US oil boom means oil prices must drop, right? Wrong.

The U.S. is experiencing a boom in the production of oil. Only since the beginning of 2011, oil production in the U.S. has gone up by 30%, from 5.5 million barrels per day (mbd) to 7.2 mbd. Just this week, the U.S. Geological Survey announced that the amount of technically recoverable oil in North Dakota was tripled from a previous estimate – so this boom is unlikely to fall away in the short term.

At the same time, U.S. and European demand for petroleum products are declining. The economic troubles in the Euro zone have dampened economic activity (and petroleum demand), while in America, economic growth has returned, but the consumption of petroleum products are down as consumers change habits and lifestyles to drive less. At the same time, the low price of natural gas, particularly in the United States due to the boom in shale gas production, has some analysts predicting that gas will increasingly act as a substitute for oil whenever possible.

Given all this – an increase in production of oil coupled with a decline in demand – an elementary Economics 101 class would say that prices should be in a steep decline. Over the past several months, there have been a slew of articles predicting that oil prices are bound to drop.

However, while there was a dip in oil prices in April, prices for Brent Crude are back up above $100 per barrel. And, while there has been a persistent price spread between the American-based WTI and the global-based Brent (reflecting the U.S. oil boom, and infrastructure problems in getting it out), the price has stayed remarkably steady throughout the boom in the last two years. 

Limited Vision

The problem is that our vision is limited only to what we see. The media is focusing on what is close to home – and by doing that we’re missing the entirety of the global market for oil. Even though production of oil from new fields in the U.S. is booming, there is a consistent decline in production from old fields around the world, and OPEC members have not increased production. Meanwhile, though demand for oil is falling in the U.S., it continues to grow around the world.

For detailed charts on the total world supply of oil, see Lou Gagliardi’s excellent post, 2013 Crude Oil Outlook. He makes the case visually better than I could: oil demand is declining within the OECD, but growing overall, while oil supply is failing to meet the demand.

We Americans are myopic: we only see what is directly in front of us. This does us a disservice when we talk about oil because the market for oil is essentially a global bathtub – more production in one area raises the total supply only so far. We have forgotten that the price of oil is more closely connected with geopolitics and the world economy than with what is happening in Texas or North Dakota.

Insatiable Emerging Economy Demand

In Lou’s post, he showed that sometime in 2013 or ‘14 the total consumption of oil within the OECD will be surpassed by consumption of oil outside the developed country group.

The truth appears to be that demand for oil in the developing world – particularly (but not exclusively) in Asia – is effectively insatiable (at least over the medium term). These are fast growing economies with rising middle classes. For every new barrel or oil produced by the United States, there are refiners in China willing to buy it to satiate their country’s ever-growing demand. (Related: The Energy Industry’s Production Challenge: 100 Million Barrels Per Day)

While the story of China’s growth is well-told, it deserves to be told again. Since 2000, Chinese oil demand has grown at what Lou calls “a torrid 6.7% per annum rate.” A post by Brad Plumer in Wonkblog illustrates that China is using up oil faster than we can produce it. While there are limits to that growth, China’s immense population means that we are not there yet.

And, the story continues outside of China – India and Southeast Asian countries like Vietnam, Indonesia, and the Philippines have had lower growth rates than China, but they are showing signs of taking off. Behind them, but finally growing, is sub-Saharan Africa: a major unknown in future oil demand. As a region, Sub-Saharan Africa posted the word’s fastest growth rate in 2012.

So, even though Americans are driving less and European economic woes mean that there is less oil needed, the demand from the rest of the world is set to outstrip these concerns.

Tight Global Control of Oil Supplies

What then, about the ‘booming’ production of oil in the U.S.; certainly that should help to moderate prices? Unfortunately, the boom in the U.S. has not been matched by a boom around the world.

The boom has been great for American-based refiners, who can buy crude oil at reduced North American prices, and then turn around and sell gasoline or diesel at the higher world price.

It is also important for America’s balance of trade. For example, in 2010 the total value of oil imports was $680 billion – larger than the total trade deficit of $497 billion. Today, oil is a declining share of a declining deficit – and some are predicting that the next battle in Washington will be over allowing crude oil to be exported. Paying for oil from North Dakota and Texas instead of Nigeria and Saudi Arabia will keep American dollars at home – helping them to cycle through our domestic economy.

However, the American oil boom is not affecting prices because total world oil production is not matching America’s boom. There is one word that can explain that: OPEC. The oil cartel was set-up to restrict supplies of oil in order to keep prices high. While there have been several periods of failure in their 40 year history, they have been mostly successful.

Yesterday, the Saudi Oil Minister, speaking in Washington, indicated that the Kingdom had no plans to expand production, saying “We’re pleased to see production coming from so many other suppliers, and see no need to go beyond our 12.5 million b/d capacity.” Surely, if the Saudis applied some of the new technology being used in the United States, they could increase production – but that would actually reduce prices, an outcome they do not desire.

Recently, I have heard the argument several times that we are entering a period that is akin to the early 1980s in oil prices. At the time, the high prices of the 1970s had incentivized American drillers to get back to work in Texas, and a boom in production there caused a bottoming out of the price of oil.  I don’t subscribe to this theory – mostly because in the 1980s, the Saudis had a geopolitical incentive to cut the price of oil: the USSR – then, as now, a major producer of oil. Saudi Arabia and its main ally, the United States, know that high oil prices were subsidizing the Soviet Union with much-needed hard currency. So, the Saudis opened their taps, and the rest is history.

Today, the geopolitical incentives go the other way. After the Arab Spring, the Saudis significantly increased the subsidies (in both direct and implicit grants) to its people. They know that they need high oil prices in order to keep their population happy.

Source: Why Oil Prices Will Remain High Despite the U.S. Oil Boom