The impact of oil prices on natural gas supply and demand balance

Over the last twenty years, world energy has been undergoing a far-reaching structural transformation in which natural gas has emerged as the net winner (together with nuclear energy). This has happened at the expense of oil, whose share in the energy consumption of the OECD countries has decreased from 54 % in 1978 to 43 % twenty years later.
Among the OECD countries the change in the respective shares of these two energy sources has been much more pronounced in Western Europe and Japan where the share of oil dropped from 56 % and 80 % to 45 % and 51 % respectively during this period, while the share of natural gas grew from 14 % and 5 % to 22 % and 13 % respectively. In the United States, the change in favour of natural gas has been less pronounced, because this source of energy played a more important part in the changing US energy scene much earlier than in the other OECD countries.

A major force behind this change was OPEC's price shocks and its policies of the 1970s and 1980s,which induced energy consumers in the industrialised countries to reduce their dependence on oil and to diversify their energy supplies. The very high OPEC prices of the 1970s and 1980s justified huge capital investments in transporting natural gas to Europe from North Africa and the Former Soviet Union (FSU). More importantly, these higher oil prices substantially improved the economics of transporting natural gas in liquefied form.
The increase in the share of natural gas and the corresponding decline in that of oil happened between 1973 and 1985, when the price of oil leapt from less than $ 3 per barrel to $ 28 per barrel. When the price crept downward thereafter, the opposing movements of both shares almost tapered off. Less than prices but still significant has been the effect of environmental factors, certainly more than in the past -- when the industrialised countries, especially in Europe, were less aware of such considerations.

Protecting the environment from the adverse effects of burning fossil fuels has been brought to the fore as an issue in world politics, especially in Western Europe where the Green parties have become a factor that counts in politics. Political pressure due to the environment has been increasing so much that the UN Conference at Kyoto had to adopt a “Protocol” aimed at a drastic reduction in the consumption of oil in favour of “friendlier” sources of energy like natural gas.
Future world natural gas consumption will therefore depend on the trends that lie ahead for certain factors, i.e. oil prices, environmental constraints, and technological developments, especially in the area of transportation. Many economic and technological developments suggest that the world will be facing an abundance of oil supplies.

At the same time, they suggest that future growth of world oil demand may not be as strong as in the past. The world may, therefore, have to contend with a continuous state of oil over-supply and mounting downward pressure on oil prices. The only force that has prevented oil prices from falling since the mid-1980s has been OPEC's production cuts, instituted to conserve the balance between demand and supply at the desired price levels. OPEC, of course, has been doing this at the expense of its own share of world oil production.
The phenomenon of inherent oil over-supply, with which we live today, has been the result of OPEC's own price policies and practices over the last three decades, beginning with OPEC's price shocks that took the price of oil from about $ 3 per barrel in the summer of 1973 to over $ 35 per barrel in the first quarter of 1980.

The concept of OPEC being the supplier of last-resort (the swing producer) led to a dramatic increase in the share of new oil (non-OPEC oil from outside the FSU and USA) from the North Sea, South America, the non-OPEC Middle East, West Africa etc. This surge in new non-OPEC oil emerged as an aggressive competitor to OPEC oil. The oil supplies from these regions increased from about 6 mm bpd in 1970 to about 27 mm bpdin 1998, replacing OPEC oil in the world market.
Given its policy of being the last-resort supplier, it was logical that OPEC's production had to fall from its peak of 1978 of about 32 mm bpd down to about 15 mm bpd in 1985 and then up to its current peak of 27 mm bpd. OPEC's production at present is about 5 mm bpd less than it was in 1978, whereas non-FSU world consumption of oil during this period has increased by about 13 mm bpd.

If both the FSU and US are excluded, OPEC's share in world oil supplies dropped from 65 % in 1978 to 38 % twenty years later. The drop in OPEC's share in defence of the oil price was not spread out evenly among OPEC's members; only a limited number suffered share losses, namely Saudi Arabia, Kuwait and Iraq, whose combined share dropped much more heavily than the others.
Between 1979 and 1997, for example, these three nations’ combined production dropped by about 4 mm bpd, whereas other OPEC members (like Iraq, Qatar, UAE and Venezuela) increased their combined production by more than 2 mm bpd. OPEC's unused production capacity today stands at over 7.0 mm bpd, more than three-quarters of which exist in only four countries: Saudi Arabia (42 %), Kuwait (10 %), Venezuela(14 %) and the United Arab Emirates (9 %).

Oil supplies are likely to continue to grow in the future, especially if the major oil producing countries, in the Middle East, open their industries to foreign investors. A sanctions-free Iraq can add, to its pre-war capacity of 3.5 mm bpd, no less than 3 to 5 mm bpd in a matter of 5 to 7 years; while many OPEC countries outside the Gulf (Algeria, Libya, Nigeria and Venezuela) are already encouraging foreign oil companies to invest in new capacity.
Furthermore, production capacity outside OPEC is expected to increase so that by 2010 no less than 5 to 6 mm bpd of additional oil will come on stream from West Africa, the Caspian Sea and South America, although some believe that certain non-OPEC sources of oil supplies, such as the North Sea, may decline bythat time.

