As oil and gasoline prices surpass $134 per barrel and $4 per
gallon, respectively, it is clear that significant change is
underway in global energy markets, portending major challenges for
the global economy and energy security. A perfect storm of demand
and supply factors is driving the high oil prices. Goldman Sachs
predicts oil will reach $200 per barrel by the end of the
year--exactly where Osama bin Laden said it should be back in 2001.
Absent significant changes, high prices are here to stay, and, a
correction notwithstanding, may keep increasing in the long
The supply and demand equation responsible for this situation is
changing quickly.Demand for oil is no longer driven by developed
economies like the United States. China, India, other developing
countries, and energy producers themselves are transforming global
energy markets through their sheer size and pace of growth.
According to the Paris-based International Energy Agency's (IEA)
"World Energy Outlook: China and India Insights," between now and
2030 China and India will account for 70 percent of the new global
oil demand; their combined oil imports will skyrocket from 5.4
million barrels per day (mbd) in 2006 to 20 mbd in 2030--overtaking
the current combined imports of Japan and the United States.
The energy needs of China and India will continue to grow as
these countries transition from developing to developed nations.
Rising incomes, strong growth in housing and construction, and the
increased use of electrical appliances will substantially increase
demand. China is in the midst of an unprecedented construction boom
in heavy industry that requires enormous amounts of oil. Massive
infrastructure and construction projects generate a heightened
demand for oil in China and India, as they did in the United States
in the last century and Germany and Japan after World War II.In
terms of vehicles on the road, China will surpass the United States
by 2015, becoming the largest automotive market in the world.Rising
demand, however, is not isolated to East and South Asia.
The oil thirst is mounting in the Persian Gulf and within other
major oil-exporting nations due to booming construction projects,
growing populations, and government fuel subsidies, which are
increasing demand for gasoline. According to Fatih Birol, Chief
Economist at the IEA, the rising demand in the Gulf is the second
only to that of India and China, and it will increase in the
future. Edward Morse, Chief Energy Economist at
Lehman Brothers, has stated that at least 1 mbd did not reach world
markets last summer because of rising consumption among
energy-producing nations, and the situation will repeat this
Additionally, as demand increases and aging oil fields produce
less, some major oil-exporting countries are switching from being
net exporters of oil to net importers. Two well-known examples are
Indonesia and Great Britain. In fact, Indonesia just announced it
is quitting the ranks of OPEC. Algeria, Malaysia, Mexico, and Iran
appear to be on this path as well. This scenario may even offset
planned Saudi increases in spare capacity, according to Amy Myers
Jaffe, an oil expert at Rice University.
Equally important, plans to increase supply through exploration
and production between now and 2030 are being frustrated by
heightened political risks and mismanagement, including
anti-competitive national energy policies in the oil-producing
countries. A third of Iraq's production capacity is off-line, while
the country is capable of increasing production from the current
2.4 mbd to 5 mbd and beyond within five years or less--if the
security situation is resolved. Iran is pumping 3 mbd, one half of
what it did under the Shah due to the failure of the mullahs'
regime to attract private capital and advanced Technology, and to
develop a predictable oil and gas investment environment based on
transparency and the rule of law. The Islamic Republic's leadership
also has made the Iranian energy sector the hostage of its
dangerous and opaque nuclear program, which triggered international
sanctions against Iran and stifled the development of its oil and
One-quarter of Nigeria's productive capacity is permanently down
due to social unrest in the Niger Delta. And Venezuela's Hugo
Chavez is destroying his country's oil sector through
nationalization, taking at least 1 mbd off the market.
Exporting countries' policies provide preferential treatment to
national oil companies (NOCs) while denying equal access to
international oil companies (IOCs). Oil-producing governments
severely restrict foreign investment and access to resources.
OPEC's 13 nations control 76 percent of global reserves; add Russia
and the number grows to 83 percent. By contrast, the integrated oil
companies, ExxonMobil, BP, Chevron, ConocoPhillips, and Shell, hold
only 3.8 percent of known reserves.
Despite high oil prices and diminished spare capacity, OPEC is
repeatedly refuses to increase production beyond current levels,
alleging that the "oil market is balanced" and "there is no threat
to or crisis in supply." The reality, of course, is quite different.
OPEC and non-OPEC exporters insist on limiting the majority of new
oil and gas projects to their NOCs, to the detriment of
international oil companies and consumers world wide. They neglect
or actively resist the development of modern natural resources
legislation, court systems, transparency, and energy sector
supervision by elected officials, as well as scrutiny by
independent media. As a result, they prevent increases in
production and disallow necessary investment by the international
oil companies, which have the expertise to bring the needed supply
online. This trend is set to increase: Over the next 20 years, 90
percent of new hydrocarbon supplies will come from countries that
provide privileged access to national oil companies. Thus,
oil prices can only go up.
