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On July 8, the G8 leaders agreed on a Document on Environment and Climate Change. The leaders of the G8 agreed to share with the members of the U.N. Framework Convention on Climate Change the vision of achieving a goal of at least 50 percent reduction of global emissions by 2050.
The G8 stated that achieving the ultimate objective of the UNFCCC will only be possible through the common determination of all major economies. It was acknowledged that participation from China, India, Brazil, Mexico and South Africa is critical to a climate deal that would take effect when the first phase of Kyoto Protocol expires in 2012.
China and India flatly refused the goals, citing reasons that energy security and economic growth are equally important for developing countries and no climate change goals can be formulated in isolation. Their argument was that the G8 countries are responsible for most of the emissions that have pushed the world into major environmental catastrophe and they should do more to rectify the damage.
Over 80 percent of the emissions in the atmosphere today have been caused by the G8. Although the G8 is home to only 13 percent of the global population, it emits more than 40 percent of global carbon dioxide. The United States comprises around 5 percent of the world population, constitutes 26 percent of world GDP and consumes 29 percent of global energy supplies.
The increase in oil prices clearly affected this year’s discussions. It played a critical factor in the G8’s adoption of a climate declaration that environmentalists have condemned as too lax and vague. The agreement reflected a consensus that any pronouncement on climate change has to take into consideration the state of the global economy and energy security concerns of developing nations.
Oil prices have increased by 1,400 percent in the last decade and have now reached a level that is threatening to drag the global economy to a grinding halt. This is the third oil shock the world has seen since 1970. During the first oil shock, oil prices almost quadrupled, from $3.50 to $13.50 per barrel between 1973 and 1975. During the second oil shock, the price jumped by more than 100 percent from $15 to $39 per barrel. In the current phase, oil prices have increased from $55 a barrel since early 2007 to current levels of $130 per barrel.
The United States and other developed countries attribute this rise in oil prices to the fact that global oil supplies by producing nations have not been able to keep pace with ever-increasing demand from consuming nations, especially emerging countries like India and China. The counterargument to that theory is that rather than fundamentals, massive amounts of speculative activity are mainly responsible for the recent hike in not only oil prices but also commodity prices across the board. If the later is true, the bubble has to burst some day and we will live to see oil prices come down to sane levels. A closer look at data suggests that it might just be the case.
Michael Masters, a U.S.-based hedge manager, suggested one month ago to the distinguished members of the U.S. Senate Committee on Homeland Security and Governmental Affairs that speculative demand is behind much of the recent rise in commodity prices and the U.S. lawmakers must curb speculators’ access to commodities if commodity inflation is to be brought under control.
The same view was again emphasized in the recently concluded Jeddah conference of oil producers and consumers. King Abdullah stated in no uncertain terms that speculators are clearly behind the sharp rise in oil prices – in fact, responsible for an estimated 60 percent of the increase. The rest of the members of the Organization of Petroleum Exporting Countries echoed his view, but this was in stark contrast to the argument put forth by the United States and Germany that the inability of OPEC to increase the supply in response to the fundamental rise in demand for oil is the real cause for much of the recent spike in oil prices.
To refute that increasing the supply is not the real problem, Saudi Arabia’s oil minister emphasized that the oil production capacity can and will be raised to increase the supply from the current 9.7 million barrels per day to nearly 15 million by the end of 2009. Also, according to the U.S. Energy Information Administration, global output this quarter should reach 86.2 million barrels per day, and in couple of years, the total output is likely to accelerate again as new oilfields come into production.
The mainstream media continue to glorify the view that the world oil demand is robust, but in reality the world oil demand growth has been slowing in the last four years. Total consumption is expected to grow by only 0.3 million barrels per day this year, which will be easily absorbed by the new production coming into the system this year. Important to note is that the new supplies are coming into the system at a time when the global economy is likely to slow down.
