A Disobliging Update on the Price of Oil

There still seems to be a deplorable uncertainty about the future price of the most important commodity in the world. A few months ago Philip Verleger - now apparently guest professor at the University of Alberta (Canada) - predicted an oil price of thirty dollars a barrel (= $30/b) for the end of the 2009, and now Mr Chris Watling - chief executive for Longview Economies - forecasts a sharp drop in the oil price (2009). He bases this forecast on an increased oil supply by Saudi Arabia, Iraq and Kuwait - who together have about 38 percent of the global oil reserves - and he also envisages  an unchanged or increasing oil production by Canada, Brazil, Angola and Kazakstan.

I won't waste my time with Verleger's failed prediction, since instead of $30/b, the year end price for oil was closer to $75/b. But I will say that Mr Verleger has been on the oil conference circuit at least as long as I have, and he should understand the intricacies of the oil market as well as I do. Mr Watling however seems to have an information problem, by which I mean that he has received  too much of that theoretically valuable commodity. He is a victim of what might be called a Greshham-type law: bad  information driving out good.

Watling tells us that Saudi Arabia has increased capacity from 9.5 to 11.5 mb/d in the past five years. Had this been true, President Bush could have stayed home instead of taking a hat-in-hand trip to that country in 2008, when the oil price was closing in on $150/b, and various certified experts were screaming to the high heavens that it could reach $200/b. And the price might have gone that high had a global macroeconomic meltdown not taken place, for which the high oil price was probably more that a little responsible.

Watling also says that Saudi Arabia intends to increase its output to 15 mb/d. That number originated with the Saudi oil minister and not the Saudi head-of-state, which gives it a very different status. Rather than go into the background of this observation, I would like to offer an excruciatingly clear prediction: SAUDI ARABIA WILL NEVER, WILLINGLY, RAISE ITS SUSTAINABLE CAPACITY TO 15 MB/D.  In fact they will not raise it to 12.8 mb/d, which was the last semi-official prediction I saw. Instead that country will produce (and export) as little oil as possible, because the economic theory that I teach tells me that the smaller the amount of oil exported from Saudi Arabia, the greater the economic development they will eventually enjoy - up to a limit of course. I also assume that the Saudi government knows what that limit is, and they know it better than I do.

Kuwait is as sophisticated in these matters as any country in the world. Watling says that their "production trend" will follow that of Saudi Arabia, which means to me that their exports are more likely to fall than rise. That brings us to Iraq, whose output Watling believes will increase from its present 2.5mb/d to 6.2 mb/d by 2017.  I'll accept this prediction for the simple reason that Russia's oil production is unlikely to greatly exceed 10 mb/d, while exports will tend to decline because of domestic consumption. Besides, it is not unthinkable that Russia will eventually become a formal or informal member of OPEC, and abide by OPEC quotas.

I also have convinced myself that if the oil price does not escalate too rapidly after the present macroeconomic difficulties have been overcome, the global oil market will have no difficulty absorbing an Iraqui supply increase of the magnitude cited. What about if a Brazilian supply increase is added? I think that I will wait to comment on that possibility, because when it comes to extracting oil from the deep ocean where the new Brazilian reserves are supposedly located, nobody can provide an exact time scheme.

A few comments on the above are in order here. At a recent conference in Siena, Professor Robert Ayres said that the price of energy has been too low. I had some problem accepting this statement, but everything considered, it might make economic sense. Had the oil price been higher, we might be closer to a more optimal energy structure, which in the long run will have to be installed regardless of the incentives or pressures that are necessary to bring it about. Watling also mentioned the peaking of the oil output of Norway and the UK around the end of the last century. On this point several Norwegians have said to me that Norway produced too much oil when its price was below or in the vicinity of $15/b, and the same might be true of the UK.

Perhaps those two countries forgot that all is fair in love, war and international trade. I doubt whether the favours they did or tried to do for the rest of the world would be reciprocated if the situation was reversed. Certainly, it would have been better for them - and perhaps in the long run the rest of us too - if  the oil price had never been allowed to fall as much as it did. That decline also allowed OPEC to find out something about the bad things that could happen for them if they made the wrong decisions about the output of oil.

Someone has questioned me about the economic strategies now being adopted by e.g.  Saudi Arabia  and Kuwait. There seems to be some doubt as to  whether it makes sense now or later to sacrifice comparatively substantial revenues from the production of crude oil in order to achieve a larger future production of petrochemicals and refinery products. When I taught development economics in Sweden and Senegal from the textbook by Howard Chenery and Paul Clark (1962), it was generally understood by every student and teacher who could read and write, and as well do secondary school mathematics, that no country capable of adding value to natural resources via a small or large amount of industrialization should fail to do so, unless of course they preferred less development and prosperity for their citizens as compared to more. I can add that in the case of Saudi Arabia, and probably others who intend to produce an appreciable slice of the international petrochemical cake, it is completely and totally illogical to construct very expensive facilities to achieve this goal, but to earlier export the most important inputs for those facilities - oil and gas.

By Professor Ferdinand E. Banks, Uppsala University (Sweden)

REFERENCES

Banks, Ferdinand E. (2008).'The sum of many hopes and fears about the energy
resources of  the Middle East'. Lecture given at the Ecole  Normale
Superieure  (Paris), May 20, 2008
______  (2007). The Political Economy of World Energy: An Introductory  Textbook.
London and  Singapore: World Scientific.
Chenery,  Hollis B. and Paul G.Clarke  (1962).  Interindustry Economics. New
York: Wiley.