The temporary drop in crude oil prices which began some months ago is due to a combination of factors affecting supply and demand. However, the trend is rising to the point that there seems to be a greater prospect of a “third oil shock.”

1. Several factors currently moderate the rise in crude oil prices.




1. After strong variations, the crude « Brent » of the North Sea, which is the benchmark on cash markets, typically averages around 100 USD per barrel. It reached a low of less than 90 USD in late June, rising to 98 USD in early July.

   As in all markets governed by supply and demand, it is necessary to seek the cause for relative price decreases caused by these two key variables.

2. Basically, the current supply is abundant while the demand is sluggish.

   The sharp fall in output from Iran, the third largest producer (relating to sanctions), dropped from 2.5 to 1.5 million barrels/day. This was offset by an increase in production from Saudi Arabia, which reached record levels in the last thirty years, to 10 million barrels/day. Within OPEC, the Saudis have always played the role of equilibrium producer (« swing producer »). Thanks to their huge deposits, the Saudis are able to offset the supply deficit of one or more members, or even reduce their production in the event of a strong surplus.

   At this “delta” of production from Saudi Arabia, added production from Latin America (Colombia, Venezuela), the United States, Iraq and Libya (restarting after the phase of a crisis), and also production from Canadian oil sands, as well as production growth from natural gas liquids (about 0.5 million barrels/day), altogether help to relax the market.

   The demand for oil is stagnating and even decreasing slightly. This is explained by the significant slowdown in the global economy, particularly from the recession undergone by economies of major industrialized countries, along with a slowdown in expanding major emerging markets, thus reducing energy requirements. Since oil stocks have never been as important than they are today, especially in the United States, no « stock effect » will mitigate the direct impact of a more sluggish demand.

   Accordingly, the excess of world supply on the global average demand in 2012 is now estimated at 0.7-0.8 million barrels/day. The global supply is also expected to grow by 2.5 million barrels/day in 2012 compared to 2011.

   Fears about the situation in Iran, particularly those concerning the threat of a blockade on the Strait of Hormuz, where one third of oil is imported by sea, have subsided. As Iran and Algeria call for a future meeting, the position that will stop OPEC, in particular Saudi Arabia, remains to be known. Both these countries were hoping that the cartel would decide to lower production, and thus mechanically raise prices…

   At the same time, Ms. Van der Hoeven, executive director of the International Energy Agency (IEA) declared, at the Summit of oil and gas, that the price trend is “more uncertain than ever.” Markets overreact to any announcement or event considered significant: this can be observed during the decline in Chinese interrest rates, more recently with each new development of the Iranian issue, and also with oil companies as they have an objective interest in high prices. These prices also allow the companies to preserve their margins and cover development costs, which are driven up by technological challenges (new methods of drilling in deep water, as well as exploration for new energy sources) and also by taking environmental concerns into a greater account.

   Are we victims of an illusion? While Brent flexes, we are in an era of high oil prices, reflecting an overall market under tension.

2. The oil prices are permanently attached to a high point, thus certifying the prospect of a “third oil shock.”




The expression, “third oil shock,” is sometimes used to designate the period from 2001-2008 when Brent crude saw a monthly average from $16 to $126. As prices continue to stay above the $100 USD mark for more than a year now, a “third oil shock” is once again becoming a relevant issue.

Why is there a high level of prices with cash payments for future “commodities” markets?

1. Oil supply has been under pressure for a long time. In the central scenario of IEA, world oil production will reach 94.6 million barrels per day in 2035 (12.8 million more barrels/day than in 2010). On the other hand, demand is expected to reach 99 million barrels/day, thus creating a supply deficit of 2.6 million barrels/day. We can therefore expect heightened tensions in the oil market during the quarter century ahead. This scenario has been generally confirmed by the forecasts of majors, namely Exxon and Total, assuming a conventional oil production (Note: excluding natural gas condensates, as well as deep and ultra deep offshore). We can expect to see a stable or slightly declining supply over the coming decades. The decline in production from many ancient deposits must be offset by the exploitation of new deposits.

