A Great Bubbling: Economics Of Oil Prices


By: Daniel Yergin

The world will never be quite the same. High oil prices are not only changing the political and economic landscapes but they could also change energy itself, because they are stimulating the most widespread drive for technological innovation this sector has ever seen.

The political shifts are striking, wherever you look. Russia was so flat on its back at the end of the 1990s that Western banks and companies competed to see who could close its Moscow offices faster. Today, even though Vladimir Putin says he does not like the term, Russia certainly appears to be an energy superpower, using oil and gas to restore its position in the world.

Balances of political power are shifting in other ways. In 2006, after his nonstate lunch with President Bush in Washington, China’s President Hu Jintao took off directly for state visits to Saudi Arabia and Nigeria.

Meanwhile, that other balance, in supply and demand, has been extremely tight. Even without actual disruptions, possible threats to supply from the war in Lebanon and from rising tensions over Iran’s nuclear program were enough last summer to push oil prices above $78 a barrel, accompanied by forecasts of $100 a barrel.

But then a slowing U.S. economy and growing inventories, and the prospect of rising non-OPEC production, sent prices down. That was enough to alarm OPEC into cutting production in order to stem the downward trend and keep prices above $50 to $55 a barrel. That’s not exactly a low price; it’s still double the OPEC price band of just a few years ago.

The flow of funds illuminates how much has changed. OPEC’s revenue has tripled over the past four years, from $199 billion in 2002 to about $600 billion in 2006. The Mideast’s trade surplus is 50 percent greater than that of emerging Asia.

While oil states are recycling a good deal of this resurgent wealth back into the United States and Europe as they did in the 1970s this time much more is going into investments in Asia and local and regional financial markets and development. What used to be said of Shanghai that it employed up to a quarter of all the world’s building cranes is now being said of Dubai.

Petrodollars are also fueling political assertiveness in countries such as Iran (where oil revenue rose from $19 billion in 2002 to $60 billion in 2006) and Venezuela (from $21 billion to almost $50 billion over the same period).

But there are two big economic questions. What do high prices mean for the economy? And what do they mean for the future of world energy?

The risks from high oil prices are clear and manifold: loss of purchasing power on the part of consumers who drive the world economy; a blow both to business and to stock-market confidence and thus to investment; and a painful shock to the balance of payments of non-oil-developing countries.

Most fundamental of all is the possibility that high oil prices will start to drive up inflation, forcing central bankers to jam on the interest-rate brakes. But at what level of price?

A few months ago one of the key OPEC decision makers, harking back to that not-so-long-ago $22 to $28 band, observed, “We thought that the world economy would collapse at $40 a barrel.” But economic growth sailed right on through $40, then $50, then $60 a barrel.

Part of the reason is that the major economies are much less oil-intensive than they were in the 1970s. What this means is that less oil is required for every unit of GDP. For instance, the U.S. economy has grown by more than 150 percent since the 1970s, but oil consumption by only about 25 percent.

The other major explanation is that this time, prices have been rising in response to a “demand shock” (epitomized by 10 percent economic growth in China) and not a “supply shock” (a disruption such as the 1973 embargo or the 1979 revolution in Iran). This is largely true, although not completely. For there has been an “aggregate disruption” a supply cut when you add up the loss of supply from Nigeria because of an insurgency in its delta region, the reduced levels of production in Iraq and Venezuela and the (now mostly healed) loss of supply from the 2005 hurricanes in the Gulf of Mexico.

Yet there was some point at which prices would begin to bite. That appears to have been in the $60 to $70 range. And those effects can be seen, along with the housing decline, in the slowing U.S. economy, with implications for all countries that export to it.

But the most lasting impact of the shift in the energy market may well be measured in energy itself. There is a bubbling and brewing of technological innovation along the entire energy spectrum from conventional supplies and renewables and alternatives, to efficiency and demand management.

Oil and gas companies continue to innovate. Last September, Chevron announced a find in the Gulf of Mexico oilfield at 6,890 feet, and an additional 19,685 feet under the seabed an extraordinary technological achievement.

