The BP Energy Outlook – the annual global bible for the energy industry – is due to be published on 20 Feb 2018.
But in this preview, BP chief economist SPENCER DALE and BASSAM FATTOUH, director of the Oxford Institute for Energy Studies, argue that reports of ‘peak oil’ are still too premature because of the real crude oil price trilemma, which comprises:
- The geo-political cost of competition from renewable energy to drive battery-powered vehicles (BPVs)
- The cost of physical production and – crucially
- The fiscal cost of domestic state subsidies in OPEC member nations
These factors now combine to postpone the date of peak-oil: Indeed, the world may not ever actually ‘run out’ of oil with vast reserves left unexplored – just like Britain’s huge remaining coal deposits.
Global oil markets are changing dramatically, and the advent of electric vehicles and the growing pressures to decarbonise the transportation sector means that oil is facing significant competition for the first time within its core source of demand.
This has led to considerable focus within the industry and amongst commentators on the prospects for peak oil demand – the recognition that the combined forces of improving efficiency and building pressure to reduce carbon emissions and improve urban air quality is likely to cause oil demand to stop increasing after over 150 years of almost uninterrupted growth.
At the same time, the supply side of the oil market is experiencing its own revolution.
The advent of US tight oil has fundamentally altered the behaviour of oil markets, introducing a new and flexible source of competitive oil.
More generally, the application of new technologies, especially digitalisation in all its various guises, has the potential to unlock huge new reserves of oil over the next 20 to 30 years.
The prospect of peak oil demand, combined with increasingly plentiful supplies of oil, has led many commentators to conclude that oil prices are likely to decline inextricably over time.
If the demand for oil is drying up and the world is awash with oil, why should oil prices be significantly higher than the cost of extracting the marginal barrel? The days of rationing and scarcity premiums must surely be numbered?
These developments are important. Growth in oil demand is likely to slow gradually and eventually peak. And plentiful supplies of oil are likely to alter fundamentally the behaviour of oil producing economies.
However, this paper argues the current focus on the changing nature of the oil market is largely misplaced.
Much of the popular debate is centred around when oil demand is likely to peak. A cottage industry of oil executives and industry experts has developed trading guesses of when oil demand will peak: 2025, 2035, 2040?1 This focus on dating the peak in oil demand seems misguided for at least two reasons.
First, no one knows: the range of uncertainty is huge. Small changes in assumptions about the myriad factors determining oil demand, such as GDP growth or the rate of improvement in vehicle efficiency, can generate very different paths.
Second, and more importantly, this focus on the expected timing of the peak attaches significance to this point as if once oil stops growing it is likely to trigger a sharp discontinuity in behaviour: oil consumption will start declining dramatically or investment in new oil production will come to an abrupt halt.
But this seems very unlikely.
Even after oil demand has peaked, the world is likely to consume substantial quantities of oil for many years to come. The comparative advantages of oil as an energy source, particularly its energy density when used in the transport system, means it is unlikely to be materially displaced for many decades.
And the natural decline in existing oil production means that significant amounts of investment in new oil production is likely to be required for the foreseeable future.
The date at which oil demand is likely to peak is highly uncertain and not particularly interesting.
Rather, the importance of ‘peak oil demand’ is that it signals a break from the paradigm that has dominated oil markets over the past few decades.
In the past, any mention of peak oil would have been interpreted as a reference to peak oil ‘supply’: the belief that there was a limited supply of oil and that as oil became increasing scarce, its price would tend to rise.
This basic belief has had an important influence on oil markets since the 1970s and before.
Oil producing countries rationed their oil supplies safe in the belief that if they didn’t produce a barrel of oil today they could produce it tomorrow, potentially at a higher price. Oil companies spent huge sums of money exploring and securing oil resources that were expected to become increasingly harder and more expensive to find.
Peak oil demand signals a break from a past dominated by concerns about adequacy of supply.
A shift in paradigm: from an age of scarcity (or, more accurately, ‘perceived’ scarcity) to an age of abundance, with potentially profound implications for global oil markets as they become increasingly competitive, and for major oil producing countries as they reform and adjust their economies for an age in which they can no longer rely on oil revenues for the indefinite future.