Against this trend of increasing oil supplies, the question is whether world demand can grow at a rate sufficient to absorb increases in production capacity amounting to no less than 10 mm bpd within 10years. Unfortunately for oil, it seems that a host of economic and technological factors may well conspire against a robust rate of growth of world demand during the early decades of this century, such as slower growth in the world economy and its components, technological developments encouraging a more efficient use of energy, environmental constraints penalising oil, adverse fiscal policies in the consuming countries, etc.
On the other hand, there have been structural changes in the dynamics of economic growth in the industrialised countries of the West towards low-energy-intensive sectors.

The ascendant industry now, especially in the USA, is the communications and electronics industry, which has a low level of energy intensity. This has meant less growth in energy demand per unit increase in GDP over the last twenty years. In fact, there has been a continuous decline in energy intensity in the industrial countries in general.
Furthermore, environmental considerations are likely to take their toll on oil consumption because the environmentalists' ambitious programmes, if successfully implemented, would mean substantially less burning of oil in order to achieve much lower levels of carbon dioxide emissions.

Although it is uncertain whether the Kyoto Protocol (mentioned earlier) can ever be fully implemented, it has, nevertheless, far-reaching implications as far as energy is concerned. Under its terms there are specific targets for the reduction of the emissions of six greenhouse gases by the year 2010 -- namely, that the OECD countries reduce their emissions by 7 % from their 1990 levels.
This naturally means a drastic reduction in energy consumption from the levels that would have been reached by that year, all other things being equal. It is estimated that without the Protocol's constraints OECD primary energy demand in 2010 would increase by 23 % over 1996. However, full implementation of the Protocol means that the consumption of hydrocarbon fuels will have to be reduced by 29 % from the levels that would have been otherwise reached by that time.

Naturally, not all hydrocarbon consumption needs to be reduced by the same percentage. Oil, having greater CO2 emissions than natural gas, will be under much more pressure. The CGES study estimates that in order to meet the Kyoto Protocol's target, oil consumption in the OECD area by 2010 would have to be 5 mm bpd below the level prevailing in the OECD in 1996, implying a cut-back of 13 % from the current level of demand.
Although such a target is hardly achievable, given the economic-growth related requirements for fuel, and despite the uncertainty about ratification of the Protocol by a sufficient number of countries to render it effective, the mere existence of the Protocol itself indicates how great is the global concern for environmental issues.
The over-supply of oil may well become an endemic feature of the world oil industry, leading to an inherent weakness in the oil price. Future trends in oil prices will also depend on whether OPEC can continue to regulate its own supplies by removing oil supply surpluses, as it has been doing by means of its quota systems since 1983.

It is difficult to see Saudi Arabia, or for that matter other OPEC countries, allowing prices to fall below levels that could be considered absolute minimums. The key issue is the extent to which these OPEC countries can continue restricting their production in order to keep the oil price above $ 15/bbl. Keeping the price at $ 16-$ 18/bbl in the longer run involves OPEC in a vicious circle that pushes its core members into lower and lower production for the benefit of other producers inside and outside OPEC. High prices tend to foster oil supply increases outside OPEC and dampen demand growth, resulting invariably in a declining “call” on OPEC oil.
OPEC's future ability to reduce production in order to keep prices up will be eroded over time with the result that the price of oil will be inherently weak in the future. Low oil prices would, of course, discourage the consumption of gas, especially as 73 % of the world's gas is to be found in the Middle East and the FSU, far from the consuming areas and thus burdened with relatively high costs of transportation. In the case of LNG, for example, a price above $ 20 per barrel for a Brent-type crude is needed to cover the fully built-up cost of delivering this gas to Japan, plus the cost of re-gasification and a reasonable profit margin. Investing in LNG requires not only a high price but also a stable price at a high level for a relatively long period of time, which is why such gas is sold on the basis of long-term contracts.

Obviously price volatility can adversely affect the long-term economic feasibility of these investments, jeopardising the recovery of the capital. The alternative of transporting natural gas through pipelines has to contend not only with the high cost of construction, which can be covered only when oil is highly priced, but also -- and perhaps more importantly -- with geopolitical problems.
For example, investment in a project to transport gas by pipeline from the Gulf to Europe is plagued by many geopolitical uncertainties, since it has to cross certain Middle East countries that are prone to local political problems or conflicts (such as Iran, Iraq, Israel, Jordan, Syria and Turkey). In this instance, investment in pipeline gas would be justified only in terms of a high premium that would cover the economic and political risks.

Natural gas resources are abundant, for global proven reserves today cover, more than 63 years of current consumption. The future of this clean, efficient and environmentally friendly fossil fuel should be much brighter than that of oil. Yet many uncertainties surround future gas demand. Gas being in fierce, direct competition with oil, future price trends of the latter will have a bearing on natural gas consumption. Weaker oil prices do not favour natural gas, but environmental considerations do, at the expense of oil, while tax policies in consumer countries penalise oil in favour of natural gas.
Unpredictable geopolitical developments in the two great natural-gas-producing regions, namely the Middle East and the FSU, could affect long-term investment in pipelines, whereas technological progress, which can reduce the cost of transporting LNG, could definitely be a plus in encouraging consumers to rely more and more, on a more benign source of energy, namely, natural gas.