Around the world, the “digital oilfield of the future” is becoming the digital oilfield of the present. The large-scale conversion of natural gas into high-quality diesellike fuel is getting closer.

Renewables have captured the public’s imagination and are coming into their own. Wind power is the one that is closest to becoming conventional. This is not just the result of market forces. The development of renewable resources is being driven by mandates and subsidies of the European Union and of the federal and state governments in the United States, and by similar programs in countries like India and China. But it is working.

In fact, renewables are growing so fast that they are straining capacity in people and materials. Right now there is a shortage of turbines and blades for windmills. Renewables are a sizable business these days; the worldwide investment in wind and solar sales for 2006 is estimated at $40 billion.

But sometimes the enthusiasm for wind and solar discounts the huge scale of the energy system and the lead times needed to develop any form of energy, as well as the fact that these sources have to eventually establish themselves as economically competitive without government help. Even with all the advances, they are still a very small part of the overall energy mix. But they will continue to grow.

What is also rising is the funding and fervor that are going into innovation. A decade ago, I chaired a task force on energy research and development for the U.S. Department of Energy. It was a quiet period in energy, supplies were ample and interest was subdued.

That would not be the case today. Prices, anxiety about supply and the quest to reduce carbon emissions because of climate-change concerns have turned energy into a major focus for technology investment. Governments and businesses continue to be big players. But they now have company: venture capitalists.

The embodiment of the old model was the centralized Synthetic Fuels Corp., a U.S. government company that was chartered in 1980 with $17 billion to promote such options as shale oil and the conversion of coal into liquid fuels. It was very much in the spirit of the oft-invoked “three M’s” Manhattan Project, Marshall Plan and Man in Space. But when prices went south in the 1980s it was wound down, and by 1986 it had disappeared.

Governments and companies are stepping up their investment in energy R&D, and will remain critical to the development of new technologies. Research-and-development spending by the U.S. Department of Energy is $1.8 billion and is slated to grow 25 percent in 2007.

Now the people who brought you Silicon Valley are also stepping into energy. Venture-capital investment in energy reached $1.7 billion in the first three quarters of 2006, almost five times what it was in the same period in 2004, according to the Cleantech Venture Network. “When we started investing in this area, it was like investing in the Internet in the early 1990s before anyone had ever heard of the Internet,” says Ira Ehrenpreis of Technology Partners, an early clean-tech investor. “Now there has been an awakening in the VC community that clean tech offers as large an opportunity as information technology and life sciences, both of which were revolutionized by venture capital.”

This means growing amounts of money going into energy businesses, operating under the discipline of venture capital. Some of the results are already there. One of the biggest recent tech IPOs, Suntech, made its founder, Zhengrong Shi, the richest man in China.

Of course, many of the new initiatives will not succeed. With this rapid growth comes a degree of hype that has some echoes of the Internet frenzy.

But that cycle of boom and bust left a set of technologies that are transforming business and society. And one clear difference is that in the Internet boom the business plans focused on eyeballs and didn’t worry so much about how to make money. Here the market opportunity is clearer.

This diverse but intense focus on energy technology will likely have wide effects. There will be new ways to find or develop conventional energy. The competitive position of alternatives will be enhanced. The boom in conventional, corn-based ethanol, with its overwhelming political support, will nevertheless run into limits of land and food-versus-fuel competition. The current holy grail in liquid fuels is the search for economically competitive cellulosic ethanol, made from crop waste or specially designed energy crops.

Overall, some of the most intriguing possibilities will come from applying biology and genetic engineering to energy problems.

Much else is now on the energy-technology agenda from fuel cells and solar energy to advances, on the demand side, in how we use energy and the ways in which our cars are powered. Technological advances, along with regulations, enabled the United States and Japan to double their energy efficiency in the 1970s. That could happen again. When it is all added up, there has never been so much activity in new energy technologies. If it stays at this pace, expect dramatic results.

Author Resource:-> Daniel Yergin, chairman of Cambridge Energy Research Associates and executive vice president of IHS, received the Pulitzer Prize for “The Prize: The Epic Quest for Oil, Money & Power” and the United States Energy Award for lifelong achievements in energy and the promotion of international understanding. Visit CERA energy reports online.

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