The economics of energy are not that difficult to understand. As with every good or service, there is a relationship between supply and demand. This relationship and the shifting of supply and demand over time are responsible for movements in the price of oil. Recently a barrel of crude has dropped by more than 75% from the record highs in the high $140’s all the way down to the mid-thirties. Clearly, there has been a severe decline in demand in the economic downturn and prices reflect the overabundance of oil produced by projects undertaken when prices were sky-high. Now, in the appropriate reaction to this unbalance, suppliers are cutting back drastically as company’s are slashing cap ex budgets and OPEC has reduced output continually to little avail.
The International Energy Agency (IEA) said today that there was a serious threat of a supply crunch in 2010 when the global economy resumes its growth. The clear implication of said supply crunch would be that prices would spike thus straining consumers and thus the broader economy. The Paris-based IEA’s xecutive director Nobuo Tanaka expects world oil demand to rise by 1 million barrels per day (bpd), or about 1%, in 2010 as growth resumes. The current investments in place will not be able to keep pace with the new demand, as many wells are not profitable to drill for oil in the mid-thirties of marginally higher. Strangely, Tanaka does not want to see OPEC cut production again at there next meeting on March 15th, as CNN Money reports:
“The IEA chief urged the Organization of the Petroleum exporting Countries not to seek rapid rises in oil prices through further supply cuts as current prices are helping the economy.”
So, what exactly is the IEA advocating? On the one hand, he says we need to continue to produce more oil so that when growth resumes prices will not skyrocket. However, if oil producers continue to produce more than is necessary price will stay low, and may go significantly lower. Many oil companies are struggling at current prices and it is necessary for supply to constrict when the price is this low. It would seem reasonable that the IEA would rather see OPEC cut production in an effort to raise oil prices again. If a short term cut in production from OPEC did in fact raise the price for crude, then more private and corporate producers would be enticed into the market. If they were successful in raising prices then more investment dollars would be put towards exploration and when the economy does truly recover there would be more supply to meet the growing demand. As many oil producing projects take time before they begin to actually produce, a higher price of oil now would likely make the spike in 2010 less intense.
However, the point is really moot because OPEC has historically been ineffective in enforcing production cuts. Especially in this economy,when many oil producing nations are running budget deficits and need revenue. The fact that the IEA does not want OPEC to issue another production cut is at least surprising as the price of oil continues to drop. In order to reach equilibrium the world needs to either demand more oil or supply less, there really isn’t anyway around that fact.