Sure and Certain Oil Shock

Andrew McKillop, July 2008


Based on the author's presentation
to the New York Peak Oil Conference
Cooper Union, NYC, April 2006



Fatal Difference — and Indifference


The 1970s short-sharp oil shocks, and the crawling but permanent oil shock we have since 1999 were and are price shocks. That is, prices went up a lot: about 295% in 1973-1974, about 115% in 1979-1980, and from 1999 to date by around 925%, all measured in nominal terms, not inflation-adjusted terms.


Both in 1973, and in 1999, the start price was very low.


What counts are the big differences between the 1970s oil shocks and what is happening since 1999, but most clearly since 2003-2004, with dramatic acceleration since mid-2007.


The biggest difference is the 1970s oil shocks were caused by short and sharp oil supply cuts for political reasons, but full supplies were always restored after a few months. After that, world oil production capacity kept growing and any kind of supply shortage was removed from the scene for about 15 years. This is not the outlook or perspective after Peak Oil. Supply growth is already almost zero, and within a short time supply will fall into negative territory due to a combination of geological, technical, industrial and national resource-conserving policy reasons in the big producer countries.


Geological shortage is not amenable to regime-change of oil exporter countries. Reserves, in Iraq notably, are not showing any sign of ‘robust annual additions’, nor is the loudly-announced peace dividend or war booty in the shape of “enhanced” oil production and “improved performance” of its exports becoming a reality. Iraq more or less produces and exports what it did before 2003, when it was under different management. Since 2003, world oil demand has risen about 8 Million barrels/day (Mbd), about 3.5 times Iraq’s current total production, or 5 times its current exports.


The biggest supply outage was in 1979-1980, triggered by Khomenei’s revolution in Iran, when Iran’s net oil exports, then about 4.4 Mbd, were cut back to nearly nothing then slowly recovered, through a period of around 6 months. Oil prices in March-April 1980 hit a record high that has only recently been beaten, 28 years later. Depending on how inflation is factored in, and what purchasing power adjustment is used to compare US dollars of 1980 with 2008, the April 1980 price peak when expressed in 2008 dollars was about 95-115 US dollars/barrel.


This peak price was attained when Iran’s exports fell to almost nothing for around 3 months, before they slowly recovered. Today however, not-yet-at-war Iran struggles to achieve net exports of around 2.45 Mbd, due to the pincer movement of stagnating production growth and rising domestic fuel consumption. Regime change in Iran would, surely and certainly, be very bad for its export ‘performance’, and everybody sane knows that fact.


Losing Iran today


In 1979 world total oil import demand was not much above 38 Mbd, but is around 51 Mbd today. Losing Iran, today, could in theory seem a lot more manageable than in 1979-80. In practice and in fact, it would be the exact opposite, due to Peak Oil. Today, every barrel counts. It is possible that unfazed and unreformed US Neoconservative boys hunkered down in their Think Tank bunkers might enthrall hand-picked audiences with hard-hitting Powerpoints, showing the world can do without Iran, for a while, during the regime-change party, in the same way it does without Iraq. But in fact the world has changed — losing Iran would be a worse disaster today, than losing it was in 1979-80. Oil prices would spiral out of sight, to yet further exotic unknown highs.


Supply is drum-tight stretched. Any small outage will instantly cause further big price rises. Spare production capacity is almost inevitably given wilfully exaggerated upward spin, while demand growth is wilfully underestimated by the main energy agencies of the big OECD oil importer countries. This is a transparent attempt to reassure the consumer herd, perhaps, but in fact world spare production capacity is low, or very low, and demand growth is alive and well. Spare capacity is also tending to shrink, not grow.


