|Oil is “the lifeblood of modern civilisation”. This paper provides an overview of the global oil market. In particular, it examines the outlook for oil supply and demand over the next five years, and the economic consequences.|
|Low-cost reserves of oil are being rapidly exhausted, forcing oil companies to turn to more expensive sources of oil. This replacement of low-cost sources of oil with higher-costs sources is driving the price of oil higher.|
|While the world will not run out of oil reserves for decades to come, it cannot indefinitely continue to produce oil at an increasing rate from the remaining reserves. Forecasts indicate that world oil production capacity will not grow or fall in the next five years while demand will continue to rise.|
|If oil production capacity does not rise as fast as demand, the buffer of spare production capacity disappears. In such a ‘supply crunch’ the price of oil ‘spikes’ to high levels. High oil prices can induce global recessions.|
|Organisations including the International Energy Agency and the US military have warned that another supply crunch is likely to occur soon after 2012 due to rising demand and insufficient production capacity|
|There is a risk that the world economy may be at the start of a cycle of supply crunches leading to price spikes and recessions, followed by recoveries leading to supply crunches.|
|New Zealand is heavily dependent on oil imports and will remain so for the foreseeable future. While there is potential to substantially increase domestic production, domestic oil production cannot insulate New Zealand from global oil price shocks because New Zealand pays the world price for goods like oil.|
|Key export-generating industries in the New Zealand economy including tourism and timber, dairy, and meat exports are very vulnerable to oil shocks because of their reliance on affordable international transport.|
The US Department of Energy (DoE) calls oil “the lifeblood of modern civilisation”. Around 86 million barrels (13.7 billion litres) are consumed each day. Oil supplies 37 percent of the world’s energy demand, including 40 percent of New Zealand’s energy demand. It powers nearly all of the world’s transportation, without which production and trade would grind to a halt. Studies have shown that GDP growth is very strongly related to increased use of oil. (Ed. note: footnote in original).
When the price of oil increases, the cost of nearly all economic activity rises. This often induces recessions. High oil prices have been associated with three major periods of economic recession in the past 40 years, including the lead-up to the recent global economic crisis.
The world’s oil production capacity may not be sufficient to match growing demand in coming years. The potential for short-falls arises from geological, infrastructure, and political/economic constraints limiting the ability of world oil production capacity to grow while demand continues to rise. If oil supply cannot meet demand a price spike may be triggered, with major detrimental effects on economies, especially those heavily dependent on oil imports like New Zealand.
There are thought to be potentially large, unfound oil reserves. A 2009 study by the Institute of Geological and Nuclear Sciences estimates that there is a 90 percent chance that reserves totalling 1.9 billion barrels of oil remain in New Zealand and a 50 percent chance there are 6.5 billion barrels. Most of these estimated undiscovered reserves are in difficult to access deposits under deep water in the Great South Basin and the Deepwater Taranaki basin.
New Zealand’s geographical position is a serious challenge to increasing oil production. A report by Lincoln University’s Centre for Land, Environment and People (LEaP) states:
“New Zealand’s isolation from the rest of the world acts as a major constraint in the attraction of international explorers. Exploration and mining companies operating in New Zealand have to bear the cost of getting equipment to and from New Zealand as well as shipping crude oil to international refineries.”
In addition to petroleum oil reserves, New Zealand has a vast resource of lignite coal, which can be converted into petroleum products. Solid Energy and several other companies are proposing lignite to liquids plants or underground coal gasification projects to create oil products. However, the IEA estimates lignite to liquids production costs are US$60-$110 per barrel, so high oil prices are needed to make lignite to liquids viable.
If New Zealand can increase its oil production, it could be a major economic boon in the long-run. The Ministry of Economic Development projects oil exports to reach $30 billion per annum by 2025. However, becoming self-sufficient would require a massive increase in New Zealand’s oil production and refining capacity, and, as with any region, New Zealand would not be able to sustain high production rates as reserves were depleted.
