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Oil Prices

Authors: Eben Kaplan, and Toni Johnson
Updated: October 18, 2007
This publication is now archived.

Introduction

Oil prices have remained at record high levels for the last few years. While economists remain concerned about effects on the global economy, so far prices have not shown to have a dramatic effect. However, that could change. Demand is increasing and production is near capacity for most major producers. While some experts think the world is running out of oil, many assert it is not. However, some analysts are calling for increases to production and refining capacity as well as new exploration and ways to curtail consumption.

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What is driving oil prices?

The current price increase is primarily the result of a rise in global consumption, these experts say; since November 2001, the cost of an $18 barrel of crude oil has risen above $80, and may top $100 fairly soon. Some analysts contend that “underlying fundamentals of supply and demand” do not support current oil prices (AP), but overall, experts point to an unprecedented competition for oil. A major reason for this rise is unprecedented demand for oil: The largest energy consumers are China and the United States, whose economies are fueled by oil. In China, energy consumption has been increasing 12 percent to 15 percent annually. In the United States, consumption of over 21 million barrels per day [bpd] represents nearly a quarter of the global demand. Every thirty months, global oil consumption—currently at 30 billion barrels per year—increases by an additional three percent.

As demand for oil increases, it threatens to outpace the world's oil-producing capacity. That leaves very little cushion in the event that supply is disrupted since global consumption is approaching total production capacity. For instance, the negative affects of political instability in major oil supplying nations like Venezuela or Nigeria have been much greater in the present climate.

Further constricting production capacity is the fact that new technologies and new oil fields, meant to help ease pressure on the oil industry, have not provided the expected supply growth. Refining capacity is also being tested, creating a bottleneck in the supply chain and putting a greater premium on gasoline and jet fuel. As the cost of those fuels rise, so does the cost of their components. One reason: No new petroleum refineries have been built in the United States in the last thirty years. Hurricane Katrina in 2005 exacerbated this situation, taking 5 percent of U.S. refining capacity temporarily off-line and incapacitating 8 percent of U.S. oil production located in the Gulf of Mexico. Some experts worry that the high concentrations of U.S. oil refining and production in the Gulf continue to be at risk from extreme weather events and could lead to more interuptions in coming years.

What effect will high oil prices have on the global economy?

Economic experts worry if the cost of oil climbs high enough, the rising prices could result in the kind of global economic disruption associated with the 1973 Arab oil embargo. Slowing world economic growth historically has slackened demand for oil, causing prices to plummet. So far, the recent rise in oil prices has not dampened economic growth. “It would take much higher energy costs to cause a global recession,” says Council Fellow Roger M. Kubarych. In fact, he says, “today's higher energy costs spur considerable business investment in both the oil and gas industries to expand production, and within industry at large to make processes more energy-efficient.”

Food prices, however, have been affected by higher fuel prices and is starting to cause some concern. In part, oil prices are driving up transportation costs. However, since oil prices have remained high, more focus has been placed on producing corn-base ethanol. Some experts say the competition to turn food into fuel in order to ease the fuel price pressures has actually resulted in increasing food prices. A recent Foreign Affairs article contends biofuels have now tied oil and food prices in a new way.

What can OPEC do?

The Organization of Petroleum-Exporting Countries, OPEC, which accounts for about 40 percent of the world’s crude oil exports, announced at its 2007 September conference it would increase its production by half a million barrels a day, the first increase in production in two years. This rise in production is intended to increase supply, drive prices down and ease political pressure on OPEC countries. In October 2007, OPEC Secretary General Abdalla Salem El-Badri said in a statement the cartel was montioring the price situation and contended that rising oil prices are “largely being driven by market speculators,” as well as persistent refinery bottlenecks, ongoing problems in the Middle East, and fluctuations with the U.S. dollar.

When the cartel last increased oil production by 2 million barrels in 2005, some analysts argue pumping extra oil will do little to affect costs because there is no capacity to refine it. “The issue is not resources,” Prince Saud Al Faisal, the Saudi foreign affairs minister told the Council on Foreign Relations, “the issue is products.” In response to the announced increase, Nigerian Oil Minister Edmund Daukoru told Reuters, “We will really know from this where the constraint is and that's in the downstream, so nobody can blame OPEC. That's really the purpose of this.”

How quickly could oil production increase?