The main energy agencies, the OECD’s IEA and the US EIA, can be counted on to publish the most optimistic possible outlooks, but even they now suggest that spare capacity will be close to zero by around 2012 — if their forward estimates of demand growth shrinking to less than 1%pa come out right. In fact, world oil demand growth by the same token should be zero by 2012, but nobody is saying how that comes about, and whose supplies get reduced, first, to help achieve zero demand growth. Asking India, China, or the main oil exporter countries like Russia or Saudi Arabia, to cut back on their domestic demand would be a fool’s game, so the cuts have to come from the OECD ‘mature postindustrial’ countries that use about 6 times more oil per head of population than industrialising China and 8 or 10 times more than India.


 Just these factors should, or could reduce world tension, specially concerning the long-running ‘Iran nuclear standoff’, although plenty of persons reason exactly the opposite. The unspoken logic runs something like: If things are going to get worse anyway, why not bomb Iran right now, ‘for the good of Humanity’?


Another bungled regime change attack


Consider this: What would happen if there was another bungled regime-change ‘experiment’, that is, war, not in Iran but in another oil or gas exporter country? The choices are bigger than you might think: even small or tiny exporters like Chad, Sudan, Equatorial Guinea, Burma and Syria have to be carefully nurtured today. Bungled regime change, like that attempted in Equatorial Guinea by friends of Margaret Thatcher’s son Mark, or on-again off-again threats against Sudan to forcibly stop its ‘malign neglect’ of the Darfur tragedy, or threats of force to improve human rights and democracy in Chad or Burma, and of course threats against ‘the Shi’ite Crescent of Evil’ and its northern outpost — Syria — are all somewhat quietened down these days. Several have been put on the back burner, sine die.The reason is simple: oil.


Since this article was written the International Criminal Court on July 14 formally charged Sudan’s president with war crimes and genocide, showing that extreme high oil prices do not give total cover against war crime charges. Since China is the biggest foreign investor in Sudan — for oil — this action against Sudan by the “international community” wll have interesting repercussions, not only on how Sudan uses its ‘oil clout’ to respond, but notably the extent to which China backs away from supporting Sudan’s regime, and loses precious oil supply from Sudan.


Another bungled regime change attempt would cut supply for the consumer world’s car, container ship and airplane fleets, raw materials and petrochemical bases for fertilizers, medicines and throwaway plastic packaging, fuels for its mechanized armies and air forces, and energy to produce the cement, steel, glass and concrete of ‘resource conserving’ new cities. Consumer confidence, already somewhat mangled by spiraling food prices and fallout from the world financial and banking sector crisis, would take another hit. This falling confidence would be bad for economic growth, and very bad for stock prices on the not-so-Teflon stock exchanges of the Old World, and New World too.


Consumer sentiment has only in 2008 begun to react and respond to continual but slow growth of oil prices since 1999, as so-called ‘psychological thresholds’ were hit. In fact, in many OECD countries, today, average household spending on energy now outpaces spending on food — which is also increasing in price, in large part due to higher oil and energy prices for producing, processing, packaging and distributing food. After about 140 US dollars/barrel the alarm signals are starting to ring out — especially at the filling station or when the family central heating tank is filled. Today there is little leeway remaining for further bit-by-bit price rises before consumer confidence collapses. In Europe, the consumer herd is already confronted with car fuel prices around 9 or 10 US dollars per US gallon, while American car drivers rage at pump prices around 4 dollars-a-gallon. Only a miracle of faith, or laziness and inertia keeps them consuming.


Another bungled regime-change attack on a big oil exporter like Iran would guarantee that what Daniel Yergin calls “the prize” — cheap oil — will be relegated to fairy story and legend status, further and faster. We can hope this real world risk could limit and cool the urge to try out more oil-grabs by the big consumer nations, usually so prompt to give lessons on ‘democracy, human rights, protection of the environment, limiting climate change’ and other wonderful causes. Their leaders’ hot talk on ‘fighting climate change’ by accelerating the arrival of the Low Carbon Economy, for example at the July G-8 meeting, always avoids doing anything right now — maybe about 2030 or 2050, but not now. The inescapable conclusion is that 2030-2050 is taken as the complete and final cutoff date for world oil and natural gas supplies, betraying the ignorance and cynicism of these leaders.


