from Energy, Security, and Climate and Energy Security and Climate Change Program

The Global Oil Market Isn’t Going Away

October 16, 2012

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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The debate over the consequences of rising American oil production has featured a wide range of serious but conflicting views from a host of informed people. This, from well-informed industry publisher Platts, is not one of those views:

“Interdependence has been a consistent theme in the world of oil for many years, the idea that even a small supply disruption in one part of the globe can have an impact thousands of miles away. Well, say goodbye to that notion, or at least part of it. The International Energy Agency has looked into the not-too-distant future and it sees a world divided between an increasingly self-contained western hemisphere and pretty much everywhere else.”

The article goes on to explain how shifting patterns of production and refining are splitting the world oil market in two. Indeed there’s something to that prediction: over the next decade, oil trade is likely to become more regional, with the western hemisphere trading more with itself, and everyone else trading more among themselves.

But there is nothing about this that warrants the conclusion that “even a small supply disruption in one part of the globe” will no longer “have an impact thousands of miles away”.

Part of me wants to ignore claims like this because they seem so patently wrong. But they’re being peddled by smart people who know a lot about energy, so they need to be challenged.

Suppose that there’s a supply disruption outside the western hemisphere (perhaps in the Middle East). In the no-impact-thousands-of-miles-away scenario, prices rise outside the western hemisphere (i.e. the usual), but they don’t rise in it (otherwise that would be an impact thousands of miles away). That raises a question: Why the heck don’t traders react by shipping oil from the western hemisphere to the higher price region or by cutting back on shipments from the higher price region to the western hemisphere? If they do, prices will rise in the western hemisphere, which means that the impact of the disruption will indeed be felt thousands of miles away. For the Platts theory to hold up, then, there needs to be some reason that traders don’t actually react this way.

One can actually imagine a couple of potential reasons that traders wouldn’t react in the way that I’ve outlined. The first is if there’s a shortage of oil tanker capacity (and if we’re looking at the scenario where more western hemisphere oil gets shipped east in response to a disruption). I’ve been working on some modeling for a while now that looks at this possibility. But it almost certainly isn’t relevant here. For starters, we’re talking about small disruptions, which shouldn’t strain a global shipping system that always has at least a bit of spare capacity. Moreover, when oil supply is disrupted, that frees up the tankers that would otherwise have been moving that oil. Once again, it’s tough to engineer a supply disruption that leaves the world short of the tanker capacity needed to arbitrage across distant markets.

The other possibility arises if, prior to the supply disruption, the western hemisphere is in perfect isolation, with absolutely no oil moving across the oceans in any direction. In that case, a small supply disruption abroad can move eastern hemisphere prices up so little that it remains uneconomic to ship and oil from east to west (since shipping costs money). But this is what economists call a “knife edge” condition – one can specify it in theory, but it practice, there’s an almost zero chance that it will occur.

The bottom line? So long as physical oil traders are out there trying to make a buck, and so long as governments don’t constrain their ability to do that through export or import controls, the western and eastern hemispheres will not be independent of each other, even if most oil trade becomes constrained to regional routes. That has big economic and security consequences – which makes it important to get right.

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