Energy Security, OPEC, and Shocks

Energy security is an elusive concept. It can refer to domestic policy obstructions, clean energy ambitions, and threats to oil supply from Middle East instability. Energy security can also mean diversification of the energy slate as discussed in our recent global gas brief. If security means the absence of — or being free from — danger or threat, then one might believe we are in an insecure era. Are we?

At DCFR, we received some straight talk from the economist’s point of view during our “Energy Security: Do Fundamentals Matter…” program. Dr. James Smith of SMU Cox drilled into recent oil shocks and OPEC’s role in energy markets. Smith calculates that there is a 10X multiplier effect with respect to how an energy shock translates into prices. He cites the example of Libya. Their production losses of 1.80 million barrels a day was a 2.1% loss to global supply. With the 10X multiplier, it results in a predicted 21% price change (10 X 2.1%). On February 10th, the price of oil before Libya’s production loss was $85.44; as of March 10th, before the tsunami shock hit Japan, prices for oil were $102.73. (The predicted price was $103.38, a shave above the actual price.) He also suggests oil prices are high because OPEC capacity is low, owing to investment shortfalls by OPEC. Since 2000, demand increased 52%, while non-OPEC supply decreased 13% and OPEC production only increased 8%. They have under-invested over time.

Additionally, Smith warns us of demand shocks also working the same way. Case in point, China. The demand for oil by China does not grow at par with its economic growth. It swings from say 2% to 17%, or 5% on average. Demand shocks work the same way. If demand falls short by 2%, then price falls by 20%. Conversely, if demand rises 4%, then price rises 40%. Smith suggests that volatility in oil prices are inherent. They are not contrived by speculators, which he supports in recent research papers. Physical markets drive futures not the other way around.

The conclusion: Fundamentals drive the market. You can view his slides DCFR Smith Talking Points.

Bonus material: Iraq will play an increasingly important role both within and outside of an OPEC context.  Iraq’s supply coming online (probably in the range of 4-5 million barrels/day within the next few years—but possibly more) has the potential to lower oil prices significantly while forcing other OPEC members to rein in their own production.

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