Managing energy transition away from oil


Real world oil addiction is primarily due to lethargy, inertia, inaction, stupidity and refusal to face facts or prepare the future. World supplies of both oil and gas will be much, much smaller than today by 2030-2050. Pretending there is “no choice” but maintaining current oil and gas intensities, especially in the OECD countries, is a handy way to deny reality, but soon this wilful ignorance will not work anymore. Anybody who can see what is going to happen, before the Final Energy Crisis removes all choices, is duty-bound to act. We can all do something about the tragic laisser-faire that glues us onto the present no-win, no-choice path. This fact is now recognized by large numbers of persons, but is carefully filtered by media, and ignored by political leaderships.


During a long lost decade-and-a-half, through 1985-1999, we had oversupply of oil, gas, coal, metals and minerals, and the agro-commodities. Unsurprisingly, the call to limit oil burning and develop solar and renewable energy to save the world’s climate was little heard in those long, lost days of Cheap Oil. Prices were often at all-time record lows. Today energy saving, and reducing energy intensity of the economy, are easier to defend, if only to maintain economic growth and try to limit inflation.


In the 1980s and 1990s oil and gas demand always trailed behind net export supply or ‘offer’. This long Holiday from Reality, the seedbed of ‘neoliberal globalisation’, started and ended with oil. For oil, the kickoff signal was the anti-shock of 1985-1986, when prices crashed about 70% in 6 months. On the demand side the Holiday from Reality was mainly due to massive growth of natural gas supplies at bargain basement, low prices, and what New Economists called ‘slow, stable and non-inflationary’ economic growth or a kind of permanent economic recession. This started in the early 1980s, after the second Oil Shock and still goes on in some countries, such as Old Europe. Economists, to be sure, compulsively study this agonizing ‘deficit of growth’ question for the OECD countries. Plenty come to the easy conclusion that cheap oil is the N°1 antidote, underlining the obsession with cheap oil that haunts all policymaking.


Looking further into the real causes of persistent slow economic growth in the highest-GNP members of the rich world’s OECD group — whatever the oil price, high or low — the simple fact of consumer saturation leaps to the forefront: how do we achieve car ownership rates at, or above 3 cars for every 4 persons, adult and young? Can we have more cellphones in operation than the total population of the country? Do we really want or need that? To be sure, the selected beneficiaries of the New Economy rout starting in the 1980s, after the second Oil Shock, were the Old World’s middle classes, who could and did indulge in an orgy of house price inflation and speculation, aided by Teflon stock exchanges that could only rise. Miraculously, the orgy of house price inflation and the inflated growth of stock market indexes never appeared in official CPI-Consumer Price Inflation figures. This was indeed a handy way to create the ‘feel good’ personal wealth effect, without spending all that much oil. Today, unfortunately or not, this genial trick is like cheap oil disappearing fast in the rearview mirror of time.


After low growth we can achieve zero growth. This indeed would come very fast after a world bourse crash and 250 USD/barrel oil resulting from Tehran regime change — or it could come in managed, open or ‘transparent’ and democratically accepted ways. Transition away from the fossil fuels is a simple necessity; it has to come, and the process has to be organized and start soon. Masking this simple and clear need with talk about ‘saving the world’s climate’ by cutting energy demand in 35 years time is not going to work. Within the next 3 years the impact of Peak Oil, and within 5 years the impact of Peak Gas will cut off any foolish dreams of “decades left to play with”.