Among the major players shaping the new oil economy, China plays an important role on the demand side of the oil equation. China imported 145.2 million tons of crude oil in 2005 and imported 159.3 million tons in 2007. The figure for 2008 is estimated to be 170 million tons. The rising living standards led by newfound wealth in China – between 1996 and 2006 the number of private cars rose from 2.9 million to 23.3 million – and the rapid pace of industrialization have created a rising demand for oil for the foreseeable future.
China overtook Japan as the world’s second-largest crude oil importer in May this year. Japan’s crude oil imports in May rose 8 percent to 3.76 million barrels per day, which was surpassed by China’s at 3.81 million barrels per day. This surge in demand could also be temporary, as China tried to corner enough oil to avoid any disruption during the upcoming Olympics and ensure enough supply for its earthquake-hit regions. In reality, China’s consumption of oil has actually decelerated in recent times. It is estimated by EIA that China’s oil consumption will only grow from 8 to 8.4 million barrels per day from this to next year, well below its anticipated GDP growth rate.
At current prices the demand for oil, which we normally assumed to be inelastic, may well drop in the long run. Much of the inelasticity stems from the subsidies enjoyed by populations of many countries. However, as governments start aligning the price of oil to market levels, as recently witnessed in Egypt, China, India, Indonesia, Malaysia and Taiwan, the demand will rationalize and consumption will fall, resulting in increased supplies as domestic oil companies capitalize on higher prices.
While the growth of emerging markets is cited as one of the key reasons that oil prices will continue to rise in future, ignored is the fact that many countries are witnessing aging populations and many countries will see zero or negative population growth for many years to come. For instance, of the top 15 oil-consuming nations, 10 will see negative or zero population growth for the next decade. This will severely restrict any significant increase in overall oil consumption.
If the fundamental demand-supply situation is only partly responsible for the astronomical rise in the current oil price, can speculators be the real culprits? One technical symptom which confirms this view is the increasing anomaly between the spot and future prices of crude oil. There seems to be more demand for paper oil than physical oil at the current prices. This, combined with the fact that crude oil inventory levels in the United States are at their highest levels in a decade, challenges the myth that oil is in short supply.
Most of the recent speculative activity in commodity prices in the United States is being channeled through a relatively unregulated mechanism. Energy futures, which were earlier traded through exchanges such as the New York Mercantile Exchange regulated by the Commodity Futures Trading Commission, are now traded on the Over-the-Counter electronic market, which was removed from the ambit of the CFTC by passage of an act in 2000.
As of last year end, the total outstanding contract value on OTC commodity exchanges stood at US$9 trillion, up by $1.9 trillion over the previous year. Assuming oil constitutes around 70 percent of the contracts, the new money being poured into oil contracts would be $1.33 trillion. This amount is large enough to justify the theory that speculation could be behind up to two-thirds of the increase in oil prices in the last 12 months.
Whether due to speculation or fundamentals, the days of cheap energy have come to an end. The age of oil led to rapid industrialization and enormous wealth creation. It created opportunities to harness technology to drive productivity and output which have transformed the world over many cycles. It gave wings to globalization, making the world a smaller place for the manufacture and distribution of goods and services. The very success and scale of this process has increased the demand and thereby the prices of oil, coal and natural gas.
The current energy price levels threaten to alter the equation of capital, labor and energy. For instance, the United States imports around 12 million barrels per day, and at $130 a barrel it now constitutes around 4 percent of the U.S. GDP, up from 2 percent of GDP a year ago. This has essentially wiped out the productivity gains of an entire year in the U.S. economy.
The oil price rise from around $53 a barrel at the beginning of 2007 to the current level has come with a tax of $2,600 billion annually to the customers. Around two-thirds of this transfer is from oil-importing to oil-producing countries.
The last several decades have been defined by rapid technological innovation on the back of cheap and abundant energy. Hopefully the same forces will prevent energy prices from devastating the major structural pillars of the modern economy.
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(Hiren Doshi is business development manager for Infosys, based in London, and a fellow of the India China Institute. These are his personal views. He can be contacted at hirend@yahoo.com. ©Copyright Hirin Doshi.)
