Focus on Peak Oil Misplaced

The point at which oil demand will peak has long been a focus of debate. BP chief economist Spencer Dale and Bassam Fattouh, director of The Oxford Institute for Energy Studies, argue that this focus seems misplaced: 

Much of the popular debate is centred around when oil demand is likely to peak. A cottage industry of oil executives and industry experts has developed trading guesses of when oil demand will peak: 2025, 2035, 2040? This focus on dating the peak in oil demand seems misguided for at least two reasons.

First, no one knows: the range of uncertainty is huge. Small changes in assumptions about the myriad factors determining oil demand, such as GDP growth or the rate of improvement in vehicle efficiency, can generate very different paths.

Second, and more importantly, this focus on the expected timing of the peak attaches significance to this point as if once oil stops growing it is likely to trigger a sharp discontinuity in behavior: oil consumption will start declining dramatically or investment in new oil production will come to an abrupt halt. But this seems very unlikely. Even after oil demand has peaked, the world is likely to consume substantial quantities of oil for many years to come. The comparative advantages of oil as an energy source, particularly its energy density when used in the transport system, means it is unlikely to be materially displaced for many decades. And the natural decline in existing oil production means that significant amounts of investment in new oil production is likely to be required for the foreseeable future.

The date at which oil demand is likely to peak is highly uncertain and not particularly interesting. Rather, the importance of “peak oil demand” is that it signals a break from the paradigm that has dominated oil markets over the past few decades.

In the past, any mention of peak oil would have been interpreted as a reference to peak oil “supply” - the belief that there was a limited supply of oil and that as oil became increasing scarce, its price would tend to rise. This basic belief has had an important influence on oil markets since the 1970s and before. Oil producing countries rationed their oil supplies safe in the belief that if they didn’t produce a barrel of oil today they could produce it tomorrow, potentially at a higher price. Oil companies spent huge sums of money exploring and securing oil resources that were expected to become increasingly harder and more expensive to find.

Peak oil demand signals a break from a past dominated by concerns about adequacy of supply. A shift in paradigm: from an age of scarcity (or, more accurately, “perceived” scarcity) to an age of abundance, with potentially profound implications for global oil markets as they become increasingly competitive, and for major oil producing countries as they reform and adjust their economies for an age in which they can no longer rely on oil revenues for the indefinite future.

One key implication of this paradigm shift is its impact on long-run price trends. The move to oil abundance is indeed likely to herald a more competitive market environment. But the assumption that oil prices will be determined simply by the cost of extracting the marginal barrel of oil risks ignoring an important aspect of global oil production. Many of the world’s major oil producing economies, with some of the largest proven reserves, rely very heavily on oil revenues to finance other aspects of their economies. The current structure of these economies would be unsustainable if oil prices were set close to the cost of extraction. Many oil producers would be forced to run large and persistent fiscal deficits or to cut back sharply on social provisions, which, in turn, would likely have knock on implications for global oil production and prices.

The argument is not that large oil producers cannot change the structure of their economies: the age of abundance means that structural reform to reduce oil dependency is more important than ever. But history has shown that economic reform and diversification can be a long and challenging process. As such, the pace and extent of that reform process is likely to have an important bearing on oil prices over the next 20 or 30 years. It is not enough simply to consider the marginal cost of extraction, developments in these “social costs” of production are also likely to have an important bearing on oil prices over the foreseeable future.

Extract from Peak oil demand and long-run oil prices