A rational reason for high oil prices

“There is no rational reason for high oil prices,” writes Ali Naimi, Saudi Arabian Minister of Petroleum and Mineral Resources, in today’s Financial Times. Well, I can think of one– if oil prices were lower, the world would want to consume more than is currently being produced.

The graph below plots total world oil production over the last decade. After growing rapidly in earlier years, production hit a bumpy plateau. In November 2007, just before the U.S. recession began, the world was producing 84.9 million barrels each day, a little less than was produced in the spring of 2005. Although production stagnated, the demand curve continued to shift out, with world GDP growing 5.3% in 2006 and another 5.4% in 2007.
Consumption of petroleum by China alone
was 800,000 barrels/day higher in 2007 than it had been in 2005, meaning the rest of the world had to decrease consumption over this period.

Global oil production, thousands of barrels per day, monthly, Jan 1994 to Dec 2011. Includes lease condensate, natural gas plant liquids, other liquids, and refinery processing gain. Data source: EIA.

Growth in oil production resumed after the recession, with world oil production up 2.8% in 2010 over 2009. But world GDP grew 5.1% that year, suggesting demand was once again growing faster than supply. And oil production hit a new snag in 2011, primarily due to disruptions in Libya.

Libyan oil production, thousands of barrels per day, monthly, Jan 1994 to Dec 2011. Includes lease condensate, natural gas plant liquids, other liquids, and refinery processing gain. Data source: EIA.

The data for the above graph only go through December. Production from Libya has increased since then, with some observers anticipating production will be back to 1.4 million b/d by April. But offsetting those gains of the last few months have been shutdowns in places such as Sudan, Syria, and Yemen, which 3 countries had accounted for 1.1 million b/d of production in February of last year.

And Iran’s 4 million b/d is a bigger deal than all of those put together. Petrologistics estimates that boycott efforts have succeeded in reducing Iranian oil exports by 300,000 b/d. Whether that turns out to be the end of the story on curtailment of Iranian shipments, or is only the beginning, remains to be seen.

How much would we have expected the growth in world GDP over the last decade to have increased the quantity of oil demanded if buyers had not faced any increase in price? The answer to this question could be calculated if we knew the income elasticity of demand, which measures the percentage increase in demand that results from a 1% increase in income. A study by NYU Professor Dermot Gately and Stanford Professor Hillard Huntington in 2001 concluded that for 25 OECD countries over 1971-1997, the average income elasticity was 0.55. But for emerging economies and the oil-exporting countries (which are responsible for most of the growth in global GDP over the last decade), the income elasticity is closer to 1.1-1.2.

In the graph below, I plot annual world oil production in blue along with an estimate in red of what demand would have been if the oil price had not risen over the last decade and if one assumes a world income elasticity of 0.75. The reason the actual quantity consumed today is around the blue line rather than the red is because the price today is not the same as it was in 2002.

Blue line: total world oil production, millions of barrels per day, annually, 2002 to 2011. Red line:
global oil production in 2002 times (yt/y2002)0.75 where yt denotes global world GDP in year t as reported by IMF. 2011 world GDP growth estimated at 3.9%.

The question is not whether there is a rational reason for high oil prices, but rather whether there is a rational reason the world is not producing 100 million b/d today. And if anyone knows the answer to that question, it should be Saudi Oil Minister Ali Naimi.