No large-scale coal to liquids projects or commercial production wells of, as yet undiscovered, conventional oil reserves are planned to come online within the next five years.
In the medium term, New Zealand will remain heavily dependent on imported oil. Domestic production at any level cannot insulate New Zealand from global short-falls or price rises. New Zealand pays the world price for oil, whether that oil is produced domestically or not because oil producers will not sell their product in New Zealand if they can get a higher price overseas.
New Zealand would be affected by oil supply crunches both directly and indirectly via the effect on trading partners.
Direct effects include higher transport costs and an increased balance of payments deficit due to the increased cost of importing oil. Transport costs constitute a significant expense for exporters, especially exporters of bulk goods like timber, meat, and dairy.
Indirect effects would be felt through lower consumer demand in the markets for New Zealand’s export goods, leading to lower prices.
The LEaP report cited above details the economic consequences of oil shocks on the $9 billion a year international tourism industry, which it states is “highly dependent on affordable oil”:
As a country that is reliant on oil imports and heavily dependent on cheap oil for its major sources of income, New Zealand is highly exposed to oil shocks. Domestic oil production is insufficient to meet New Zealand’s oil needs. Equally, increasing domestic oil production would not protect New Zealand from either the direct or indirect effects of price spikes caused by global supply crunches.
The global economy is heavily dependent on affordable oil.
It may seem counter-intuitive that, when oil reserves and production capacity are higher than ever, the future of the oil market appears bleak. The problem is that production capacity is not expected to keep up with demand. That fact leads to severe economic consequences.
To replace the declining production from existing oil wells and increase production, oil companies are forced to extract oil in more difficult and expensive conditions (deep-water, oil sands, lignite to liquids) from smaller, less favourable reserves. The marginal (price-setting) barrel of oil costs around US$75-$85 a barrel to produce. This will continue to rise with higher demand and exhaustion of reserves.
Although there remain large reserves of oil which can be extracted, the world’s daily capacity to extract oil cannot keep increasing indefinitely. A point will be reached where it is not economically and physically feasible to replace the declining production from existing wells and add new production fast enough for total production capacity to increase. Projections from the IEA and other groups have this occurring, at least temporarily, as soon as 2012.
The difference between the global capacity to produce oil and global demand is the supply buffer. When the supply buffer is large, oil prices will be low. When the supply buffer shrinks - due to demand rising faster than production capacity or production capacity falling - prices will rise as markets add in the risk that supply will not be available to meet demand at any given point in time.
When a supply crunch forces oil prices beyond a certain point, the cost of oil forces consumers and businesses to cut other spending, inducing a recession. The recession destroys demand for oil, allowing prices to drop. Major international organisations are warning of another supply crunch as soon as 2012.
The world may be entering an era defined by relatively short periods of economic growth terminating in oil price spikes and recession.
New Zealand is not immune to the consequences of this situation. In fact, its dependency on bulk exports and tourism makes New Zealand very vulnerable to oil shocks.
Dwindling oil supplies threaten economies
Martin Kay, Stuff.co.nz
The world faces decades of economic turmoil and a vicious cycle of recessions as oil supplies run low and prices spike, according to a Parliamentary research paper.
The paper, The Next Oil Shock, says that known oil reserves would last for another 25 to 32 years, but an oil ''supply crunch'' could occur in 2012 or shortly afterwards as demand rises and supplies fail to keep pace.
It was likely to be followed by a pattern of supply and demand crises.
''While the world will not run out of oil reserves for decades to come, it cannot indefinitely continue to produce oil at an increasing rate from the remaining reserves. Forecasts indicate that world oil production capacity will not grow or fall in the next five years while demand will continue to rise.
''There is a risk that the world economy may be at the start of a cycle of supply crunches leading to price spikes and recessions, followed by recoveries leading to supply crunches.''
The paper, by Parliamentary Library economics and industry research analyst Clint Smith, is based on international research, reports and data...
(13 October 2010)