Future Dependence on Gulf Oil?

Originally posted September 2009

A number of oil market analysts hold the view that there will be a growing dependence on oil from the Gulf countries. This view is based on the fact that these countries account for a large share of global proven oil reserves. This view is also prevalent among government and national oil company officials of the GCC (Gulf Cooperation Council) countries, who believe that oil prices and export volumes will rise in the near future, resulting in increased oil revenues that will alleviate budget deficits. While this argument is plausible, there are factors which could undermine its validity. This essay is intended to shed light on the merit of this expected growing dependence upon Gulf oil and to discuss the resulting implications for the economies of the GCC countries.

The Role of Gulf Oil in the World Oil Market

Many factors account for the dominance of Gulf producers in world oil markets. First, according to the latest issue of the BP Statistical Review of World Energy, the Gulf countries accounted for about 65% of global proven oil reserves at the end of 2007. The oil-producing countries of the Gulf have been in the business for the past five decades, yet the amount of their proven reserves has not declined; on the contrary, they have increased by at least 30% over the past two decades.

Second, Gulf oil is cheap to produce, due to the size and geological formation of the oil fields as well as their proximity to deep water. Given the advantage of low production costs and the fact that Gulf capacity could be brought on stream quickly as demand grew, the Gulf has become the foremost supplier of oil.

Third, the geographical location of the Gulf — between the growing markets of both the East and the West — has provided excellent market opportunities for its oil producers.

As a result of these factors, Gulf oil dominated the world’s export markets, and Gulf producers became the main inventory for the international oil industry. However, the higher crude oil prices triggered by the Arab oil embargo of 1973 led to widespread inter-fuel substitution and oil conservation. This trend continued for years because of continued expectations of higher oil prices coupled with persistent security of supply concerns in many industrial nations. The huge increase in oil supplies from non-OPEC sources such as Alberta’s oil sand was a reflection of frantic searches for “secure” oil. In the early 1990s, much of the resulting reduction in the call for OPEC sources fell upon the Gulf producers, with Saudi Arabia in particular bearing most of the drop. In recent years, however, the demand for oil has substantially increased, driven largely by the growing needs of the newly developed economies of China, India, South Korea, and Singapore, among others.

Many energy analysts argue that the expansion of world demand for oil over the next two decades, mainly due to consumption growth in the developing countries coupled with constrained non-OPEC supplies, will substantially boost the call for Gulf oil. However, there are some major conceptual problems with this argument, both on the supply and the demand side.

Supply Side Questions

First, the definition of oil reserves needs to be considered carefully. Oil reserves are generally taken to be those quantities which geological and engineering information indicate with reasonable certainty can be recovered in the future from known reservoirs under existing economic and operating conditions. This definition does not call for a fixed number of billions of barrels as a measure of the finite nature of the reserve base. Rather, the above definition considers oil reserves figures as the outcome of a dynamic process, whereby technology keeps pushing up recoverable reserves, as do changes in economic conditions.

For example, estimated worldwide proven oil reserves estimates rose by 30% in 1988 not because of major new oil discoveries, but as a result of technological innovations in oil recovery, such as enhanced and secondary oil recovery techniques and horizontal drilling. Similarly, in 1995, the estimated Gulf countries’ proven oil reserves grew by about 10% due to technical innovations. Thus, proven oil reserves numbers are flexible figures that reflect changes in technology and/or the economic environment.

Second, it is unlikely that non-OPEC supplies will decline sharply in the near future. In recent years, the industry has witnessed major technological innovations in offshore production practices and in oil sand production technologies. Currently, there are new technologies — ranging from horizontal drilling to 3-D seismic imaging — that have substantially reduced the per-barrel costs of production. According to some estimates, the worldwide per-barrel costs of exploration and development also fell in real terms, from US$16 in 1982 to about US$4 in 2004. Furthermore, sub-sea completion and offshore loading technologies have significantly reduced lead times on offshore projects, which have dramatically transformed the economics of such projects. For example, the Foinaven offshore oil field, which is located west of Shetland (Scotland), has been developed for a fully built-up cost of about US$5 per barrel (bbl), and with a lead time of less than three years.

Moreover, traditionally, national oil companies (NOCs) had been the predominant actors in exploration and production in many developing nations. In recent years, however, many NOCs have been privatized or restructured. This trend has, in fact, improved the ability of the NOCs to discover and develop reserves, thereby further influencing the rise in world oil supplies.