   In result of these tensions on supply, the increase in price level should logically allow for an increasing exploitation of resources, which have been previously considered “difficult.” This can be achieved thanks to improved recovery techniques (“enhanced oil recovery”), notably in the Middle East.
   The expansion of deepwater (500-1500 m) and ultra-deep water (beyond 1500 m) techniques will reach 10% of the total production of liquid hydrocarbons by these methods in 2025, according to Exxon.

   Unconventional oil also takes an increasingly important role in global production. Whether it is “tightoil” (oil shale found mainly in the Williston Basin) in the United States and Canada, oil from Canadian oil sands, or extra-heavy oil produced in Venezuela, all of these have seen a rapid progression.

   Depending on the price levels, the production of oil from gas or coal could expand significantly.

2. The components of demand are long-term dynamics

Global demand for oil continues to rise: most of this demand comes from the transportation sector (which is rapidly expanding in emerging markets) where the prospects of developing alternatives to oil are limited. In 2040, nearly 90% of transport will operate from hydrocarbons, compared to 95% today. Demand in the sector will increase by 45%, and transportation-related sales will increase to nearly 80% between 2010 and 2040.

Stabilizing demand for oil-related transport will essentially hold energy efficiency gains in traditional vehicles.

3. Although the prices will not decline, the extent of their increase is uncertain

No operator commits to forecasts beyond a few months

The political factors related to the situation in the Middle East contribute to the uncertainty.

Prices should not go below 80-100 USD. This level corresponds to the marginal operating cost of a barrel of oil as it becomes increasingly difficult to extract (thus this is a floor for operators). Furthermore, the budget analysis of major producing countries as well as OPEC members reveal a convergence around a price of 100 USD, a level intended to ensure a balance of public budgets. This has been stressed in the context of the “spring Arab” under social spending.

The extent of future increases remains difficult to assess. If the price floor is roughly identified, the band of price fluctuations is potentially large because:

• The price factor has a decisive impact on the supply: oil companies take this into effect when deciding whether or not to invest in a deposit based on oil prices expected for the period of operation (Note that it is thus necessary to distinguish the notion of deposit in the “geological” sense from the “economic” sense, depending on a break even point). This reasoning particularly concerns unconventional oil, with high production costs: bituminous shale and oil shale (50-110 USD per barrel), gas to liquids (40-110 USD), coal to liquids (60-110 USD). For ultra profond complex (Arctic etc) and Canadian oil shale, the $100 USD production costs are already exceeded.




• However, the impact of price on demand is very limited. Oil demand is price inelastic, primarily because transportation occupies a major part and their needs are incompressible. Additionally, because alternatives to hydrocarbons remain underdeveloped.




• A high risk of peak prices are in the years and decades to come.




• In any case, prices will remain very volatile, especially as a crisis in a producer country could cause a supply disruption. Their impact would be stronger than the reduced, spare production margins, currently around 3 million barrels/day. The impact of price speculation is the subject of intense debate, mainly because of transaction in forward markets and options markets.




• Only a strong and rapid surge in oil prices seems to justify the expression “oil shock.” According to Total, a $200 USD barrel would result in a substantial slowdown in growth. In this case, the bill on oil would exceed the maximum reached in 1980 (9% of global GDP compared to 8%). At this point, higher prices in the decade from 2000-2010 have not had as much of an effect on the overall economy as the first two oil shocks. This is particularly because the prices have risen more slowly.

Conclusion

Without certainty, the new oil shock crisis is looming, already raising critical issues for the future of peoples, states, businesses, and international relations.

In terms of supply, how can we respond to the exponential global demand related to both population growth and economic growth? How can we reconcile economic growth, driven mainly by emerging countries who make it their number one priority, with the climate issue? How can we achieve an “energy mix” to provide energy transition without going through a major shock? In other words, how could we gradually change our energy system while still being able to work at full capacity? Given the slow growth in industrialized countries along with the public financial crisis, how can extremely expensive investments to develop low-carbon energy and efficient energy for the climate issue be financed?

As observed by Christophe de Margerie, CEO of Total, we must make sure to enter in a new era of human history: an era for the “transformation of the energy system,” “smooth transition,” “complementary energy,” “research efficiency,” and “recognizing the need to reconcile energy demand with climate change.”

In any case, oil companies will have to profoundly renew their culture and project an image of corporate responsibility. They need to show change by putting their selves in the common space where the interests of economy, production, and public good come together.