After the Cheap Oil holiday from reality


Perhaps to avoid regime-change in Saddam’s Iraq, or to help Iraq fight Khomenei’s hordes in the 1980-88 Iran-Iraq war, Saudi Arabia’s rulers engaged in a heroic oil pumping feat, hiking their production to the ultimate peak Saudi Arabia ever attained — around 12 to 12.5 Mbd — which today Saudi rulers talk about repeating, but don’t or can’t do. The Saudi pumping feat of the late 1980s and 1990s is a long story with plenty of ways to be interpreted. One certain reason was the Sunni-Shi’ite, Iraq-Iran war. At the time, Saddam Hussein was the heroic defender of the Arab Sunni cause against Khomenei’s Shi’ite hordes, and he needed big cash to buy weapons, including chemical weapons willingly offered in return for petrodollars by the US, Europe and the Soviet Union.


Today, we have a real prospect of this Sunni-Shi’ite war coming back, in an ethnic conflict that would probably ripple round the entire Middle East region, thanks to “liberation” of the artificial country called Iraq. When the US Army finally quits Iraq, few give much life expectancy to the current ‘democratic’ regime put in place by the USA and UK. Oil and gas and petrochemical production and export infrastructures would be sure and certain ‘collateral damage’ in a regional, ethnic-fuelled civil war.


This future fear is reflected by current and rising fear of Iran among the Sunni minority leaderships of the GCC (Gulf Cooperation Council) countries. Their Shi’ite majorities are tuned in to Tehran news media and Iran’s fervent predicators. Iran is running out of sufficient oil to both satisfy domestic demand and maintain exports to pay for its food, refined oil products and raw materials imports for its urban populations, fast growing car fleet and growing industries. This is easily translated by GCC country leaderships as a threat by Iran to seize their own oil reserves, and petrodollar piles. Anxiety is high.


Whether the Sunni-Shi’ite war comes back or not, however, one thing that will never come back is Saudi oil production of nearly 12.5 Mbd.  Maybe 10.75 Mbd, maybe 11.25 Mbd for not too long, but then Saudi total output will fall, and fall, and fall. Saudi exports will fall even faster, because its own oil consumption is increasing at 7%-per-year, and ‘conserving oil for future generations’ is a new slogan to bandy round when Saudi rulers are asked why their national oil production isn't being hiked to new-and-marvelous highs. Saudis can conserve their oil reserves the way Brazil claims to conserve its Amazon rainforest — a nice claim, which one day might become reality, if at that future time there are any oil reserves or rainforest remaining to save. But brave and boastful words from Saudi rulers about “undepletable” oil reserves are just that: boasting. The acid test is can they deliver? The answer is no.





In the mid-1980s and into the 1990s, some while before China and India’s vertical takeoff industrial growth and urban development, and the stunning, explosive growth of first Chinese, and soon Indian, airplane and car fleets, world oil demand growth was rarely above 1.3%-per-year. This was believed by Old World media and public opinion to be a permanent situation. Bright-eyed journalists, economists, investor fund managers and politicians threw together flimsy theories to explain why permanent slow growth and permanent outsourcing and de-industrialization in the OECD countries were sure signs of economic progress on the high road to Universal Prosperity. Even more hilarious was their claim this was a ‘win-win situation’ where everybody gained, even the dirt-poor basic resource exporter countries of Africa, confronted with ever-shrinking export revenues, year after year in that long lost decade of Cheap Oil, from supplying their unattractive and outdated Sunset Commodities.


The European countries hunkered down best to the New Economy. They cranked up 10% or 15% permanent mass adult unemployment, and 25% for younger persons, in a permanently stagnant economy — and called this the squeaky-clean New Economy. Japan soon went into semi-permanent recession. Africa, thanks to enforced and grinding poverty, went into the Pan African civil war, and is only now slowly coming out of it. The Soviet Union crashed in 1989, yielding a very precious peace dividend for oil consumers in the shape of mass poverty and unemployment inside its borders, and rising oil and gas exports outside its borders — due only to a collapse of domestic demand. Today, Putin and Medvedev like to remind everybody this was a one-off situation that Russia wants revenge for — in the shape of high oil and gas prices and complete control on who gets the supplies.


What could be a nicer, better, and more stable way to manage the world economy?


