Russia’s economy is heavily dependent on fossil fuels, particularly oil. All recent empirical studies highlight that about one third of the Russian economy’s growth can be explained by the huge surge in oil and natural gas prices over the period from 2002 to 2008. Oil and gas production accounts for between 20% and 22% of Russia’s current GDP, while between 50% and 60% of total export revenues since 2003 came from these two resources. Russia’s colossal foreign exchange reserves ($460 billion in May) provide a further illustration of this dependence.
The price of oil surpassed the $75 a barrel threshold last week, remaining persistently high. Many energy experts say $100 or more is a likely figure in the not so distant future. In 1998, the price of oil was about $14. In 2002, it averaged $27 per barrel.
Are high energy prices good news for Russia’s prospect of long term economic development and modernization? First, how did glut turn into shortage so quickly?
The rising price is no accident of economics, nor can it be explained by the war in Iraq in 2003, the nationalization of Venezuela’s oil sector, Israel’s instability and other geopolitical spasms. The price rise is fundamentally structural, something Robert Skinner, a Senior Research Advisor at the Oxford Institute for Energy Studies, pointed out in many of his working papers and reports. Energy companies and governments around the world invested too little on exploration and development in the 1990s. Then unprecedented demand hit since 2004, thanks to China, India and other burgeoning economies. Many oil experts tell us that a third of the price of a barrel today can be attributed to geopolitical tensions and what they call a “terror premium.” Price decreases are inevitable. But the longer-term trend seems in place for increases. In fact, geopolitics’ role in high energy prices is nominal. Here’s a simple way of making sense of the surge in oil prices, caused above all by a supply shortage, in the past two decades.
Every day, the world consumes about 85 million barrels. Oil fields that produce that amount of oil are decreasing by about 8 per cent a year, corresponding to around 6.6 million barrels a day. That rate of world oil depletion is equivalent to the daily production of the two Abu Dhabis, or the North Sea, or more than two Nigerias. The problem in the world energy sector is that there is a rarity of discoveries the magnitude of the North Sea, the Caspian Sea or the newly discovered deep-sea oil fields off the Brazilian coast. The Caspian Sea discoveries, for instance, will add only about 3% to the current world daily production. Most of the various non-OPEC fields coming on stream might add not more than 70,000 to 400,000 barrels per day of production.
This situation has to be combined with the fact oil demand is climbing rapidly. The International Energy Agency (IEA) calculates world demand will rise to 86,7 b/d million in 2012, up from 76.8 million in 2001. The combination of natural depletion and rising demand leads inevitably to an oil crunch that won’t wane quickly. Contrary to what classic economic theory says, oil supply is not likely to rise in tandem with price. The gap between supply and demand is widening every year.
The oil shortage was inevitable because oil companies acted rationally. In 1985, oil prices were about $28 a barrel. After that, prices more or less went into steady decline and didn’t recapture their 1985 level until 2000, after which they fell again for two years. As prices fell, Western oil companies – and Soviet as well – invested relatively less in exploration and development for fear of creating overcapacity that would have driven prices further down. The focus instead was “buying” oil in the stock market through mergers and acquisitions. The global consolidation wave, for instance, put Exxon and Mobil together to form Exxon Mobil, PanCanadian and Alberta Energy to form EnCana. Russian “majors” have followed suit. The Merger & Acquisition trend has yet to end.
The Organization of Petroleum Exporting Countries (OPEC) did the same. As prices fell, the OPEC countries, led by Saudi Arabia, had little incentive to invest billions into oil projects that wouldn’t earn a decent return; social spending programs in oil-exporting countries of the Persian Gulf took priority instead. Currently, as demand in the world soars, OPEC spare production capacity is disappearing, and this further tightens the market. Today, the spare capacity is about 6 million b/d. However, if world oil prices skyrocket like they did three years ago, the spare capacity could easily be brought back to the 2004-2005 level, that is, 1.5 million barrels or even less. Lack of investment in other parts of the intricate global supply web is making a bad situation worse. There are too few tankers, too few gasoline refineries. In North America, the refineries are running at more than 95 percent capacity. In the post-Soviet space, refineries need to be built and soon. The breakdown of a single refinery of any size could send the whole market into a major energy crisis.
Years may pass before a balance between supply and demand is reached, if it can be reached one day. The annual world oil consumption is almost 31 billion barrels, the equivalent to a little more than the level of production of Alaska’s Prudhoe Bay, one of the biggest reserves discovered on the planet in 1968. How many more Prudoes Bays are we likely to find in the next 10-20 years? Hardly one in the Caspian Sea.
All this explains why crude oil is trading high on the markets. The world has been there before. During the energy crisis of the 1970s, oil and gasoline prices were actually higher than they are now if you adjust everything for inflation. That was 30 years ago. Things are different now. The world is more complex. It’s more than just the big, bad OPEC countries calling the shots. Commodity traders seem to assume everything happening in the world is bad news, and the price goes up another dollar.
Eventually, everyone pays for oil price jumps since they trickle down into the price of almost every good we buy. Is $80 or $95 a barrel pleasant? Certainly not. Can we live with it? Absolutely. If crude oil and gasoline prices are entering a new era of high and sustained prices, the economy and consumers will naturally react. It’s what economists call “demand destruction” – pricing something so high that consumers stop buying it. People will start dumping their SUVs for smaller cars – it already started, but not in Georgia and CIS countries. Companies will replace oil-fired plant equipment for those that run on natural gas or other fuels, or they will find ways to conserve on fuel consumption in general. Commuters will walk, or ride their bike. Transportation companies will find ways to cut fuel costs – replacing their old equipment to improve fuel efficiency.
Most importantly, researchers will double their efforts to find new sources of energy that move us away from hydrocarbons. They are already doing this with research in fuel-cell technology, solar and wind generation, biomass, and so on. All of these technologies have promise.
With oil at $28 a barrel, who cares about alternative energy sources? Not a good investment of time or money. But with the recent price hikes, there is a lot more on the line and the European Union, the main importer of Russian oil and gas, is already exploring ways to reduce its dependency on its Eastern neighbor. For example, the little-publicized Algeria-Sardinia-Italy Natural Gas Pipeline (GALSI), connecting Algeria, Sardinia and Tuscany and scheduled to begin construction in 2011, will supply Europe with 10 billion gas cubic meters per year in 2014, while Libya and Nigeria are two other candidate countries to export their large reserves to Europe. Sooner or later, this European and world reaction will affect Russia’s economy and society negatively. It is not good news for Russia. Economic modernization and diversification should be indisputable goals for all Russian leaders as the sustainability of Russia’s international status and well-being of its population is at stake.
Richard Rousseau, Ph.D. is Associate Professor in international relations at the University of Georgia and columnist for the newspaper The Georgian Times (www.geotimes.ge)