Kyoto, climate change, and the price of oil

Last weekend, UK prime minister Gordon Brown visited Jiddah to plead with oil producers to increase supplies. This would seem to be a very strange thing for a politician with the declared intention of leading a worldwide crusade against climate change to do.

For years now we have been told that our addiction to fossil fuels is causing global warming, and that the only way to avert catastrophe is to reduce fossil fuel consumption to below 1990 levels. What better incentive to do this than a steep rise in oil prices? Surely the prime minister should be celebrating not whingeing.

Governments all over the world have at least paid lip service to the Kyoto Protocol. They have stated and re-stated their intention to reduce demand for oil, by whatever ruthless means may be necessary. So how is it that we now have a shortfall in production that has caused oil prices to double in just six months? Falling demand should be driving prices down by now, or at least keeping them stable.

The reasons that the pundits are giving for the current spike in oil prices are many and various, usually a sign that no one really knows the answer. Increased demand from the emerging economies is certainly a factor, but the growth in these economies has been long foretold. Why have oil industry strategists not seized on the opportunities in these new markets and implemented plans to increase production in response?

Political instability is also blamed, but again, this is not really a new feature of the oil market. Wars and rumours of wars have influenced oil production for decades. Iraq is now producing roughly the same amount of oil as before the war. Although Nigeria has problems in the delta and Venezuela is unstable, vast new fields have come on stream in other parts of South America and Russia.

Speculators too have been blamed for our present misery, and there can be little doubt that when traders in the futures markets see supply lagging behind demand, they know exactly what to do. But speculative buying in the hope of even higher prices points to a temporary spike, not a long-term escalation, and this should be ameliorated if oil production catches up with demand.

There have also been suggestions that reserves of oil are running out, and production is being limited by availability; more about this later.

So what did Gordon Brown tell the oil producers who assembled in Jiddah on Sunday? Here is what he BBC World this Weekend news programme reported:

He is calling for more investment by oil supplying countries to increase their production capacity. He also wants to limit the world’s dependence on oil in the future with more investment in alternative sources of energy, such as nuclear, solar and wind power.

“I urge oil producers to rigorously break down old barriers standing in the way of new strategic investments.” Gordon Brown

From BBC Radio4, The World this Weekend, 22/06/2008

As this has all the hallmarks of a quotation from a Downing Street press release, there is little reason to doubt that it is an accurate description of the prime minister’s position. Or perhaps it would be more accurate to say ‘positions’, as there is a quite remarkable contradiction here. He is simultaneously asking producers to commit long term capital investments to increasing the supply of oil, while at the same time saying that he will be working overtime to make sure that demand does not increase, but that in fact it will be reduced.

You would have to be a pretty stupid oil producer to go along with a plan like that.

Here is some more from the BBC’s report that suggest that Gordon Brown’s pitch for increased production was less than warmly received in Jiddah:

Initially the plan was for the PM and his entourage to leave Heathrow early, sometime yesterday. In actual fact the prime ministerial plane did not end up leaving until the early hours of Sunday morning. And since we’ve been here, the time that he is destined to leave has been pulled back too. Now I understand that although no meetings have been cancelled, some of the meetings that Downing Street was hoping to set up behind closed doors have not materialised.

From BBC Radio4, The World this Weekend, 22/06/2008

Apparently there were more people who Gordon Brown wanted to speak to than there were people who wanted to speak to him.

What has emerged from the meeting is that we are dealing with a supply-side problem; all will be well if only the oil industry will invest more in production. So is it possible that the oil producers could increase supplies if they wanted to, or are we just running out of oil? This is what an expert on the industry has to say:

Presenter: Well at least some of the uncertainty contributing to the high price of oil is about how much of it there is. There are figures available for the size of the world’s oil reserves, although Mr Brown told the summit today that he wanted more of that information made public. And according to Richard Pike, chief executive of Royal Society of Chemistry, who has thirty years experience in the industry under his belt, these are probably an under-estimate. . [Although Pike is an old oil industry hand, his public utterances suggest that he is certainly not a global warming sceptic]

Pike: Reserves have a very specific definition within the oil industry. It’s that oil which is known, recoverable and economic under prevailing conditions. But within that definition of reserves there is another very important definition, which is proven reserves. And proven reserves represent that quantity of oil that is judged to have a 90% chance of being exceeded. And therefor it is almost the, –I would call it the dead cert figure – what will actually be produced is, is, [sic] considerably more. If you ask what total in the world has a 90% chance of being exceeded, the figure is not the 1.2 trillion barrels that we often hear about but something like double that. And so there’s a lot of debate right now, about how best to represent the global figures.

Presenter: How important is the distinction between the oil that may be available and the extraction of that oil?

Pike: It is a very important distinction. Right now the constraint tends to be the number of wells and the facilities rather than how much oil there is available. In fact probably the best analogy is to say, if you had an enormous tank of oil and just one tap, it would be the tap that was the constraint. As you begin to put more taps on you, you, [sic] begin to understand what the constraints are under ground, or in the tank in this analogy. And right now I would say that we are at the position where we don’t have enough taps.

From BBC Radio4, The World this Weekend, 22/06/2008

New oil wells do not come cheap, nor can they be brought into production at the drop of a hat. They are the result of strategic planning and investment that begins with exploration, continues with assessment of reserves, then culminates with the provision of extraction facilities and the storage and distribution network required to get the product to market. To embark on this kind of long-term investment, producers must be convinced that future demand will justify their expenditure.

For nearly a decade now, world leaders have been pleading for a reduction in our consumption of oil. Their exhortations reached a crescendo just a year ago when the Intergovernmental Panel on Climate Change (IPCC) published its Fourth Assessment Report. But in spite of all the pious words, demand for oil has soared.

World commodity markets are fragile creatures, and sentiment has at least as powerful an influence on them as fundamentals. They can be talked up to unjustifiable levels, or prices can crumble on the strength of rumours, without much reference to what is actually happening in the real world. Sentiment, either in the form of unwarranted optimism or unjustified pessimism, can lead to massive fluctuations in price. And at all times, the traders whose activities determine what we pay for commodities, are buying or selling on the basis of what they think will happen days, weeks or months ahead.

For oil industry strategists the timescale is far longer. They are trying to anticipate market trends five years, ten years or even further into the future. Although the returns for investing successfully can be enormous, so are the costs of bringing new oil fields into production or increasing the capacity of existing ones. They must be very sure that demand for their product will hold up in the long term.

It is unreasonable to expect that talking down the fossil fuels for a decade can pass without having any effect on market sentiment. Why should oil producers be expected to invest in increasing supplies when governments worldwide are telling them that they will introduce draconian measures to cut consumption?

Political instability, speculation and a surge in demand may all have played some part in the present rise in oil prices, but at the heart of the problem is a loss of confidence in oil as a commodity, and this has not been caused by normal market forces. The Kyoto Protocol, alarming predictions from the IPCC, and a worldwide campaign to convince everyone that using fossil fuels is morally and ethically unacceptable were never likely to bolster confidence in the oil industry. Now we are paying the price.

Update 04/07/2008. There is an interesting article here that takes much the same line on this topic, and by coincidence it was published on the same day. Professor Deming deals specifically with the way in which environmentalism has restricted oil production in the USA and adds some interesting context about the availability of supplies over the next few centuries.