Why oil still matters

The way oil production has been organised goes back to the 1970s and the change that took place then. In the post-war period before the 1970s, something called the Texas Railroad Commission in the United States was the effective arbitrator of world oil prices, outside the Soviet Union. As American oil power or energy power declined in the 1970s, and as Saudi energy power increased (although there is some fluctuation well into the early 2000s), the dominant production cartel came to be OPEC (Organization of the Petroleum Exporting Countries).

Shale production involves a different kind of technology to blast open rocks, to extract oil and gas. It is more expensive than most conventional oil production, though some deep-sea water conventional oil production is also expensive. The other crucial aspect of shale production (which is why the American producers have not been keen on production cuts) is that any particular drilling operation through fracking, the name for the technological process by which the oil is extracted, means that shale wells are depleted much more rapidly than conventional wells. Once you start a drilling operation in a shale well, it needs to be done quickly. The company does not want to take a long time to extract all the other oil that is to be had. Its credit is highly dependent on capital, which is why, although the technology for shale has been available for a long time, it only became practically viable once there was a credit environment that could support loss-making activity.

When President Nixon and President Carter were responding to the energy crisis in the 1970s, they both wanted America to achieve what they called energy independence. They both thought that shale oil was one of the routes to energy independence. Particularly for Carter, perhaps it was the most important route to energy independence. But even though the technology would have worked, the finance of shale at the time did not. It took the crash of 2008 and the monetary response from the Federal Reserve Board in the first three quantitative easing programmes and zero interest rates to make it possible to create the credit conditions in which shale oil would be viable.

If we want to understand the different crashes that were happening in 2008, and the relationship between the oil crisis and the financial crisis, we need to do two separate things. The first is to think about oil and financial crashes as two separate phenomena, and then to look at the way in which they intersected with each other.

What is misunderstood about the 2008 crash is that, whilst it is true that there was a big financial crash that had dollar banking at its centre, it was not actually the financial crash that initially sent Western economies into recession. Indeed, the American economy entered recession in the latter part of 2007. So, how did those recessions in 2007 and 2008 begin?

The answer has more to do with oil than it has to do with the financial crash. Although the financial crash has its first part in the summer of 2007, and then plays out through 2008, very high oil prices send the American economy into recession. They send the eurozone economy into recession, and the British economy into recession. Once that is happening, there is an intensification of the financial crisis in the late summer and early autumn of 2008 around the Lehman Brothers’ bankruptcy and what followed. So, we need to separate the oil crash and the financial market crash.

Oil plays its part in causing the financial market to crash. From about 2004, central banks led by the Federal Reserve Board in the United States start to worry about the inflationary consequences of oil price rises that are taking place at that time. They start to raise interest rates, starting with the Federal Reserve Board, but then the European Central Bank and the Bank of England follow suit. It is a period of tightening interest rates, and particularly in the United States, those higher interest rates cause all kinds of problems in the American property market and in the subprime market.

It is simplistic to say that at the heart of the financial crisis is the subprime crash. But there is a connection between the two: mortgage-backed securities. At the time, mortgage-backed securities are being used as collateral in banking funding markets. Once it becomes impossible for banks to use mortgage-backed securities for that purpose, the financial crisis begins.

Why were there these problems with mortgage-backed securities? This goes back to the fear that once the subprime lending bubble had burst, there was going to be lots of bad debt packaged up in these mortgage-backed securities. Why was it the case that the subprime bubble burst? A good part of that explanation is higher interest rates. Why was the Federal Reserve Board raising interest rates from 2004 onwards? The answer is the fear of inflation generated by rising oil prices. There is a causal relationship that goes from oil into the financial crash, but it is an indirect one.

By the time of the 2008 crash, oil prices had become unprecedentedly expensive. In the middle of 2008, a few months before the Lehman Brother’s bankruptcy, oil prices peaked at around $150 a barrel. Then, the situation brought those oil prices crashing down with the financial crash. But in order for there to be any possibility of economic recovery, such that there would not be a repeat of oil prices hitting the $150 mark, there had to be new production. There had to be new supply. And that came essentially, though not entirely, out of the United States, and it came out of shale oil production.

In the end, shale oil has meant that there is too much oil supply. Just because the United States wanted to produce more oil did not mean that Saudi Arabia and Russia, the other two large oil producers, were going to produce less. Intense competition began to take shape between the three large oil producers. Obviously, the United States, Saudi Arabia and Russia have incredibly complex geopolitical relations with each other. On top of this, they now have oil production rivalry.

Because of how Saudi Arabia in particular reacted to shale oil, from 2014, oil prices change from being much too high for consumers – which is what they had been up to 2008 – to being too low for producers. It became too difficult for the shale oil companies to make a profit. And it became difficult for Saudi Arabia to maintain its levels of state expenditure in the way it supports its population by oil revenues. Venezuela, as a medium-sized oil producer with a lot of reserves, was the biggest casualty in 2014 of the fact that oil prices became too low for producers.