22 thoughts on “A rational reason for high oil prices

  1. Jeffrey J. Brown

    Perhaps oil prices could be rising because of a declining supply of net oil exports?
    I estimate that 2011 Saudi net oil exports (BP data base, total petroleum liquids) will be between 1.0 and 1.6 mbpd below their 2005 net export rate of 9.1 mbpd, or between 7.5 mbpd and 8.1 mbpd in 2011. The following chart shows a midpoint estimate of 7.8 mbpd for 2011 Saudi Net Oil Exports (in dark blue).
    Note that Saudi Arabia showed a very sharp increase in net exports from 2002 to 2005, as global crude oil prices doubled from $25 in 2002 to $55 in 2005. You can see what happened, starting in 2006, as global crude oil prices doubled again, from $55 in 2005 to $111 in 2011:
    While the Saudi net export decline could be mostly voluntary, a simpler explanation is that Peaks Happen, even in Saudi Arabia.
    In response to the first crude oil price price doubling, we did of course see a substantial increase across the board in total liquids production (inclusive of biofuels), in total petroleum liquids, in crude + condensate (C+C), and in Global Net Exports (GNE) and in Available Net Exports (ANE). GNE and ANE numbers are calculated in terms of total petroleum liquids. ANE are defined as GNE less China and India’s combined net oil imports.
    In response to the second Brent crude oil price doubling (2005 to 2011), we have so far seen a very slow rate of increase in total liquids production (up 0.5%/year from 2005 to 2010), virtually flat total petroleum liquids and virtually flat C+C production (through 2010), and a 1.3%/year and 2.8%/year respective decline rate in GNE & ANE (through 2010).
    GNE fell from 46 mbpd (million barrels per day) in 2005 to 43 mbpd in 2010, while ANE fell from 40 mbpd in 2005 to 35 mbpd in 2010. (Top 33 net oil exporters in 2005, BP + Minor EIA data, Total Petroleum Liquids.)
    Five annual “Gap” charts follow, showing the gaps between where we would have been at the 2002 to 2005 rates of increase, versus the actual data in 2010 (common vertical scale):
    EIA Total Liquids (including biofuels):
    BP Total Petroleum Liquids:
    EIA Crude + Condensate:
    Global Net Oil Exports (GNE, BP & Minor EIA data, Total Petroleum Liquids):
    Available Net Exports (GNE less Chindia’s net imports):
    I would particularly note the divergence between the first chart, Total Liquids, and the last chart, Available Net Exports (ANE).
    I estimate that there are about 157 net oil importing countries in the world. If we extrapolate the Chindia region’s rate of increase in their combined net oil imports, as a percentage of GNE in 17 years, around 2029, just two of these oil importing countries–China & India–would consume 100% of Global Net Exports of oil.

  2. Jeffrey J. Brown

    Saudi Oil Minister in April, 2004:
    Saudi Oil Is Secure and Plentiful, Say Officials
    … “Saudi Arabia now has 1.2 trillion barrels of estimated reserve. This estimate is very conservative. Our analysis gives us reason to be very optimistic. We are continuing to discover new resources, and we are using new technologies to extract even more oil from existing reserves,” [Saudi Minister of Petroleum and Mineral Resources Ali Al-Naimi] said.
    Naimi said Saudi Arabia is committed to sustaining the average price of $25 per barrel set by the Organization of the Petroleum Exporting Countries. He said prices should never increase to more than $28 or drop under $22. “This is a fair price to consumers and producers. But, really, Saudi Arabia and OPEC has limited control on world markets,” said Al-Naimi. “Prices are driven by other factors: Instability in key oil producing countries; industry struggles to produce specialized gasoline; and the resulting strains on refineries to meet local demand.”
    … “Saudi Arabia’s vast oil reserves are certainly there,” Naimi added. “None of these reserves requires advanced recovery techniques. We have more than sufficient reserves to increase output. If required, we can increase output from 10.5 million barrels a day to 12-15 million barrels a day. And we can sustain this increased output for 50 years or more. There will be no shortage of oil for the next 50 years. Perhaps much longer.”

  3. 2slugbaits

    Jeffrey J. Brown And we can sustain this increased output for 50 years or more. There will be no shortage of oil for the next 50 years. Perhaps much longer.”
    Good catch. So back in 2004 was the Saudi oil minister whistling past the graveyard or lying through his teeth?

  4. TA

    Interesting — working from your graph and 2002 prices, we had to multiply 2002 crude prices by five times in nominal dollars to pull consumption 13% below expected. I’ve wondered how inelastic crude demand is; that’s pretty inelastic.

  5. aaron

    Unless someone is using massive amounts of cash and debt to buy oil to make products to be sold at a loss, or consumers are racking up massive amounts of debt…

  6. aaron

    Shouldn’t uncertainty only raise prices to the extent that reserves are increased?
    Uncertainty should only raise prices as reserves are increased and prices should return to normal as storage capacity is filled. And manufactures increase production of oil products (plastics, rubber, chemical, etc.) can increase their production and inventories in anticipation of disruption.

  7. mike mccracken

    Every time I read an oil post here at econbrowser I wonder what Lutz’s handle is. Is it 2slugbaits? Probably not, he/she is a big10 fan and germans don’t care about basketball.
    All jesting aside, I love the oil posts. Thanks for all the work.

