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Recently, IMF released a fine econometric study of oil production and prices. It examines both the peak oil view (which is mainly based on geology and projects a decline of global oil production in the near-term future) and the ‘economic’ view where price forces lead to substitution and increased production. It agrees with the geological view that, since 2003 geology has played a major role with global oil production maintaining a plateau without achieving the long-term historical growth rate of 1,5-2%. Coupled with a large increase of oil demand, especially from Chindia and a gradual drop in spare capacity oil prices sky-rocketed and had a serious role in pushing the world into the Great Recession.

It seems that the world oil production and economy has a ‘response function’ to high oil prices, mobilizing spare capacity and new oil fields (in the medium-term) and substituting away from oil. Nevertheless, the long-term outlook is one of a plateau in oil production and a doubling of real oil prices which could lead to serious economic shocks, especially to sectors where oil prices play a decisive role (air industry, tourism etc), although the IMF downplays the dangers, projecting world economic growth between 3-5%. Nevertheless they acknowledge the fact that the effects of high oil prices might become non linear and post serious threats to global economic development.

From a trading point of view, a long-term position on oil will probably provide for high returns, although they might include high volatility (since high oil prices will push the global economy to a series of recessions and a low growth/high inflation setup).

Below are a few key points from the paper itself:

Most importantly, the fact that the main output response to prices has been contemporaneous may be a reason for concern, because this indicates that output has mainly been able to respond to high prices by producers immediately dipping into spare capacity, rather than by increasing exploration or improving technology to increase longer-run capacity. To the extent that the future may be characterized by much tighter supply constraints and therefore much lower spare capacity, this option may no longer be available to the same extent as in the past.

We begin with Figure 7, the decomposition of oil prices. By 2008 oil prices had reached a

level that was 60% higher than what the model would have predicted on the basis of 2002 information. The major contributing factors in the earlier years were very strong oil demand, principally from booming emerging economies, and a positive world output gap. Oil supply, at least until some time in 2005, actually helped to, ceteris paribus, keep oil prices lower than what they would otherwise have been. From that time onward however, as we have seen, world oil production stayed on a plateau, and by 2008 insufficient world oil supply had become the major factor behind high oil prices. The Great Recession, from 2009, was so severe that oil prices dropped below the original 2002 forecast. The model attributes roughly half of this drop to a negative output gap shock, and the other half to a positive oil supply shock. The latter is the model’s interpretation of the increase in oil excess capacity in 2009. By 2011 real oil prices had regained their 2008 average (not peak) levels. The model attributes almost all of this to negative oil supply shocks, with oil demand and output gap shocks showing no major trend reversal after 2008. In other words, the insufficient growth of world oil supply that had begun to assert itself between 2005 and 2008 returned to center stage, as production remained on the same approximate plateau that it had reached in late 2005. It is very important, and evident from Figure 7, that it is not the shocks that are the major driving force behind the trend increase in oil prices in our model. Rather, the no-shocks scenario predicts an increase in oil prices that is not far from the actual trend. The reason is the significant estimate of the Hubbert linearization coefficient β1 in the oil supply curve. This confirms that the problem of oil becoming harder and harder to produce in sufficient quantities was an important factor that would have significantly increased oil prices regardless of shocks.

Our data and analysis suggest that there is at least a possibility that we may be at a turning point for world oil output and prices. A key concern going forward is that the relationship between higher oil prices and GDP may become nonlinear if oil prices become sufficiently high.

While our model is not as pessimistic as the pure geological view, which typically holds that binding resource constraints will lead world oil production onto an inexorable downward trend in the very near future, our prediction of small further increases in world oil production comes at the expense of a near doubling, permanently, of real oil prices over the coming decade. This is uncharted territory for the world economy, which has never experienced such prices for more than a few months. Our current model of the effect of such prices on GDP is based on historical data, and indicates perceptible but small and transitory output effects. But we suspect that there must be a pain barrier, a level of oil prices above which the effects on GDP becomes nonlinear, convex. We also suspect that the assumption that technology is independent of the availability of fossil fuels may be inappropriate, so that a lack of availability of oil may have aspects of a negative technology shock. In that case the macroeconomic effects of binding resource constraints could be much larger, more persistent, and they would extend well beyond the oil sector.

Update: An interesting overview of the paper in the Oil Drum

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Kostas Kalevras

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