Even Cheaper Oil Will Be Costly

Worldwide demand is rising and production can't keep pace, so don't bet on a return to $25-barrel-a-barrel prices anytime soon

By John Carey

Oil prices skyrocket. Everyone begins to fret about what a new era of higher-cost energy will mean. Then oil prices fall, and the worries fade. It happens so often that we should've learned by now not to overreact the next time a barrel of oil jumps to $43 barrel, as it did on July 30.

Yet this roller-coaster ride is telling us something important, something new. It's not about the actual supply of oil: The world's reserves are still abundant enough that the "natural" market price of oil shouldn't rise much more than $25 per barrel, analysts say.

Instead, the lesson is about the world's ability to produce and deliver that oil, especially with rising demand. "With a worldwide recovery, we are bumping up against world production capacity," explains Philip Clapp, president of the National Environmental Trust, a nonprofit group that educates the public about environmental problems. So when there's a glitch in the delivery of oil, the whole system is strained.


  That's what is happening now. Russian oil giant Yukos is facing possible bankruptcy. On July 28, the company says Russian courts told it to stop pumping oil. The courts were quick to say it was all a big misunderstanding and the spigots are now open. But the imbroglio stoked fears that millions of barrels of oil will stop flowing from Russia onto the world market. If that's not enough, continued violence in Iraq is sparking similar worries about its ability to deliver oil.

If the world had more production capacity, Saudi Arabia and other countries could simply speed up their pumps and fill any shortfall. This time, however, they can't. OPEC nations are already pumping at more than 90% -- or higher -- of capacity. Similarly, Venezuela warns that it can't supply much more oil than it already is.

As a result, the world's ability to supply oil is reaching its limits. Furthermore, the problem is being exacerbated by rising demand everywhere, from the U.S. and Japan to China. This means the imbalance between demand and available supply will only get worse. We already saw a hint of a new future in the mid-1990s, when the Asian boom strained production capacity and sent oil prices soaring. That crisis ended with the Asian downturn and the U.S. dot-com bubble bursting. Oil prices came back down.


  But now the problem has returned. This time, there's far less chance that it will go away. "I think we are facing a very different world oil market," says Clapp -- one with sustained higher prices.

As if that's not enough of a challenge, oil analysts say that non-Middle East producers aren't supplying as much oil as had been expected. "There have been much bigger declines [in production] in the rest of the world, which is why prices are higher than expected," says Fareed Mohamedi, chief economist at energy consultant PFC Energy.

Why can't the oil producers gear up? Given the still relatively abundant worldwide oil supply and a "natural" price in the mid-$20s or lower, it's been hard for producers to justify making additional investments in capacity. With the rise of worldwide demand, though -- to the point where production capacity is strained and prices may have taken a longer-term leap -- those investments are starting to look more potentially profitable.


  It's in producers' interests not to gear up too quickly, however, and that's where politics comes into play. If OPEC and other oil producers had more capacity, they would be under great pressure from the U.S. and other importers to pump more to reduce prices. So, it's in their interests to let capacity lag any rise in demand.

The U.S. government can push for more drilling and exploration at home, as the Bush Administration is doing. Yet even if companies get a green light to drill in the Arctic National Wildlife Refuge or elsewhere offshore, the new wells wouldn't start producing for years -- and it would only be a drop in the barrel of the world oil supply, in any case. The government can stop filling the Strategic Petroleum Reserve (as many Democrats have advocated, but which the Bush Administration will not do), or even release some oil from the reserve. That would only provide a short-term -- and small -- dip in price. (Besides, it's extremely unlikely.)

The only really effective step the government could take: aggressively push energy efficiency and the use of alternative fuels, which Democratic Presidential candidate John Kerry has proposed. That could knock demand back enough to relieve the strains on production and supply.

For now, the world's oil-production capacity is under stress. The system is right on the edge, and even small supply disruptions will propel prices upward. As long as demand remains strong, the problem won't go away. This time, oil prices may have taken a ride to a higher-altitude roller coaster.

Carey is a senior writer for BusinessWeek in the Washington bureau

    Before it's here, it's on the Bloomberg Terminal. LEARN MORE