The illusions of ‘permanent oversupply of oil’, and the ‘oil-lean de-materialized economy’, were soon melded into the cranky and incoherent theories of New Economy gurus and talking heads. These crackpot theories explain why the wealth gap and inequality just go on growing while the real economy stumbles along, the environment is systematically destroyed, and depletable non-renewable resources are treated as ‘infinitely abundant’ despite clear and stark evidence to the contrary. At the time, in the late 1980s and early 1990s, when these crackpot theories were being cobbled together, any talk of far-out things like Climate Change and Energy Transition was strictly for consenting adults in private. This was an official nirvana for right-thinking persons of the Old World! Oil and energy were “non-problems” in a cult atmosphere of smug indifference.



Paradigm Shift


This era of ‘stability’ is well behind us but with no surprise, because oil prices are nearing 150 USD/barrel, we are told by the OECD’s IEA and US EIA that world oil demand is finally responding to price elastic ‘laws’. From late 2008, the IEA claimed in July ’08, price elastic behavior of consumers would slash oil demand growth to about 0.9 Mbd (about 1.1%) for the year forward. We can forget about the 70 million new cars manufactured in the last 12 months, and the 55 million of them added to the world car fleet. We can also forget about 25% growth of business jets put into service, and hundreds of new container, tanker and bulk cargo ships added to the world’s marine transport fleets in the last 12 months.


What do buyers of these new cars, planes or ships do with them? Their first action is to fill up the tank. Unless there is radical compression of average utilisation, the growth of world transport fleets will itself add about 1.25 Mbd to world oil demand.


Arguments for ‘collapsing’ demand growth naturally include China and India, both claimed to be “capping” their oil demand growth, but how exactly this feat will be achieved is not explained. Thanks to economic stagnation returning in Europe and the US economy being in such a bad way that its new car output will be less than 15 million in 2008, oil demand growth is going to shrink so much that we might even have 100 USD/barrel oil back again, and that alone would be the next best thing to cheap oil!


We can unfortunately conclude that rare and recent honesty from the IEA on the subject of world oil discoveries, new production capacity, and extreme high costs and long lead times for finding and developing new oil and gas reserves make it necessary to lie about world oil demand growth. Public opinion — even the opinion of Teflon politicians — has been shaken up by reality. Rather a lot of people today know the underlying reason for oil output decline, and it is simple: depleting reserves. Finding some way to deny the logical sequel of this — exploding oil prices — becomes the most politically acceptable story in town.


We can therefore forecast a coming and big paradigm shift when reality makes it obligatory to do something about DSM — demand side management. Short-term demand changes due to price elasticity are exactly that: short-term. When or if oil prices fall, demand will bounce back. This does nothing except guarantee a repeat of 2007-2008 during which demand growth collided with inflexible, near zero growth of supply. The result was and is price explosion.


This cycle will repeat, but in a shorter timeframe. As we have already found that world natural gas supplies are far from infinitely extensible and LNG supply growth takes time and is high cost, the theoretically possible ‘Gas Bridge’ is another too little-too late non-solution. Even coal supplies, growing at about 6%pa, are limited by transport and port infrastructure expansion and their costs.


The real paradigm shift is therefore easy to define: use less oil, and soon this has to be joined by using less gas — and less coal in China and India as well as USA.



The Only Way Out: Use Less


The only real solution is planned, organised and constant energy demand compression in the rich world OECD countries, led by fast and continual shrinkage of oil demand, with natural gas and coal intensity reduction close behind. Restructuring the economy and society are the only ways to do that. The slogan ‘Negawatts not Megawatts’ says it all.


Renewables will have to grow very fast, or we will have a big and widening gap in supplies, and an even tighter schedule for bigger cuts in fossil energy consumption. Back-of-envelope calculations suggest that both conventional and new renewables, including hydropower, will have to be expanded to cover about 23 Mbd of oil equivalent, or over 25% of current total energy obtained from oil, within 20 years. If total energy demand goes on growing, and both the IEA and EIA continue to stubbornly forecast this will happen, the figure will be even higher and more impossible to achieve.


