A super-spike, Schrödinger’s cat and other stories

Dr Edward Libbey

The investment bank Goldman Sachs grabbed the headlines last week with an analysis suggesting oil prices were headed beyond $100 a barrel and cautioned that we may be entering an era of increasing price uncertainty and the possibility of a “super-spike.” Strangely, the report released almost simultaneously by the International Energy Agency (IEA) stated there was “less reason for concern,” but that almost sank without trace in the media.

So, what are we to believe?

Last year, international oil prices nearly doubled—from near $30 per barrel early in the year (dependent, of course, upon the grade) to recent peaks of around $60 per barrel. One of the other noticeable features of the crude oil market last year was the widening differentials between sweet and sour, and light and heavy crude oil prices, which had a significant impact on petrol prices. Hindsight makes it easy to be wise, but it seems that we didn’t really understand what was happening in the market 12 months ago. The closer we looked at the details, the more difficult it became to understand the key issues.

Erwin Schrödinger had the same problem in 1935 when he discussed his Cat and his Uncertainty Principle. His theories showed us that there is an apparent conflict between what quantum theory tells us is true about the nature and behavior of matter on the microscopic level and what we observe to be true about the nature and behavior of matter on the macroscopic level. He was also able to show that observation or measurement of something can actually affect the outcome. The more precisely you know the location of something, the more uncertainty there is about its movement—and vice versa. Sometimes we can choose which is more important.

Schrödinger is rumored to have said in later life that he wished he had never met the cat of his theoretical experiment, but we are grateful to him for providing it, for the oil market is much the same. Is it more important to know the exact detail of what the supply and demand balance is, or do we really want to know how it is changing: the static position versus the movement?

If we look at China’s demand for oil, it grew about 10% in 2003 compared with 2002, and suddenly shot up another 20% in 2004! At 5 million barrels per day, we were comfortable, but when it grew by another million per day, our calculations were thrown off balance. In the second quarter of last year, we thought there was adequate supply, but that was because we had missed a large increment. We were comfortable that we knew where we were, but we didn’t know the speed of change. In this globally integrated world, this growth in demand for oil disturbed both the freight and the minerals markets—especially coal and iron—as we realized what was going on in China.

But this was not the only problem. In the wake of the Iraq war, some commentators, and particularly some politicians with their own agenda, predicted a rapid growth in Iraqi oil production. Iraq used to produce more than 3 million barrels of oil per day, and the US Administration foresaw a rapid recovery which would help pay for reconstruction. In its latest report, the IEA is now talking about reassessing Iraq’s production capacity and lowering the ceiling from 2.5 million to 2.0 million barrels per day. We should certainly not be surprised. History tells us that Iran produced more than 5 million barrels of oil per day before the 1979 revolution, a level to which it has never recovered, as it currently struggles to meet 4 million barrels of oil per day.

What other contributing factors are there? Economists tell us that as a resource becomes increasingly scarce, the price will rise, and we observe increasing volatility. In the 1980s, OPEC was producing around 20 million barrels per day, and capacity was recognized to be about 30 million, alongside the usual uncertainties. Market stability was largely maintained by the Saudi Arabian government restricting production and running a huge budget deficit. By 2003, the situation had changed radically, and surplus capacity shrank to less than two million barrels a day, or about 2% of the total.

So, if we get Chinese demand wrong and Iraqi supply wrong, we find we have no margin for error left. We now face the same issue with refining capacity. Some 20 years ago, there was an excess of at least 20%, and no one was worried. Refineries were even being shut down in Europe and North America. The experts disagree, but some will say that the surplus now amounts to just a few percentage points. As the tragic explosion in BP’s plant at Texas City in the US showed us, even a small loss of production can give petrol prices a significant boost, not just in the US, but across Europe.

Does all this mean that we need to plan to live with oil at $50

a barrel going forward? Perhaps, but reflect on the following: it was not very long ago that oil companies planned on $15 for a barrel of oil, and they said they were not “opportunity constrained,” i.e., there were plenty of reserves that were economically recoverable, and the companies could pick and choose. Some of that stance involved a bluff factor, intended to prevent host governments from pushing up the tax take, but at $50 a barrel, hard-to-recover reserves become attractive to produce, and demand growth will surely be restrained.

When we consider whether we will revert to $15-$20 a barrel for oil in the near future, we have to admit that it is not likely if the ChevronTexaco purchase of Unocal is any indication of direction. ChevronTexaco is paying in the region of $17 billion to get 500 thousand barrels per day of production (oil equivalent). We need to compare that with BP’s investment of about half this amount in TNK-BP, the Russian-British oil company, to get twice that level of production in Russia. Russia certainly has some significant added risk associated with government behavior, but forward price expectations have increased significantly.

So are we about to run out of oil? Some commentators have recently predicted that global oil production is about to peak. Yes, we will eventually reach the geological limit and have to face up to a terminal decline, just as the US Lower 48 reached that position some time ago. Those of us with longer memories will recall that these were the concerns in the early 1970s, before the 1973 oil crisis. Historians tell us that concerns surrounding dwindling oil supplies have been around since the beginning of the 20th Century.

Predicting oil prices is a fool’s errand, but we have all too often made the mistake of extrapolating from recent trends only to predict calamity. We have all learned to live with expensive oil and adjusted our behavior accordingly. The creative human mind and technological innovation have responded in the past: watch this space!

May 2008, with 2021 updates