  8. aaron

    The FT piece suggests that SA is keeping oil prices this high intentionally, which is only natural and their right if true. Lack of competition is what would allow this.
    Are we living in Paul Krugman’s world? Is all that’s needed to bring production up and prices down to demonstrate our seriousness of bringing our own production online?
    If we focus on alternative fuel R&D rather than scaling up current, uneconomical processes. If we announce that alternative energy will drive the price of oil down. If we announce that we believe oil prices are as high as they will ever be and therefore we must bring production online as quickly as possibly. If. Will we shift back to a more prosperous equilibrium?

  9. Miiockm

    It’s impossible for the world to consume more than what is produced. If there was more demand and supply was scarce the price would just go back up.

  10. Steven Kopits

    Well, this post more or less sums it up, I would say.
    I’ll still take 2012 in the office pool for peak petroleum liquids production. I’ll have an article explaining why on this at some point.

  11. Mark

    You write that the red line in the last chart shows hypothetical demand adjusted for $20-30 oil (2002 nominal prices)but wouldn’t growth itself have been far more robust? And wouldn’t this more robust growth have driven even higher oil consumption? Is there a way to model that result? I think that oil production levels are now acting as a major limiting factor on the global economy as forecast in LTG.

  12. ppcm

    The IEA statistical report March 2011 shows evidence,there is no shortage of oil supply (see Econbrowser Strategic Petroleum Reserve to the rescue) the resolution of prices increases is trough prices,paradoxical it is.
    Let us visit the reverse relationship prices volume,and loss of fiscal revenues due to commodity price movements 2008 2009 (cf IMF report The State of Public Finances,Outlook and Medium-Term policies after 2008 Crisis). Page 13 exhibits the loss of fiscal revenue, oil and mineral production dependent countries.The KSA appears in 2009 as the most vulnerable of all mineral resources dependent -26.9% loss of fiscal revenues.At contrario,the K.S.A should be the largest beneficiary on the oil prices upside.Where are the surplus incomes and revenues invested is not apparent from the TIC report or its European non existent report.As always China,Japan,UK and Cayman islands are steady investors in US securities.
    Nymex open futures contracts for may 2012, oil light and sweet is showing a constructive chart and contributing volume,still would not spend much real assets and would believe in the futures.

  13. fladem

    The problem with every discussion I read about oil is that I have never been confident that anyone really knows what SA’s intentions are, and what they actually know about the extent of their reserves. This puts an enormous unknown into any equation.
    Rich Hilt is dead right: I rarely see any attempt to determine what the marginal cost of production actually is.

  14. Jeffrey J. Brown

    Indonesia once was as Saudi Arabia is now. Before too long, will Saudi Arabia be as Indonesia is now?
    I estimate that 2011 Saudi net oil exports will be between 1.0 and 1.6 mbpd below their 2005 annual net export rate of 9.1 mbpd (total petroleum liquids, BP).
    Using the lower estimate of 2011 net exports, 7.5 mbpd, and projecting their rate of increase in their ratio of domestic petroleum consumption (C) to domestic petroleum production (P) suggested that Saudi Arabia would approach zero net oil exports in about 16 years, around 2027. Using the higher estimate of 2011 net exports, 8.1 mbpd, Saudi Arabia would approach zero net oil exports in about 19 years, around 2030 (in both cases extrapolating the 2005 to estimated 2011 rate of increase in the ratio (C/P) of Saudi consumption to production of total petroleum liquids).
    At the 2005 to 2010 rate of change in the C/P ratio, Saudi Arabia would have approached zero net oil exports by the end of 2024. So, the slope of the projected Saudi net export decline has changed slightly.
    Note that the 100% C/P point marks the demarcation line between net exporter status (below 100%) and net importer status (above 100%).
    A rough rule of thumb* suggests that the Saudis would have shipped half of their post-2005 Cumulative Net Exports (CNE) by the end of 2012, based on the 2010 estimate, and they will have shipped half of their post-2005 CNE by the end of 2014, based on the most optimistic 2011 estimate.
    Consider another founding member of OPEC. It would appear that Indonesia’s final production peak was in 1991, at 1.67 mbpd (Total Petroleum Liquids, BP). Note that their Consumption to Production Ratio (C/P) increased from 42% in 1991 to 52% in 1994. If we extrapolate this rate of increase, they would hit the 100% mark in 2003.
    The actual data for Indonesia show a C/P ratio of 94% in 2002 and 105% in 2003.
    Saudi Arabia has shown a two year C/P plateau of about 28%, versus 18% in 2005. So, the next two or three years will be interesting. Does their C/P ratio stay about the same, decline or increase? Of course, a simple model, and our case histories (UK, Indonesia, Egypt) show that an initial increase in their respective C/P ratios forecasted their respective arrivals at zero net oil exports. But there are of course counterexamples, frequently related to political unrest, e.g., Colombia.
    However, the larger the group of exporters showing an overall increasing C/P ratio, the more likely it is that the increasing C/P trend line is forecasting all of the unpleasant things that “Net Export Math” implies, especially an accelerating rate of decline in net oil exports. So, it could be argued that while the Saudi increase in their C/P ratio from 18% in 2005 to about 28% in 2011 is very worrisome, what is of far greater concern is what our study showed–that the top 33 net oil exporters’ oveall C/P ratio increased from 27% in 2005 to 31% in 2010.
    For more info, you can do a Google Search for: Peak Oil Versus Peak Exports.
    *Half of post-peak CNE tend to be shipped about one third of the way into a net export decline. In other words, relatively high initial post-peak net export volumes are disguising a very high post-peak depletion rate, the depletion rate being the rate at which post-2005 CNE are being shipped. Based on the most optimistic 2011 estimate for Saudi net exports, I estimate that the 2005 to 2011 post-2005 CNE depletion rate for Saudi Arabia is about 8%/year.