Without very fast adoption of structured, organised and funded plans for Energy Transition away from fossil fuels, first in the OECD countries then worldwide, the old North-South conflict and strife we were told was dissolved and defused by ‘win-win Globalization’ will come back in a big way. One big reason for this is poor people get an awful lot more out of a barrel than rich. A simple example is the fact that India and China, using about 8 and 6 times less oil per person than the OECD average (of 14.3 barrels/person/year in 2006), have little or no difficulty paying for their oil imports, despite their populations counting hundreds of millions of persons with revenues below 10 US dollars per week. Oil subsidies to the poor now take about 3.3% of India’s total GNP, and likely the same amount in China, this subsidy being heavily criticised by OECD economists as a ‘distortion’ that encourages oil consumption, raising prices for ‘energy efficient’ consumers in the OECD’s post-industrial societies.


The story line from these experts, and from government friendly NGOs is that the Emerging Economies, who export oil to the OECD countries in the form of oil-intensive industrial consumer goods and products, are claimed to be ‘energy inefficent’ and addicted to oil. Based on this faulty reasoning, rent-a-crowd ‘experts’ go on to urge that oil producers should cut their prices because “high oil prices hurt poor countries”. This in fact is not absolute: they also hurt the rich. Most OECD countries, in dramatic fashion the USA and many European countries, have massive national debts and large trade deficits. Paying more for their huge oil imports hurts them more than China or India, sitting proud on top of huge financial investment inflows and ever rising, massive foreign exchange reserves.


Whichever side wins in the race to outproduce its rivals and rack up the biggest trade surpluses, however, everybody loses when oil, gas and coal reserves run out. Long before that fatality, the so-called Great Powers will resort to the only thing they know when things get really tough: war for resource control, and resource denial to rivals. This is an endgame solution which we can avoid if Energy Transition becomes serious, structured and automatically funded.



The Last and Permanent Oil Shock


What we have is a no-win situation. Everybody will lose when oil supply fails to match demand, even without bungled regime change ‘experiments’, and much faster with them. How we break out of this easily forecast Final Oil Shock is critical for the whole planet. Any and all logic says we have to start a world energy transition plan, but nothing like the Kyoto Treaty.


That treaty has been transformed by slavish obedience to market-only mechanisms and processes into a finance sector plaything, where carbon credits are given artificially high values, which then collapse overnight leaving the last purchaser with a hot potato and big losses — until they get back in the circus and get new credits at low prices. The circus goes on, but fossil energy intensity, measured by average consumption per capita, does not change. Present ‘interpretation’ of the Kyoto Treaty is likely to achieve nothing in the way of cutting oil and gas intensity in the fossil energy addicted OECD countries, fast enough and deep enough.


In this case, if nothing happens to change attitudes and policies, we asked for it and we will get it. Media talking heads, to be sure, will continue telling you that high oil prices are only due to three things: cold or hot weather, geopolitical risk and strikes or accidents in producer countries and the industrial production process — and hedge fund speculators. These last, we can note, will talk up the price of their favorite share issue, or gold and sugar prices, in fact any old “real resource” but they must not talk up oil. When this fraternity of gamblers talked down oil prices, for a near decade in the 1990s, they suffered no media blame or politicial acrimony of any kind. But when they bid up oil prices this becomes a subject of major national interest, almost an affair of State! Above all, however, this circus of mirrors helps deflect public opinion from the real causes and real solutions.


Any and all talk of moving towards a really global, and multilateral plan for energy transition, with set and fixed goals for energy economic restructuring and worldwide, organized development of renewable energy, is still treated as off limits. If this remains the case, the ‘classic solution’ of Change By Crisis will be the final, de facto solution. We shall likely know within a few months which solution is chosen.



Copyright Andrew McKillop 2008