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Why Oil and Gas Prices Are So High: Don't Blame OPEC

Tigh Supplies, Politics, Speculation, But Not Arabs Causing High Oil Prices

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Economist's drowning in oil cover

Those were the days before high oil prices: The Economist's Drowning in oil cover of March 6, 1999.

Updated June 13, 2008

Oil prices are so high for many reasons — some rational, some not. Once thing is certain this time: Neither OPEC countries countries in general nor oil-producing Persian Gulf countries in particular are to blame for the high oil prices this time--what can now legitimately be called the Third Oil Shock.

The first oil shock, in 1973, was provoked by the third Arab-Israeli war . OPEC countries, protesting American support for Israel, turned off the oil spigot in their first and last use of oil as a weapon. The second oil shock, beginning in 1978, was provoked by the fall of the Shah of Iran and the ensuing Iranian Revolution. Iran was the second-biggest oil producer at the time. In December 1978, it ceased oil production. Saudi Arabia and other OPEC producers couldn’t pump enough oil to make up for the entire shortage. Prices rocketed up, and went up further when Iraq invaded Iran in 1981.

As always, prices had gone up so high that they had to come down, if not crash: by 1983 oil production had recovered around the world, so much so that it provoked an oil glut. It’s not unheard of for oil-producing countries to unilaterally cut the price of oil. OPEC did it in March 1983, slashing the price by 15% (from $34 to $29 a barrel). It did so to keep the price from tumbling further, as the huge run-up in prices of 1979-81 had forced consumers to conserve and the American recession of 1981-82 had reduced demand further. But in late 1985, the price of oil collapsed anyway, with some oil coming out of the Persian Gulf selling for as little as $6 a barrel.

Prices would not shoot up again until 1990, when Iraq invaded Kuwait, and only briefly, as Operation desert Storm , the American-led counter-offensive against Iraq, freed Kuwait and led to a resumption of oil production in both countries. Prices collapsed again as the world was awash in oil, with barrels selling for as little as $10.

And that happy period ended as the 1990s ended. In 1998, when prices, adjusted for inflation, had fallen to a 25-year low, The New York Times was sounding alarm bells : “Twenty-five years after an oil embargo proved that fuel supplies were neither reliable nor endlessly cheap, the United States has given up almost all the gains it made in conserving energy. On average, Americans have returned to consuming nearly as much energy as ever before.” In 2002, the average fuel economy for America’s cars and trucks fell to a 22-year low, according to the Environmental Protection Agency.

That begins to answer the question of who, or what, is to blame for this third oil shock. Here are the other reasons:

  • Soaring demand, especially from developing nations such as China and India. In 1986, China consumed 2 million barrels of oil per day (com pared with about 16 million barrels per day in the United States at the time.) By 2006, China was consuming more than 7.4 million barrels per day, according to the U.S. Energy Information Administration , and rising. In April 2008, China Daily reported that China’s oil consumption had jumped another 2.5% over a year earlier.

    In India, oil consumption has risen from just over 1 million barrels per day in 1990 to 2.63 million barrels per day today. And let’s not forget the United States, which consumes more than a quarter of the world’s combined energy products. Energy demand is growing there, too, despite an economic slowdown in 2008, to 20.63 million barrels of oil per day in April 2008, compared with 19.6 million barrels per day in 2000.

    Worldwide, year-to-year demand for oil has increased by over 1 million barrels per day on average every year since 1991. The increase was especially steep in 1999 (when demand increased by 1.7 million barrels) 2004 (2.6 million) and 2007 (1.7 million).

  • Dwindling spare oil-production capacity among producing nations. It used to be that whe n oil markets got tight, either because of economic or political reasons, big oil-producing nations like Saudi Arabia, Russia, Iraq and even the United States could pump more oil to stabilize supplies.

    No longer. On average, the world’s spare oil-production capacity was just under 3 million barrels of oil per day in the 1990s. It peaked at near 6 million barrels in 2002. But it has plummeted since then to 1.5 million barrels of oil per day or less. That’s almost insignificant in real terms. Excess capacity that small can be wiped out by a sudden, minor political crisis—and has been, as in May 2004, when terrorist on oil facilities in Saudi Arabia and Iraq drove the price of oil to $40 a barrel. The price hasn’t stopped rising. The partial closing of a BP Alaskan oil field in 2006 also caused a price spike.

    Saudi oil officials were claiming just a few years ago that they could pump as much as 15 million barrels per day. But that’s a myth. For the last several years, Saudi Arabia's capacity to pump oil has been stuck between 10 and 11 million barrels a day.

    A little help is on the way. In 2009, Saudi Arabia will be able to add an additional 1.2 million barrels a day to world supplies, thanks to the development of the giant Khurais oil field, a 1,116-square mile field almost as large as Rhode Island in the east-central part of the country. That’s good news—for a while. The Khurais oil field is Saudi Arabia’s last of the giant-producing fields it can develop. There is one other big field it will develop, the so-called Manifa field off-shore in the Persian Gulf, but oil there is much harder to reach and will be more expensive to produce.

    Evidence of the sort led the Paris-based International Energy Agency in spring 2008 to project an oil-supply crunch by 2015. The agency, surveying the world’s 400 biggest oil fields, says oil producers are planning on extra capacity of 25 million barrels a day. But the world will be demanding 37.5 million barrels in extra capacity (on top of the 87 million barrels a day the world consumes in 2008).

    In short, the days of great oil discoveries are over. Which brings us to the next trigger of higher oil prices.

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