We have entered a new oil world in which most of the old oil market truths can go overboard. This was the stark message given off by BP’s Chief Economist Spencer Dale in a speech he gave in London on 13 October. According to Dale, oil market realities have changed fundamentally: “We need a new set of principles reflecting the New Economics of Oil”. Karel Beckman discusses the profound implications following from Dale’s ground-breaking analysis.
Every once in a while an article comes along that has the ability to change the way we look at the world. This is what Spencer Dale’s article (really: speech) “New Economics of Oil” does with regard to the oil market. It captures the implications of the most important developments taking place in the market today and integrates them into a new perspective.
Dale, who took over from Christof Rühl as BP’s Chief Economist last year and before that worked as economist for the Bank of England for over 25 years, starts with setting out the four “core principles” on which economists up to now have based their thinking on the oil market. These are, he writes:
- Oil is an exhaustible resource. As it becomes increasingly scarce, the price of oil is likely to increase over time.
- Oil demand and supply are price inelastic: demand because there are few substitutes for oil and supply because oil production requires huge fixed investments.
- Oil flows from east to west.
- OPEC stabilises the oil market
In the “new economics of oil”, says Dale, none of these four principles are true anymore.
In particular, two changes are happening that are altering oil economics irrevocably. One is the shale oil revolution, the other is the “increasing concerns about carbon emissions and climate change”.
The US shale oil revolution, which is likely to be replicated at least to some extent elsewhere in the world, changes the oil market picture in several fundamental ways, says Dale. First of all, oil has turned out to be not so exhaustible after all. In the past 35 years, “for every barrel of oil consumed, another two have been added … Total proved reserves of oil … are almost two-and-a-half times greater today than in 1980.”
“There is no longer a strong reason to expect the relative price of oil to increase over time”
The huge increase in oil reserves has not only been caused by the introduction of fracking. However, notes Dale, fracking has altered the nature of the oil production process. Fracking, he writes, “is far more akin to a standardised, repeated, manufacturing-like process, rather than the one-off, large-scale engineering projects that characterise many conventional oil projects. The same rigs are used to drill multiple wells using the same processes in similar locations. And, as with many repeated manufacturing processes, fracking is generating strong productivity gains.”
This implies that “oil resources are probably never likely to be exhausted”, in particular if the US shale oil revolution can be replicated outside the US. A mind-boggling thought.
But shale oil changes the economics of oil in other ways too: it is a much quicker process than the traditional one. The time between investment and production is short, and what is more, the productivity of the well declines rapidly. This means that the oil market becomes much more responsive to price changes (“elastic”). If prices rise, production will be quickly stepped up; if they fall, it will be quickly reduced. This will dampen price volatility.
At the same time, however, the nature of the shale companies acts to “introduce an additional source of [price] volatility”, notes Dale. Whereas conventional oil supply is dominated by large companies such as BP which are able to finance their own investments, the much smaller shale oil producers are more directly linked to financial markets. Dale notes: “In macroeconomic speak, US shale has introduced a credit channel to the oil market. And we all know from the misery of the financial crisis how destabilising credit and banking flows can be in transmitting and amplifying shocks.”
“The EU’s oil consumption is projected to be back down to levels last seen in the 1960s, even though EU GDP would have almost quadrupled over the same period”
Meanwhile, on the demand side, a profound change may be happening as well, although Dale does little more than hint at this. He writes that “increasing prominence is being given to climate change concerns, in China and the US as well as Europe, and momentum for increased action is growing – particularly this year as the Paris talks approach. If that sense of urgency translates into policies this could have significant implications for the long-run demand for all fossil fuels.”
Dale does not spell out what these policies might be and how they might affect the oil market. He avoids words like “peak demand”, “carbon bubble” or “stranded assets” – too sensitive perhaps for the Chief Economist of BP. But he does explicitly draw another key conclusion, also quite sensitive from the perspective of investors and market actors: “there is no longer a strong reason”, he writes, “to expect the relative price of oil to increase over time. As with other goods and services, the price of oil will depend on movements in demand and supply.”
The third basic assumption about oil, that it flows from east to west, also does not hold true anymore either, notes Dale. This is not a new insight, but he makes it very forcefully. Oil consumption in the US and Europe, writes Dale, “peaked about 10 years ago and has been on a downward trend ever since”. This is largely due to increased efficiency and presumably also simple saturation of demand. The EU’s oil consumption, notes Dale, “is projected to be back down to levels last seen in the 1960s, even though EU GDP would have almost quadrupled over the same period.”
As to the US, “we expect the US to become self-sufficient in energy by the early 2020s and in oil by the early 2030s”. This has important financial as well as geopolitical implications: “It is inconceivable that the reduced dependency of the US on oil imports won’t affect its relationship with some of the key oil producers.”
This will also have a profound impact on China’s foreign policy: “it seems likely that the creation of the Asian Infrastructure Investment Bank (AIIB) – and the associated ‘one belt, one road policy’ which has been a centrepiece of President Xi Jingping’s first term – stems in no small measure from these energy security concerns.”
So where does this leave OPEC? According to Dale, the assumption that OPEC would “always stabilise the market” was, in fact, never correct. OPEC, he notes, was always willing and able to stabilise the market in cases of temporary demand or supply shocks. But when it comes to structural shocks, OPEC is simply powerless.
If, for example, “a mass-produced electric car” were invented overnight and replaced our existing car fleet, what could OPEC do, asks Dale? Nothing. The same goes for the emergence of US shale oil: “OPEC is no more able to wage war on US shale than it could on the electric car”.’
This, then, should be the starting-point for a New Economics of Oil, concludes Dale.
Indeed, it may be the first outline of a New Oil World Order.
Dale’s full article can be found here on BP’s website. For a summary see here. The arguments advanced by Dale are in many ways foreshadowed by Roberto Aguilera and Marian Radetzki in their forthcoming book, “The Price of Oil”, which you can read more about here. My own recent article on the significance of Shell’s exit from the Arctic also discusses some of the fundamental changes occurring in the oil market.