning to tax oil to contain demand–will obviously bring enormous inflation, smothering the effort “to catch up” industrially with the West.

(Clearly, as U.S. prices continue their bumpy road upward, the U.S. consumer is going to holler louder and louder about the taxes on oil, pointing out that other countries unfairly subsidize prices.)

The writers spend a good deal of the report discussing Sovereign Wealth Funds and the enormous sums of monies some SWE’s are gathering as a result of oil–think Middle East. Money is power; in the case of the Middle East, enormous money is enormous power in the hands of tiny countries ruled by a few families. He who owns the spice…. interesting that Dune is a desert planet. That oil is becoming a closed market makes possible not only a different pricing modality but also a radical shift in wealth. (Poor America, it will never know what hit it.)

In short, the future of oil in the not too distant future does not make easy or pleasant reading.

As I read these kinds of informative reports, I have to wonder where the economists have been…and those who celebrated the coming wonders of globalization. Did anyone bother to check the cupboards for supplies?