‘Next oil shock will be far worse than $147 a barrel’

The world is breathing easy, now that oil prices are below $40 a barrel, down sharply from $147 a barrel in June. But, in fact, the current financial crisis and recession could accentuate the severe supply-side constraints that drove up prices last year to record highs, cautions Mikkal Herberg, research director of the energy security programme at the National Bureau of Asian Research in Washington and a veteran strategist in the oil industry.

“It’s hard to say how long and deep this recession will be and how soon the global economy — and demand for oil — will recover, but when it does, in a year or two, it will immediately run into supply constraints,” says Herberg.

In fact, the current financial crunch has already led to the postponement or cancellation over $100 billion worth of oil projects in the past six months, which will aggravate the “supply pathology” when recovery begins, he points out.

At that point, oil prices will ride swiftly back up the escalator, perhaps even beyond their earlier highs. Last year’s ‘oil shock’ was the culmination of a “perfect storm” that built up over five years — in the sense that “nearly everything that could go wrong went wrong,” recalls Herberg.

Oil subsidies in developing economies drove demand for oil, but the real problem cropped up because there was a “slow-motion supply shock”. Global production remained flat owing to “resource nationalism” in oil-producing countries, and there was no slack in oil supply.

“The oil market was running flat out and had no spare, and it was this — rather than speculation — that primarily accounted for the price spiral,” he reasons.

Add to that the cumulative effect of a lack of refining capacity, natural disasters in the Gulf of Mexico, instability in West Asia, the dollar’s decline, and the surge of big-money from hedge funds, and it was “a recipe for high oil prices.”

The price slideback was equally dramatic because high prices — principally, $4-a-gallon at the pumps in the US, “the most profligate oil consumer” — began to hurt, and the global recession clobbered demand, says Herberg.

Virtually overnight, the oil market went from having no slack to having spare capacity, and Opec countries haven’t kept pace with the demand collapse. And with commodities, the short-term elasticity of demand is low, so typically, only a massive price shift can induce even a small change in demand.

But even today, the supply side looks “hugely problematic”, says Herberg. And now that oil prices are down again, investments in alternative energy sources have fallen off the table, and sales of gas-guzzling SUVs have picked up again in the US, he points out. All this, in his opinion, bodes ill for the next oil shock.

Asian countries are particularly susceptible to this, because “Asia is the Ground Zero of global energy”, says Herberg. Oil demand in Asia, driven by a growing China and India, is expected to increase over the next 25 years by 25 million barrels a day — “that’s two Saudi Arabias”.

Energy security is already on top of the security agenda, and is bound to acquire greater priority — and trigger much anxiety and “toxic, competitive oil diplomacy” and even a naval arms race with the intention of physically capturing oil supplies at source. “It’s a hoarding response that says, ‘to hell with everyone else,’ and is born of the perception that other countries are undermining your future oil supplies,” he adds.

But the current recession gives about two years’ elbow room for Asian countries to pull away from mistrust and set up institutions for cooperation, bilaterally, regionally and on multilateral forums.  “It’s important to bring China and India into the IEA, which works as a global manager of emergency stocks. Not having two of the five big oil consumers defeats the very structural reasons for having an agency like the IEA.”

Simultaneously, Asia should build up regional emergency oil stocks and cooperate on regional energy infrastructure initiatives, he says.