One key implication of this paradigm shift is its impact on long-run price trends. The move to oil abundance is indeed likely to herald a more competitive market environment.
But the assumption that oil prices will be determined simply by the cost of extracting the marginal barrel of oil risks ignoring an important aspect of global oil production.
Many of the world’s major oil producing economies, with some of the largest proven reserves, rely very heavily on oil revenues to finance other aspects of their economies.
The current structure of these economies would be unsustainable if oil prices were to fall close to the cost of production.
Many oil producing sovereign states would be forced to run large and persistent fiscal deficits or to cut back sharply on social provisions, which, in turn, would likely have knock on implications for global oil production and prices.
As such, the pace and extent of that reform process is likely to have an important bearing on oil prices over the next 20 or 30 years. It is not enough simply to consider the marginal cost of extraction, developments in these “social costs” of production are also likely to have an important bearing on oil prices over the foreseeable future.
There is wide range of estimates of the point at which oil demand is likely to peak.
Some projections suggest global oil demand could peak soon after 2025, others expect demand to continue to grow out to 2040 and beyond.
Indeed, different projections from the same organisation can point to quite different estimates depending on the assumptions used.
For example, the IEA’s Sustainable Development scenario, which is predicated on a sharp tightening in climate policies, suggests oil demand may peak in the mid-2020s, whereas its “New Policies” scenario, which envisages a less sharp break in environmental policies, points to demand continuing to grow in 2040.
A comparison of BP’s “Even Faster Transition” case with its base case points to a similar difference3. BP’s Energy Outlook also highlights how relatively small differences in assumptions about GDP growth or improvements in vehicle efficiency can radically shift the likely timing of the peak in demand.
The point here is that any estimate of when oil demand will peak is highly dependent on the assumptions underpinning it: slight differences in those assumptions can lead to very different estimates.
Over the past 35 years or so, for every barrel of oil consumed, two have been added to estimates of Proved Oil Reserves7.
In its recent Outlook8, BP estimated that based on known oil resources and using only today’s technology, enough oil could be produced to meet the world’s entire demand for oil out to 2050, more than twice over! And future oil discoveries and improvements in technology are likely to only increase that abundance.
The world isn’t going to run out of oil. Rather, it seems increasingly likely that significant amounts of recoverable oil will never be extracted.
The recognition that there is an abundance of oil is likely to trigger profound changes in global oil markets and the behaviour of oil producing economies, although the pace at which these changes take hold is a key source of uncertainty.
Most fundamentally, it is likely to cause global oil markets to become increasingly competitive. Over the past few decades – during the age of (perceived) scarcity – the oil market hasn’t behaved like a normal market. In particular, high-cost producers have been able to exist and compete alongside low-cost producers, even though high-cost oil is many times more expensive to produce. The laws of competitive markets, in which high-cost producers are driven out of the market, haven’t applied.
The reason is because owners of large, low-cost resources have until now effectively rationed their supplies of oil: rather than using their competitive advantage to maximise market share, they have preserved their resources for the future.
This made sense during the age of scarcity, since concerns about peak supply suggested the value of these oil resources was likely to increase over time. Moreover, rationing supplies in this way provided a clear and transparent way of managing a country’s oil such that it was distributed fairly across future generations. A high reserves-to-production ratio – implying a country could continue producing oil at the same rate for 80, 90, 100+ years – was a sign of both strength and intergenerational fairness.
But the shift to an age of abundance changes all that.
Faced with the possibility that significant amounts of recoverable oil may never be extracted, low-cost producers have a strong incentive to use their comparative advantage to squeeze out high-cost producers and gain market share – just as with any other competitive market.
Moreover, if some oil may never be extracted, a high reserves-to-production ratio is no longer such a sign of strength: Better to have money in the bank than oil in the ground.
This suggests that the oil market is likely to become increasingly competitive over time as producers fight for market share.
Beware soothsayers who profess to know when oil demand will peak.
Group chief economist, BP
Director of The Oxford Institute for Energy Studies
22 Jan 2018