In November 2014, the Saudi leadership took the decision to see whether it could bankrupt the shale oil industry and take it out as a market competitor. It probably hoped that it could inflict some damage on Russia at the same time. The Saudi government was able to lead OPEC to push prices much further down than what they had been and managed to do so despite considerable dissent within OPEC itself, not least from Venezuela.

There are problematic dynamics around oil production and oil consumption today that make the way in which oil markets work dysfunctional. That is partly why, even leaving the COVID-19 crisis aside, there has been such turbulence in oil markets over the last few months. Indeed, at one point the future prices for oil went into unprecedented negative territory. Why has this situation come about?

The answer begins in the 1970s. Several important changes in oil production took place. First of all, production that had been taking place in the United States by conventional means – meaning oil that wasn’t being produced as shale oil is produced today – peaked around 1970. As a result, the United States became a significant importer of oil in the 1970s. At the same time, Soviet oil production became more important. Middle East oil production, particularly in Saudi Arabia, became more important. And the United States had to reconstruct its whole approach to energy security in the Middle East. Through this time, oil consumption continued to rise.

But regardless of what had happened in terms of consumption, we could see some difficulties in the supply of oil by the late 1990s. The extra oil supply that came from the North Sea, from Alaska and from Mexico through the 1980s and into the 1990s, was not reaching its absolute peak, but it was not growing as fast as it had previously. Into that position came China and China’s economic rise. China’s economic growth meant that China was going to consume much more oil than it had previously done. We see a development whereby China will ultimately replace the United States as the single largest importer of oil in the world, which is where we are today.

With the COVID-19 crisis, the big shock to Chinese oil demand at the beginning of 2020 spread through the rest of the world economy. This made prices so low that it induced the Saudi government, and Crown Prince Mohammed bin Salman in particular, to make a rash decision. In early March, the Saudi government decided to flood the oil market with supply to address the problems that the COVID-induced slump in demand was causing for Saudi Arabia, particularly since Mohammed bin Salman and Putin had fallen out about how to deal with the situation.

It was that decision to flood the market that brought things to a head. Since then, the Americans, the Saudis and the Russians have had to make a compromise – the details of which are not entirely clear – that put a floor under how far oil prices could fall. But the fundamental problem remains in place. We live in a world in which oil is either too expensive for consumers – making economic growth very difficult – or it is too cheap for producers. And that has very dysfunctional consequences, not only in terms of the relations of these states with each other geopolitically, but in terms of the internal politics of Saudi Arabia in particular.

The Saudi government and Putin made an accommodation with each other. They formed a de facto organisation called OPEC Plus, which essentially meant OPEC plus Russia. From November 2016 to March 2020, until the beginning of the health emergency outside China, OPEC Plus was trying to manage oil markets. It was doing so in ways that allowed the shale producers in the United States to freeride from it. OPEC Plus restrained production in order to keep prices not massively high, but relatively high: high enough to be viable for oil producers. The shale producers got the benefit of that without having to restrict their own production.

The accommodation that OPEC Plus represented between the Saudis and the Russians broke down in early March 2020. This triggered the oil market crash and, with it, the financial market crash. The trigger for the huge falls in share prices in the week of 9 March was the decision that Mohammed bin Salman had made over the preceding weekend to flood oil markets. The Trump administration then got involved in trying to put OPEC Plus back together again without having to accept many restrictions on what shale producers produce, because that would be difficult for the shale producers to accept. How much the Americans contributed to the cuts in production that allowed oil prices to recover over the last few months is far from clear.

If we think about trying to move to a world of cleaner energy, in which we do not have to deal with the kinds of problems I have been describing about oil markets, several things must be clear. First, in the short- to medium-term, it is difficult to decrease the demand for oil significantly without crashing the world economy, as we have been doing for the last few months. That does not mean that it is impossible. But to do so with any rapidity is impossible without making fundamental changes in how we live our lives that are not politically contemplable for most politicians.

We have to be realistic about how far, and how quickly, oil can be replaced, particularly in relation to the transportation sector. That is not a reason why we should not be trying – indeed, quite the contrary – but it does require a certain energy realism to accompany climate realism. We need to be absolutely clear about what the dangers of fossil fuels are for the climate. And we need to understand how much our way of life and the way in which the whole world economy works is dependent on fossil fuels. The transition is an enormous undertaking to even conceive, let alone to execute. I do not want to diminish the importance of climate in any way. Simply, we must also understand what it means to transform the material foundations of our way of life by changing the energy that powers it.

There is no way to achieve an energy transition that will not be incredibly disruptive in terms of geopolitics and political stability across the world. Whole states are dependent on fossil fuels. We in the West have encouraged this. We cannot just say that this is what happens in Russia, or what happens in Saudi Arabia.

The construction of political authority in Russia or Saudi Arabia and the economies in these countries are extraordinarily dependent on not just oil, but in Russia’s case, on gas as well. So, we cannot transition away from fossil fuels and think that we are not going to have to deal with huge problems in regard to what gets left behind in these countries where they have made not only their economy but their politics dependent on fossil fuel production. We need to understand in the West that we are complicit in that. That is not just something they inflicted upon themselves. This is something that our way of life gave them very strong incentives to do. We need a geopolitics strategy, as well as an energy strategy, for transition.