1. www. ecomentary. com 1 Economics, Demography & Oil What’s Going On? 10/14/04

2. www. ecomentary. com 2 Does 9-11 explain recent oil market moves? Do the current problems in Iraq explain the oil market? Is the world going to be more dependent upon Middle Eastern oil? What will this mean for U.S. Middle East Policies? Oil and the Middle East: Four Possible Questions

3. www. ecomentary. com 3 1999: Year of Change

4. www. ecomentary. com 4 A Closer Look: Weekly 2002-2004

5. www. ecomentary. com 5 Moving into the 40’s

6. www. ecomentary. com 6 Oil is different because it is ‘Strategic’ Modern economies require oil Modern military power requires oil States intervene when dealing with oil because price volatility creates distrust of markets and politicians like to claim “solutions”

7. www. ecomentary. com 7 Historical Notes Churchill and Admiral Fisher—don’t depend on coal and the politics of coaling stations GB Invests in the D’Arcy Concession— Anglo Persian Oil (now BP) is formed Lawrence overturns the Mid East in WWI and oil becomes the currency of Middle East Geopolitics

8. www. ecomentary. com 8 Oil and the Cold War The “Dark Side” of Cheap Oil U.S. begins from a position of ‘independence,’ but gradually becomes a significant importer of oil (after 1971) The Soviet Union’s interests in the Middle East during the Cold War become the context for ‘resource nationalism.’ (Libya) US loses its absolute control over Middle East Oil, but not its interest in a stable oil supply OPEC tries to regulate oil prices but the cartel is unstable in the face of burgeoning non-OPEC supplies. Saudi Arabia then imposes “discipline,” and oil falls below $10/barrel in 1986 undermining longer term reserve development The Soviet oil industry collapses under the price pressure and revenue losses hasten the collapse of the entire Soviet state “Energy Independence” in the U.S. falls by the wayside but lingers as a continuing political theme

9. www. ecomentary. com 9 The Post Cold War Oil Market From the end of the first Iraq War until 1996, crude oil rises from about $20 to over $25 with a pit stop at $15 in 1993 The US economic “boom” begins after the Mexican Crisis (1994) and oil moves above $25 With the Asian Crisis of 1997, falling world aggregate demand conditions push oil downward toward $12/barrel, again undermining new capacity expansion. After the Russian default (September 1998), oil essentially triples to an unsustainable $37/barrel during the Tech Boom In the Bust of 2001, oil collapses once again, climaxing with the 9-11 attack driving down consumption, but the US recovery in 2002 moves oil up again, this time over $50

10. www. ecomentary. com 10 Government or Markets? Understanding Recurrent Themes Oil demand is price inelastic and for fast growing economies, highly income elastic Over time, new sources of oil become harder to find and more costly to develop If oil were strictly a ‘market commodity,’ oil supply would be far more responsive to expanded demand conditions, but oil is a ‘strategic resource’ Sources of ‘cheap reserves’ are under government control, making it virtually impossible for private companies to ignore governmental policies regarding oil supply development The SPR undermines private incentives to hold private inventories (the law of unintended consequences) creating conditions for even more price volatility

11. www. ecomentary. com 11 Crude Oil isn’t the Only Thing petroleum products are the ‘inflammables’ ‘Crisis’ not only about crude supply but about the supply of refined products. Can have adequate crude and inadequate product supply, but high product prices invite bad policy Refined product supply very affected by NIMBY sentiment Balkanization of gasoline supply reflects our Federal system The US has insufficient ‘cracking’ capacity to use cheaper heavy, sour barrels. Why is refining an area of ‘underinvestment?’ US energy policy is political parochialism in extremis. Supply expansion or demand restriction? Which party wins in November? Only a crisis will stimulate political cooperation but usually the wrong policies are chosen

12. www. ecomentary. com 12 Demographics of New Oil Demand New Sources of oil demand growth include China and India See next slide China is responsible for some 40-50% of additional demand Other Asian Demand is also rising (India, Korea, etc) Oil demands include transportation fuels and space heating (or power generation). Oil demand in the emerging markets is highly income elastic and petroleum products are used less efficiently than in the developed countries These sources of new demand are likely to continue rising Oil price instability leads these governments to adopt State-run oil reserve holding (adding to demand) but undermining a market based solution

13. www. ecomentary. com 13 New Demands

14. www. ecomentary. com 14 Why Can’t the Market do the Job? Vicious Circles! Private Inventory Holding and the SPR New Government ‘strategic reserves’ The financialization of oil markets Risk sharing and uncertainty Government can create uncertainty and undermine markets by state reserve-holding Financialization plus insufficient ‘excess capacity’ produces additional price volatility Price volatility produces more political intervention

15. www. ecomentary. com 15 Why Are Prices More Volatile This Time? economists: no spare capacity prices have upside volatility when excess capacity drops below a critical value (3mb/d). See slides 16-17-18. financialization: futures are heavily influenced by traders and the marginal barrel is priced this way Financial optics attract bad politics

16. www. ecomentary. com 16 Excess Capacity Problem

17. www. ecomentary. com 17 Spare Capacity and Pricing

18. www. ecomentary. com 18 DESPITE ‘DEBATES’ PROBLEMS WILL REMAIN

19. www. ecomentary. com 19 New Oil Supply is a long run proposition subject to politics ( “all politics are local”) Alaskan North Slope Gulf of Mexico Territories of the Former Soviet Union West Africa Venezuela Brazil Libya PG countries including Iraq, Iran and Saudi Arabia Global Warming and the Green Movement

20. www. ecomentary. com 20 Oil and the Middle East: Four Possible Answers 9-11 heightened fears of terrorism, creating “uncertainty” but not fundamental Only superficially. Key is expanding capacity Yes, because it is the cheapest barrel and the reserves are known Inevitably, the geopolitics of energy cannot be avoided Does 9-11 explain recent oil market moves? Do the current problems in Iraq explain the oil market? Is the world going to be more dependent upon Middle Eastern oil? What will this mean for U.S. Middle East Policies?

21. www. ecomentary. com 21 “oil is a greasy business” Calouste Gulbenkian as quoted in The Seven Sisters Calouste Gulbenkian: “Mr. Five Percent,” long ago discovered a basic truth about oil. Oil generates a great deal of money. The “pen may be mightier than the sword,” but money trumps the pen! Jessup’s Law: politicians can’t handle the truth because they fear their electorates. The result is almost always an inferior solution to an energy dilemma The “CRIC”cycle (courtesy of Robert Feldman) applies to Energy Policy in the US Crisis Response Improvement Complacency