It's unclear. Increasing production is not a mere matter of turning the tap; it requires drilling new wells and building an infrastructure to get the additional oil to consumers. This takes time and money: Increasing production by one million bpd would require five years and cost $20 billion to $50 billion. Most oil-producing nations are reluctant to make such an investment. As a result, “Nobody in OPEC has invested in new oil fields in twenty years,” says Youssef M. Ibrahim, managing director of the Strategic Energy Investment Group.

Yergin is more optimistic. He predicts a 20 percent increase in production capacity within the next five years. This increase is expected to come both from OPEC nations as well as from non-OPEC sources, such as Canada, Kazakhstan, Brazil, Azerbaijan, Angola, and Russia. Saudi Arabia, which owns 22 percent of the world's oil reserves, currently pumps some 10.5 million bpd and plans to increase that number to 12.5 million by 2009, though there is some talk of reaching 15 million.

But increasing production rates are risky; pumping oil too quickly can damage a reservoir, reducing the total amount of oil the field can produce. Oman made this mistake in 1997, when it ramped up production at its Yibal field by 30 percent to 225,000 bpd in 1997. Six years later, the daily yield from that field is down to 80,000 bpd, despite the use of the latest technologies.

When will oil supplies run out?

Like all natural resources, reserves of crude oil are finite. But estimates vary because many of the oil-producing nations closely guard data on their reserves. As a result, no one can accurately know the size or capacity of the world’s reserves. However, most experts agree that the world’s supply of oil will not run out for quite a long time. However, experts say the real crisis will occur when producers can no longer increase output enough to meet demand. With steadily rising demand already nearing supply, experts say an increase in capacity is needed to avoid this scenario.

A 2007 U.S. National Petroleum Council report examining energy supplies to the year 2030 contends that the world is not running out of oil. However, many experts are concerned that demand levels are beginning to outpace production capacity. A recent CFR Task Force Report on U.S. oil dependence suggests increasing production from unconventional sources, such as oil sands, to help beef up production. This CFR Backgrounder shows that higher oil prices have made production from unconventional sources more attractive, but notes that should prices drop, developers for these projects face losing money. Experts are concerned that for many older wells and some newer exploration the oil available will be heavier grades of crude, thus harder to refine. This could pose a problem even if overall supplies increase unless increased refining capacity is modernized.

What can be done to increase the oil supply?

One way to increase the supply of oil is to develop new technologies to allow more oil to be pumped out of existing reservoirs. Contrary to popular conception, oil reservoirs are not underground lakes of oil. Rather, oil exists in porous rocks that require pressure to release the oil. Using current technologies, producers are only able to extract 40 percent of a reservoir's oil. Experts say improved technology could increase that percentage and improve the long-term outlook of the global oil market.

The oil market would also benefit from new oil fields, such as the Arctic National Wildlife Reserve in Alaska or off the U.S. coasts, though exploration there is a sensitive political issue in the United States. But many prospective new fields, experts say, are not very promising, either because they produce lower-quality oil or because they have lower capacity potential.

Is it possible to lower consumption?

Yes, but it is not easy. There are many mainstream alternative energy sources, such as nuclear energy, solar power energy, hydroelectric power, bio-diesel fuel, and ethanol. However, all of these sources have drawbacks. Nuclear power is potentially dangerous, both due to the dangers associated with all fissile material as well as the risk that bomb-quality material could fall into the hands of rogue regimes or even terrorist groups. Even at current higher prices, many experts, including Ibrahim, say other alternative sources are so inefficient that it is cheaper to buy seventy-dollar barrels of oil.

Increasing efficiency may also help avert a crisis. Gasoline-electric hybrid vehicles are a popular example. Simmons proposes a few other energy-efficient alternatives, such as relying upon trains and boats, rather than trucks, to ship goods. Encouraging telecommuting—where workers work from a home office—is another way to cut consumption. Other experts believe that increases in oil prices will eventually lead to decrease in consumption, but such consumer responses can take up to five years to make an impact. Some experts believe a hefty U.S. gas tax could encourage the purchase of more fuel-efficient cars. Lawmakers in the United States are weighing stronger fuel economy standards for car manufacturers. The Task Force report also suggests discouraging country-subsidized energy because allowing “energy prices to rise to world market levels would encourage users to become more efficient in their use of energy and would also encourage additional investment in both energy supply and innovation for greater end-use efficiency.”

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