Non-OPEC output is also slumping due to steep declines in key
production areas like Mexico's Cantarell Field and the North Sea.
Russian oil production, which has accounted for over 80 percent of
the net increase in non-OPEC oil production since 2003, is stagnant
as the government insists on state ownership of the oil sector.
Aging fields, high taxes, gasoline subsidization, a lack of private
ownership, and other misguided policies are also decreasing
The global financial crisis is another key driver behind the
high oil prices. After the Federal Reserve cut the prime lending
rate last August in hopes of assisting major lending institutions,
investors saw this as the Fed giving up on its battle with
inflation. As a result, traders, hedge fund managers,
and pension fund managers began to shift large amounts of cash away
from the dollar into commodity futures markets, such as oil, in an
effort to protect their investments from being devalued by
inflation. As a result, increased demand in oil futures (no
different than in any other commodity) has led to higher
While the falling dollar has increased speculation and helped
drive up oil prices, it is the awareness of the aforementioned
trends and the exploding demand for oil that is driving investors
to put their money into oil futures.
What to Do?
There needs to be recognition that the depletion rates of oil
fields world-wide are rising, and new oil fields are not coming
online fast enough to replace the existing production capacity.
Industry experts agree that the giant oil fields containing light
sweet crude--the preferred form for gasoline refining--are not
being discovered as often as in the past. Additionally, in order to
meet growing demand, at least in the short and medium term, the
world will need much more investment and production capacity--more
than may be available. Even corrected for speculation, high oil
prices adequately reflect current and future supply and demand of
petroleum if access to oil remains restricted by governments. One
result of high energy prices is that many new and exciting
technologies--in oil and gas production and as substitutes--are
becoming increasingly competitive in global markets.
With diminishing global spare capacity and the growing
geopolitical potential for future supply disruptions, it is time to
confront these anti-competitive policies head-on. To increase
investment, open access to the remaining oil and gas reserves, and
diversify the basket of transportation fuels, international oil
companies and consumer countries should:
- Increase pressure on OPEC and non-OPEC countries to
level the playing field and to open access for international oil
companies to develop existing petroleum reserves. The rule of law
and competitive market principles and institutions should be put in
place to facilitate further development of energy resources. This
includes cessation of cartel-like behavior by OPEC, which is
illegal under U.S. law. Consumer nations should make energy
investment a part of their bilateral agenda with all
energy-producing countries. They should also keep in mind that the
NOCs depend on imported oil services, information Technology,
banking and finance, food, and other external providers to function
adequately--just as consumers depend on fuel producers. Consumer
countries may begin conditioning supply of these vital services on
equal access to energy resources.
- Promote market-based energy-saving technologies and
unconventional sources of fuels world-wide. Japan and the U.S. are
the world leaders in industrial and residential energy
conservation, whereas the fast growers (China, India, the Middle
East, etc) are energy inefficient. U.S., Japanese, and other
Western companies can do well by doing good, marketing
energy-saving technologies. Governments can prioritize energy
saving through their export promotion activities. Technology is
also key to oil production from unconventional sources, such as oil
sands (Canada, Venezuela, Congo, etc.), oil shale, and deep water
drilling, using the most environmentally friendly methods
- Prepare for the likely transformation of automotive
transportation when market forces will shift it to electric,
hybrid, and plug-in hybrid cars. If oil-producing countries do not
take measures to bring down oil prices, a number of market-driven
solutions will likely replace internal combustion engine cars in
the next couple of decades. The U.S. automotive industry should
gear up today to be a market leader in these emerging
transportation technologies. Otherwise Detroit will suffer even
more from competition by Japanese and other companies and will lose
more jobs and industrial base.
High oil prices are here to stay due to heightened political
risks, irresponsible behavior by oil-producing governments and
growing global demand outside U.S. control. Oil is a finite
resource which is produced by a partially cartelized imperfect
market. Consumer countries should expand cooperation in order to
level the playing field and reduce prices by increasing investment
and production, promoting conservation, and diminishing
geopolitical risks. Yet, in the long term, high demand, inadequate
supply and severe geopolitical risks combine to make oil a
problematic transportation fuel.
High oil prices are driving science and R&D to produce
better and cheaper sources of transportation fuels and new engine
designs, which may eventually offer alternatives to conventional
oil and reduce its price.
Ariel Cohen, Ph.D., is Senior Research Fellow in Russian and
Eurasian Studies and International Energy Security in the Douglas
and Sarah Allison Center for Foreign Policy Studies, a division of
the Kathryn and Shelby Cullom Davis Institute for International
Studies at The Heritage Foundation, and Owen Graham is a Research
Assistant in the Allison Center.