  15. Jeffrey J. Brown

    Re: ppcm
    “No shortage of oil supply”
    This is correct. Rising oil prices have kept demand in balance with a declining supply of Global Net Exports of oil (GNE).
    As global oil prices doubled from $55 in 2005 to $111 in 2011, oil consumption in most developed oil importing countries, e.g., the US, fell, while consumption in many developing countries, especially the Chindia region, increased.
    At the 2005 to 2010 rate of increase in the Chindia region’s combined net oil imports as a percentage of GNE, the Chindia region alone would consume 100% of Global Net Exports of oil in 17 years, around 2029.

  16. Jeffrey J. Brown

    Re: fladem
    Re: “SA’s intentions”
    What we do know is that BP data base shows that Saudi net oil exports rose from 7.3 mbpd in 2002 to 9.1 mbpd in 2005, as global annual oil prices doubled from $25 to $55. In early 2004, the Saudi oil minister stated that “Prices should never increase to more than $28 or drop under $22.”
    As annual global oil prices doubled again from $55 in 2005 to $111 2011, and using a 2011 net export estimate of about 7.8 mbpd, the average Saudi net export rate for 2006 to 2011 inclusive would be 8.0 mbpd, versus 9.1 mbpd in 2005.
    At the 2002 to 2005 rate of increase in Saudi net oil exports, in 2011 Saudi Arabia would have been (net) exporting about 14 mbpd, versus an actual estimate of about 7.8 mbpd in 2011 (and 7.2 mbpd in 2010)
    I’ve used the following analogy before. If you were just run over by an 18 wheeler, does it matter to you whether or not the driver was aiming for you? Regardless of intent, the Saudis have gone from a historical pattern of increasing their net exports in response to rising oil prices to a pattern of declining net exports in response to generally rising oil prices.
    As they say, frequently the simplest explanations are the best, to-wit, Peaks Happen.
    As noted elsewhere, it’s difficult to say with certainty what one country will do, but when we sum the output of the top 33 net oil exporters, I think that the pattern is pretty clear.

  17. eric

    @JH: “The reason the actual quantity consumed today is around the blue line rather than the red is because the price today is not the same as it was in 2002.”
    Or vice versa.

  18. Gary Vonderhaar, G4i Partners

    Why oh why is natural gas near an all time low and oil an all time high, both are not sustainable?
    I realize it is supply and demand, but is it just the case that the oil supplying states are making hay while the sun shines? Be honest would WE be any different???

  19. Steven Kopits

    Well, this post more or less sums it up, I would say.
    I’ll still take 2012 in the office pool for peak petroleum liquids production. I’ll have an article explaining why on this at some point.

  20. benamery21

    The world driving the price up by demanding more oil rather than substituting or conserving at lower net cost isn’t actually rational, unless there is an expectation of dramatically lower future prices.

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