The Future of Oil: “Geology versus Technology”

The IMF has just published a working paper on the future price of oil.

It concludes that:
a) the price of oil in real terms will most likely double over the next ten years,
b) there is a large degree of uncertainty in how things might actually turn out.

What the IMF working group did

Predictions about oil typically fall into two camps. First there is the ‘geological’ viewpoint, which says that there is a limited amount of oil in the ground and it will run out soon. You might call this the ‘doom and gloom’ scenario.

Then there is the ‘technological’ viewpoint, which says that higher prices will inevitably lead to innovations that solve the problem. This might equally be cast as the ‘naive optimism’ scenario.

The IMF, with its focus on international trade and sustainable economic growth, wanted to look objectively at the oil price, without pre-judging whether either of these views is correct.

The working group built an economic model that contains their best understanding of how increased demand for oil might drive production upwards, as well as their best understanding of how increased economic activity (and higher oil prices) would drive demand.

The working group’s conclusions

The result is a model that predicts historic price changes, “far better” than previous models do.

And the best forecast of the new model is that the impact of technology will only be a slight increase of world oil production (compared with the straight ‘geological’ scenario), and that there will be “a near doubling, permanently, of real oil prices over the coming decade.”

Key drivers

It seems that three key factors will determine how this turns out in practice. They are (paraphrasing):

  1. How much recoverable oil actually turns out to be in the ground;
  2. How much money people turn out actually to be willing to pay for a barrel of oil; and
  3. The degree to which oil producers decide to raise production in response to higher prices.

None of these can be known until after the event, so there is a wide range of possibilities as to how things might turn out. (These are shown as dotted lines in the diagram above.)

Uncertain impacts on the economy

The working group also finds it difficult to predict what the consequences of tighter oil supply and higher oil prices would be for the world economy.

Firstly, “This is uncharted territory for the world economy, which has never experienced such prices for more than a few months.”

Second, “there must be a pain barrier, a level of oil prices above which the effects on GDP becomes nonlinear, convex.” (Presumably this is similar to the way that rising levels of water would have a ‘nonlinear, convex’ impact on a person’s ability to breathe, once the water level reaches their nostrils.) The key question is, does that ‘pain barrier’ come after the real oil price reaches $200/barrel, or before? Again, the world economy has not experienced this before, so it is difficult to know.

And third, “the assumption that technology is independent of the availability of fossil fuels may be inappropriate, so that a lack of availability of oil may have aspects of a negative technology shock.” In other words, a lack of (cheap) oil may impede our ability to develop new technologies, and/or use existing technologies.

The bottom line is that, in terms of impact on the economy, “The macroeconomic effects… could be much larger, more persistent, and … would extend well beyond the oil sector.”

What to do

The working paper says that for the IMF, further studies “will be a priority of our future research.”

But it is clear that what happens between now and 2022 cannot be predicted. It is not set in stone but will depend on the choices we make now and the actions we take. How well we prepare.

We do not know how much world oil production is going to rise. But we do know that it  has plateaued since 2005 (despite historically high prices), and that demand is going to continue to rise more quickly than production. Someone, somewhere, is going to face a shortfall.

We also know that the price is headed upwards, in real terms, permanently. And that the impact on the economy (that is to say, on individual businesses) has the potential to be ‘nonlinear’ — if we do nothing.

But business leaders do not wait for 100% certainty before they take action.

And it will be much easier to quantify the likely effect on individual businesses, than to try and forecast for the whole world economy.

This report provides enough information to know that every business should now be taking steps to do four things:

  1. Identify where and how the price of oil/availability of oil impacts their current business model.
    (As a raw material; in the supply chain and distribution; in core operations; in the ability of customers and employees to participate in the business; …)
  2. Quantify and prioritise those risks, and develop plans to mitigate or manage them appropriately
  3. Identify business opportunities that are likely to arise in a future, oil-constrained world
  4. Consider the development of step-change business models

(Businesses might also find it instructive to carry out the first two steps for their customers, their suppliers, and their competitors.)

The IMF’s working paper report is available from their website here, as well as here.

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