additional output. “We had seen the trend in China since the early 1990s,” said one Saudi. “But the cumulative effect was greater than any of us had realized. China was facing a shortage at the time. It was a structural change in the oil market.”2 China was on a red-hot growth streak. Economic growth in 2003 was 10 percent; in 2004, another 10 percent. Coal, the country’s main source of energy, simply could not keep up with the demands of China’s export machine. Compounding shortages, the railway system that carried the coal was overloaded and gridlocked, and long trains of coal cars were sidetracked on tracks across the country. Oil was the only readily available alternative for electricity generation, whether in power plants or diesel generators at factories. As an insurance policy, enterprises were also stockpiling extra petroleum supplies. Oil demand normally grew at 5 or 6 percent a year in China. In 2004 it was growing at an awesome 16 percent—a rate even more rapid than the overall economy. The world market was not prepared. By August headlines were reporting soaring prices in “the incredibly strong crude market.”
The world economy was moving into a new era of high growth. Between 2004 and 2008, Chinese economic growth averaged 11.6 percent. India, entering on the “growth turnpike,” would average over 8 percent during those same years. Strong global growth translated into higher oil demand. Between 1999 and 2002, world oil demand increased 1.4 million barrels per day. Between 2003 and 2006, it grew by almost four times as much—4.9 million barrels.
That was the demand shock.
THE TIGHTEST MARKET
All the elements were there for an oil boom: Spending to develop new supplies had been held in check by the trauma of the 1998 price collapse. But demand was now surging, and the disruptions—in Venezuela, Nigeria, and Iraq—were taking supplies off the market. The result would be a historically tight market.
Usually the global oil industry operates with a few million barrels of shut-in capacity—that is, production capability that is not used. Between 1996 and 2003, for instance, spare capacity had averaged about 4 million barrels per day. That shut-in capacity is a security cushion, a shock absorber to manage sudden surges in demand or some kind of interruption. One supplier country has made an explicit commitment to hold significant spare capacity. Saudi Arabia’s policy is to build and maintain spare capacity of between 1.5 and 2 million barrels per day in order to promote market stability. But for other countries, spare capacity is somewhat inadvertent. In 2005, however, the surge in demand and disruptions of supply shrank spare capacity to no more than a million barrels a day. In other words, the cushion was virtually gone. In terms of absolute spare capacity, the oil market was considerably tighter than it had been on the eve of the 1973 oil crisis. In relative terms it was even tighter, as the world oil market was 50 percent bigger in 2005 than in 1973.
In such circumstances the inevitable happens. Price has to rise to balance supply and demand by calling forth more production and investment on one side of the ledger, and on the other, by signaling the need for moderation in demand growth. By the spring of 2005, OPEC’s $22-to-$28 price band was an artifact of history. Many now may have thought that $40 to $50 was the “fair price” for oil. But that was only the beginning.
Other factors reinforced the rising price trend. In the aftermath of the 1998 price collapse, the industry had contracted, and then had continued to do so, on the basis of expectations for low prices. It was focused on keeping spending under tight control. As late as August 2004, the message from one of the supermajors was that “our long-term price guidelines are around the low $20s.” Or, as the chief financial officer of another of the supermajors put it, “ We remain cautious.” The industry continued to fear another price collapse that would undermine the economics of new projects. Investors exerted tremendous pressure on managements to demonstrate “capital discipline” and hold back spending. The reward was a higher stock price. And if companies did not heed the admonition, they would be punished with a lower stock price. As one such investor warned in mid-2004, if companies started increasing investment because of higher oil prices, “I’d look at that skeptically.”3
WHERE ARE THE PETROLEUM ENGINEERS?
“Capital discipline” translated into caution. The mantras were “take out costs” and “reduce capacity.” That meant reductions