Contents

『Summary and comment
Since 2003 the international oil market has been moving away from the previous 20-year equilibrium in which prices fluctuated around $25/bbl (in today's dollars). The single most important reason is that growing demand has eliminated the structural surplus of crude production capacity which had existed since the oil price shock of 1979-83.

So far, the higher oil prices since 2003, and even higher since 2005, have not induced economic recession in oil-importing countries so that oil demand has not fallen as it did in the 1980s after the second oil shock. Unless this occurs, a structural surplus will not be recreated, and prices are likely to remain ‘high’ - above $50/bbl - until longer-term reactions take effect. If the political situation in the Middle East deteriorates further prices could reach new levels, but the reaction would be quicker and stronger.

Meanwhile, supply and demand are set to expand roughly in balance over the next five years, though there are many uncertainties which will lead to short-term fluctuations. With so little controllable flexibility in supply or demand, prices will remain volatile in the short term.

Five or more years of oil and related energy prices averaging double (or more) their previous long-term average cannot fail to create a new long-term situation both in terms of economic behaviour and government policy. This will bring new competition which will simultaneously reduce the demand for energy, increase the supply of oil, and increase the substitution of other fuels for oil outside the transport sector. As these forces develop, oil prices will be unstable through the long term.

For the transport sector, there is a very large range of possibilities which do not depend on the development of new technology. Examples are a shift in US vehicle demand to vehicles with typical Japanese or European fuel efficiency (which would reduce world transport fuel demand by nearly 10%) and the opening of US and European markets to competition from Brazilian and other developing country ethanol supplies. A period of high oil prices will also lead to investment to increase the production of liquid fuels from oil sands or natural gas. Once these investments are made, they are likely to continue producing as long as their operating costs remain lower than the price of oil.

Outside the transport sector, oil has a higher share of the energy market in many countries than in the US. If other countries substituted other fuels for oil to the same extent as the US has, world oil demand would be about 25% lower. However, other countries do not have the same range of natural resources and competitive energy markets as the US has. The main uncertainty about the long-term outlook is where and how new natural gas markets will develop at the expense of oil. This in turn depends on changing the pricing system for natural gas, which has so far tracked high oil prices outside the US, and on investment to expand gas production and transport infrastructure for international trade. The business model for these projects must adapt to the trend for liberalisation of gas markets in importing countries
and specifically to rules which are often better adapted to secure competition within established markets than to the management of infrastructure expansion risks.

Power generation in centralised systems currently absorbs about 5% of world oil demand. This would reduce to 2% if the rest of the world used other fuels for power generation to the same extent as the US. There are some trends in this direction. Over half of the world's oil use in power generation is in oil exporting countries, many of which are replacing oil with domestic gas in order to free oil for export. A further third is in South East Asia, where oil is being replaced by imported coal because coal prices have not tracked the rise in oil prices, and expansion of coal imports (unlike gas imports) does not depend on massive infrastructure projects. The global oil market and price are only marginally affected by the
European use of oil for power generation (less than 1% of world oil consumption) and the promotion (for climate policy reasons) of ‘renewable’ sources of electricity generation.

The main ‘energy policy’ conclusions of this analysis are:

• Price stability is an unattainable goal. The disappearance of the structural surplus of oil production capacity means than the main mechanism for stabilising oil prices - production control by OPEC and other key oil exporters - will in future only work during periods of deep economic recession when exporters will seek to protect their revenues. Markets can, with some risk-taking, handle day-to-day volatility. The question is how to understand the possible effects of longer-term price uncertainty.
• A new equilibrium will not wait for new technology. This in turn has the strong policy implication that economic incentives, such as prices, can be effective. The current period of ‘high’ oil prices, if it persists, will generate a wave of competition to replace energy use, particularly in transport, thanks to more efficient demand technologies which already exist and are applied in some countries. This competition will also replace oil outside the transport sector by other fuels. It may be politically difficult to overcome market failures which protect vested interests in existing market structures and distribution systems, but it may be more rewarding than spending money on long-term technological ‘fixes’ for existing systems.
• Gas matters. Reducing the role of the‘high’priced oil outside transport and power will depend on the expansion of the international gas market. The challenge is to find policies that simultaneously promote competition (as in market liberalisation) and investment in massive new infrastructure and production projects for international gas trade.
• The power sector does not matter much to oil. The questions of gas or nuclear, and how far to subsidize or mandate renewable energy sources, are important for other reasons, such as climate policy or energy security. Their economics depend respectively on the price of coal (competing with nuclear for base loads) and gas (competing with
  renewables).』

1. In transition
　1.1 Has there been a failure to invest?
　1.2 Balance of supply and demand to 2010
　　Supply projections
　　Demand: no recession yet?
　　What next for prices?
　　Instability is certain
　　Chart 1: History of crude oil prices
2. The long term
　2.1 Demand destruction
　2.2 Economic activity and energy demand
　　Chart 2: US Energy use per unit of GDP
　　The tranport sector
　2.3 Liquid fuels in the future
　　‘Unconventional’ oil
　　　Heavy oil, shale oil and tar sands
　　　Gas or coal-to-liquids (GTL or CTL)
　　　Ethanol in Brazil and the US
　　　Biomass
　　　The EU bio-fuels policy
　　　Hydrogen and fuel cells
　2.4 Substitutes for liquid fuels
　　Chart 3: Oil price and market share
　　Chart 4: Oil for transport
　　Chart 5: Sectors with a higher use of oil than in the US
　　Gas: the challenge to oil has not materialized
　　Chart 6: Gas versus oil prices
　　　Trends towards more competitive gas markets
　　　Project-led expansion of gas markets
　　　Key uncertainties in gas
　　The power generation sector
　　　Coal
　　Chart 7: Coal versus gas prices
　　　Nuclear electricity
　　　Renewables

Chart 1: History of crude oil prices Source: BP Statistical Review 2006. 〔Mitchell,J.V.(2006): A New Era for Oil Prices. Chatham House (the Royal Institute of International Affairs), August 2006, 32p.から〕