Finally, GCC producers also will have to contend with growing supplies from non-Gulf OPEC countries such as Angola, Venezuela, Nigeria, Libya, and Algeria — all of which have invited international oil companies (IOCs) to assist in the development of their capacity and to explore for more oil and gas reserves.

In the longer term, the development and discovery of new reserves, coupled with greater technological gains and breakthroughs in the field of exploration and production of oil are likely, casting further doubt on the view of a growing dependence on Gulf oil.

Demand Side Questions

Oil demand is driven by consumer decisions regarding the possession and usage of equipment and appliances — decisions that are likely to be interdependent. In the short run, only utilization can be altered. Oil consumption is therefore driven by the stock of equipment and appliances.

Given the current stock of oil-using appliances and the fact that rising income is likely to lead to increases in this stock, the expectation that oil demand will rise over the next decade seems reasonable. However, over the longer term, the probability of significant efficiency improvement in the equipment and appliance stock increases; such improvement will undoubtedly change the pattern of oil demand.

These changes in consumption patterns may eventually occur partly because of recent trends in oil pricing and tax policies. During the 1990s, the majority of developing nations began to shift from subsidized to market-based oil prices. Although subsidies remain in place for specific products, it is likely that these will eventually be removed. More recently, the governments of many developing countries have begun to raise significant revenues by imposing various forms of taxes on oil consumption. Higher prices could induce consumers in developing nations to convert to cheaper alternative fuels, as so many consumers have done in the industrial nations. Such a trend would lead to reductions in oil demand.

The concerns over the environment and climate change are an obvious additional source of significant changes in oil consumption patterns. However, it is difficult to project how environmental concerns will affect future oil demand. This is because any environmental policy which might influence oil demand in the future will not succeed without significant costs to consumers and governments. Currently, the concern over urban pollution from automobiles and CO2 emissions is at the center of the US environmental policy agenda. It is reasonable to argue that in the future, gasoline and diesel engines, which currently dominate the vehicle stock, could decline and be replaced by alternative forms of propulsion, such as hybrid or liquefied natural gas (LNG), or by greater use of public transit.

There also is a growing demand for alternative forms of energy. Here, technical innovation is the name of the game. The costs of renewable forms of energy appear to be declining. For example, some estimates suggest that the cost of wind turbine electricity in California fell from 24¢/kWh in 1985, to 9¢ in 1995, and to only 6¢ by 2006. Additional technological breakthroughs in alternative energy forms (e.g., photovoltaic, hydrogen cells, nuclear fusion, and super conductors) would further reduce the importance of oil in the overall energy mix.

Finally, after the oil price shocks, the drive for conservation and inter-fuel substitution was triggered above all by “expectations” of higher oil prices yet to come. Presently, if oil shortages are expected to materialize in the future as non-OPEC oil runs out, would not these expectations provoke a reaction away from oil, at least in the industrialized nations? The history of the oil industry is filled with such dramatic behavioral changes, where the pattern of consumption has changed drastically and rapidly.

Conclusions

The validity of the view that dependence on Gulf oil will inevitably grow is questionable, at best. Furthermore, economic logic argues that low-cost reserves should be developed and produced first; however, since 1973, geopolitical factors in the Middle East have led to the development and production of higher-cost non-OPEC supplies, thereby limiting OPEC’s control of the market. As this essay has shown, there is ample reason to believe that this pattern will continue.

For the GCC countries to realize the full advantages of their huge oil reserves, they must act now rather than later to replace the production from non-OPEC sources while world oil demand recovers and continues to grow. The Saudi policy of stability of supply coupled with oil price moderation is a step in the right direction, the fruits of which are already apparent. Other steps, however, should follow. Since the GCC countries own the largest crude oil reserves, they must divert the investment into developing further capacity from non-GCC sources. GCC national oil companies could join forces with international oil companies to develop their known reserves, even within the limits of the existing infrastructure. For example, were GCC countries to operate at the reserve-to-production ratio currently observed in non-OPEC countries, their combined production rate would reach 55 million barrels per day (bld).

GCC countries should also play an active role in global decisions related to current environmental issues. Of particular importance are policies for emission controls and road and gasoline (green) taxes. Moreover, they need to monitor and evaluate the likely impacts of new developments in all areas of alternative energy sources.

Furthermore, the GCC countries should diversify their economies as quickly as possible while practicing fiscal restraint in the meantime. They also must increase investments in human development and give the private sector an increased role in the economy. It is prudent for the GCC countries to plan for a future where growing dependence on Gulf oil is not inevitable — to shape their economic and policies and oil market strategies accordingly, lest they risk being left with huge oil reserves that no one wants to buy.