With a sustained fall in crude oil prices since June 2014 — around US$40 per barrel at the time of writing (and as low as US$27 early in 2016) — our conventional understanding of the global oil economy continues to be questioned. 

At the end of 2015, Spencer Dale, chief economist of BP, proposed that a new set of principles would be necessary to reflect the “New Economics of Oil.”  With recent uncertainty in the markets, this analysis is worth revisiting.

What is the traditional understanding of the Global Oil Economy?

According to this analysis, the four core principles underlying the traditional understanding of the oil economy are: (i) oil is an exhaustible resource; (ii) oil demand and supply curves are very price inelastic; (iii) oil flows from east to west; and (iv) OPEC stabilises the oil market.

The four new principles – an overview

Dale proposed the following four new principles reflect the “New Economics of Oil”:

1. Oil is not likely to be exhausted

  • In the past 35 years for every barrel of oil consumed, another two have been added to reserves.
  • Political pressure to curb climate change is likely to limit the consumption of fossil fuels, subject to the caveat that coal is the highest-carbon fuel, and therefore the most likely to be affected by such policies.
  • Technological progress will continue to make oil extraction in difficult environments cheaper.

2. Different supply characteristics of shale oil

  • Shale oil is more responsive to price changes than conventional oil in the short run as the decision to drill can be made in a matter of weeks and production is characterised by low fixed costs and high variable costs. However, as the industry is dependent on financing, this makes it more exposed to financial shocks.
  • Dale sees shale oil as a shock absorber to reduce price volatility. When prices fall the supply of shale oil will decline due to the high variable costs. When prices recover, shale oil production increases which would prevent a spike in oil prices.

3. Oil is likely to flow increasingly from west to east

  • Demand for oil is falling in the west due to tighter regulation and technological advances. Meanwhile, growing economies in the Far East are increasingly dependent on energy imports. China and India are likely to account for around 60% of the global increase in oil demand over the next 20 years.
  • North America has become a major energy supplier and US import demand has more than halved over the past eight years. Dale expects the US to become self-sufficient in energy by the early 2020s and in oil by the early 2030s.

4. OPEC remains a central force in the oil market

  • OPEC counts for about 40% of crude oil production and is able to stabilise the market in response to temporary shocks to demand or supply. Dale questions OPEC’s ability to respond to persistent shocks — such as the effect of US shale oil on the supply side or a mass-produced electric car on the demand side.

What does the future hold for oil prices?

While there have been and will no doubt continue to be significant advancements made in alternative energy industries, oil and other fossil fuels are still projected to be the dominant form of energy as we look ahead to the 2020s and 2030s.

On the one hand, demand for oil is likely to continue to rise in developing economies with a burgeoning middle class, increased urbanisation and industrialisation — most notably the growing economies in the Far East led by China and India. On the other hand, technological progress, pressure to curb climate change and the shale industry will likely dampen the effects of the former.  It will be interesting to see if the hypothesis of shale oil as a shock absorber holds true in the long run, and whether the combination of these factors will prevent a return of US$100 oil prices.

Recent developments

Current indications are that market forces have worked to stabilise prices. As noted by the International Energy Agency (IEA), the lower shale oil output in the US has curbed the excess supply in the oil market while the increased supply from Iran has not been as dramatic as previously feared. Equally, while demand from China has lowered (and risks lowering oil prices further), the demand growth in India and other smaller non-OECD Asian economies may act as a counterweight for 2016. 

There are significant developments in the oil industry on a regular basis — whether it is Iran’s sale of 300,000 plus barrels of crude oil a day to European customers following the lifting of sanctions or, ahead of the Doha oil talks, Saudi Arabia stepping back from proposals with Russia to freeze oil output at current levels. As some commentators have noted, if prices were to rise above US$50 per barrel, shale producers would be able to step in more effectively, therefore there are significant incentives to Saudi Arabia increasing output and maintaining market share. We will need to keep a close eye on the development of oil prices and industry news — only time will tell whether Dale’s analysis hold true.