This year's relentless upward surge in oil prices was different from other increases, and not only for the heights it reached. Never before had the benchmark price of West Texas Intermediate crude passed even $45 per barrel, much less $50. And the caveat that "real prices were higher in the late 1970s" was little more than cold comfort.

No, this year's price surge was different because of what "the chart," said. Which chart? One of the first you see in Economics 101, with demand going in one direction along the price axis, supply coming the other way, and both intersecting nicely and neatly.

The problem with "the chart," however, was that, although every student could see that supply increased with price, they could also see that at a certain point supply couldn't go any higher because there was none left. The price of oil has surged plenty of times in the past. But spikes in other years always seemed to be associated with a particular event that could be cited as their cause: the Arab embargo of 1973-1974, the Iranian Revolution of 1979, or the disappearance from the market of Iraq and Kuwait in 1990-1991 following Saddam Hussein's invasion of the latter. Even during price surges in those times, the world always had enough surplus capacity to produce more oil. Always, there was the belief that once the "temporary market situation" was resolved, there would be a return to normalcy. Normalcy was essentially guaranteed by the world's spare capacity.

Defying expectations

But the oil price surge of 2004 wasn't caused by any event. Instead, it could be explained by referring to that portion of "the chart" where the supply curve no longer follows the price curve. What's more, even as the price of oil moved into the $50 territory, on the chart the demand curve was defying Economics 101 lessons by refusing to flatten.

To be sure, factors that are somewhat political could be blamed for this year's imbalance, as in the past. But it remains to be seen whether those factors are temporary or should now be considered permanent features of the oil industry's landscape.

For example, Venezuelan production, which was so battered in early 2003 by an oil workers' strike that it affected the worldwide industry, was showing no sign of rebounding in late 2004. Today, no one is even bothering to guess when it might come back to pre-strike levels. Platts data in fall 2004 put the current level of Venezuelan production at 2.65 million bbl/day. Prior to the strike, it exceeded 3.1 million barrels.

Another factor to consider is the continuing sabotage of Iraq's oil infrastructure. It means that Iraqi production and exports can no longer be included confidently in calculations of the world's regular supply. While production has been inching higher as a result of the sabotage, it is a long way from reaching the sort of pre-war bonanza that some had predicted would accompany the end of Saddam Hussein's regime.

Time for a new model?

Energy economists who believe the global oil industry is nearing its productive peak might refer to the events of the past several months as a sign that "The Big Rollover" is nigh. It was defined concisely in one presentation as "when demand for oil outstrips the capacity to produce it."

In October there was enough red meat in the International Energy Agency's (IEA's) monthly report to satisfy legions of Big Rollover believers. For example, the IEA--whose monthly numbers are both roundly criticized for their level of accuracy and awaited with almost religious fervor--said worldwide supply was clearly reacting to movement down the price axis. The report noted that it had risen in September to a new high of 84 million bbl/day and had been boosted by output increases from Iraq and Saudi Arabia. The figure, the report added, would have been higher had it not been for scheduled North Sea maintenance and the unscheduled Hurricane Ivan, which ripped through the Gulf of Mexico. In other words, supply reacted to prices and demand, as expected.

However, the report also said that the world's total sustainable capacity sitting on the sideline was "well below" 1 million bbl/day. Though it is acknowledged that--in a pinch--OPEC could bring on another 1.5 million to 2 million bbl/day of capacity, such an increase probably could not be sustained for very long. Accordingly, the academic model that says supply will always increase as prices rise may no longer apply in the oil industry due to the structural reality of limited capacity. Nonetheless, the IEA's October report does project that worldwide supply will rise in 2005.

It sees non-OPEC production rising from 50.1 million bbl/day in 2004 to 51.4 million barrels next year--an increase of 1.3 million bbl/day. With world demand forecast to rise by 1.5 million bbl/day annually, OPEC will be called upon to fill the 200,000 bbl/day gap. And also worth keeping in mind is that demand estimates are just that, and are usually revised upward rather than in the other direction.

Something else worth pondering is the mystery of what will happen to OPEC's sustainable capacity next year. Will it rise as much as or more than the increase in non-OPEC output? Whereas energy economists occasionally can get a peek into the capacity of some OPEC members with extensive Western investment--such as Algeria--the amount of oil that might come out of a place like Kuwait or Iran is not particularly clear.

Wrong number

A quick look at the IEA numbers for the fall of 2004 could provide some comfort to consumers. The IEA does not project OPEC output. What it does provide is an OPEC "call," what the organization says the world will need from OPEC to fill the gap between non-OPEC production and world demand. That call in the fall of this year was less than 28 million bbl/day--which appeared to be great news, because OPEC at the time was producing about 30 million barrels daily.

The only problem with this picture is that it looked a lot like the one painted in the fall of 2003, and a year later oil was at $50. In both 2002 and 2003, IEA projections at the end of the year indicated that non-OPEC supply growth would just about match total world demand growth, and that any additional OPEC output would lead to downward pressure on prices. During that period, there also was talk about significant strife in OPEC, as members with growing productive capacity wanted to bring more oil to a market that was having all of its increase in demand serviced by non-OPEC members.

That didn't happen. The reason is simple: Demand surged. In the fall of last year, the IEA projected that worldwide demand for oil in Q1 2004 would be 79.8 million bbl/day. It turned out to be 82.4 million barrels. The IEA also projected that Q2 2004 demand would be 77.4 million bbl/day. It ended up being 81.1 million bbl/day. That meant that rather than OPEC fighting over a static market share, as was predicted, the world needed just about every last barrel that both the cartel, and anybody else with a rig, could bring to the market. The specter of the Big Rollover loomed.

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