Even without the external factors that tug at energy prices, there are underlying supply constraints and demand drivers pushing prices higher. Amelior-ating those trends, tapping new energy sources, seeking alternatives and curbing demand are the challenges of the future.

There is no shortage of noise in oil prices. Speculators, war, political strife among key suppliers —such as Iran, Nigeria and Venezuela — and the cheating that goes into data for both supply (Organization of Petroleum Exporting Countries) and demand (China) roil oil markets. But even after filtering out that noise, there are fundamental trends in supply and demand that appear to support higher prices.

TD Bank Financial Group attributes more than one-third of the spot price of oil to a “fear premium,” resulting from worries about tightness of supply, geopolitical risks and refining capacity bottlenecks. Even so, TD said in a report published last fall, the price justified by supply and demand fundamentals has risen to about US$40 a barrel from US$30 in the past few years, as the cost of extraction has risen.

Moreover, CIBC World Markets Inc. said in a recent presentation, global oil demand was bumping against maximum supply in 2005, with both at about 84 million barrels a day. Assuming 2.5% growth in demand, CIBC projects that demand will outstrip supply starting this year, with the gap widening in the next few years.

The basic story is that oil demand is seeing relentless upward pressure, particularly as the emerging economies of China and India generate strong economic growth. Much of their development is energy-intensive, which, combined with high growth rates in countries with very large populations, points to robust increases in demand.

Just how robust is hard to say, as plenty of fudging goes into economic statistics, particularly from China. In late January, for example, China announced that its oil demand actually fell slightly in 2005 — a claim discounted by many market observers. TD indicates that crude consumption in China grew by 18% in 2004 alone.

Indeed, the International Energy Agency says strong growth in the U.S. and China was the leading contributor to growing global oil demand in the past two years. “The years 2004-05 turned out to be a ‘demand shock,’ with world oil product demand growing significantly above the historical long-term trend,” the IEA said in a recent report.

At the same time, supply appears to be constrained. Saudi Arabia, the world’s biggest oil producer and the traditional source of excess production capacity — which has enabled the world to enjoy relatively cheap oil for the past 30 years —claims to have little excess reserves to tap in times of shortage. As well, natural events, such as the hurricanes in the Gulf of Mexico last year, combined to knock out some U.S. capacity. “Spare capacity in the oil complex tightened rapidly, putting upward pressure on prices,” the IEA noted.

Uncertainty about the true state of the Saudi oilfields adds mystery to the supply side as well, giving rise to renewed debate about the possibility that the world’s oil supply has peaked, or will soon peak, and will start to decline. Advocates of the theory argue the Saudis’ biggest oilfield is in decline, which could herald an era of diminishing oil supply.

Other analysts, however, dispute the notion that the oil supply is dwindling. The Saudi oilfields are certainly aging and may not be able to offer much added capacity in the near future, they agree. But they expect such conventional sources to maintain their production at current levels for years to come, with other sources and technological improvements providing much of the growth in supply.

Increased supply

In a recent report, Massachusetts-based Cambridge Energy Research Associates Inc. projected that global supply could be increased to about 108 million barrels a day by 2015 — growth of 20%-25%, which should exceed the growth in demand. CERA doesn’t see a peak in global oil production before 2020 and, even once supply plateaus, it doesn’t anticipate quick exhaustion.

The firm says non-traditional energy sources will make up a bigger chunk of oil production in the years ahead. Deepwater oil, gas liquids, heavy oil and the oilsands are all expected to take on much bigger roles, so much so that CERA says they could represent 34% of global production by 2015, compared with 10% in 1990.

@page_break@For its part, CIBC expects almost 60% of capacity growth in the next few years to come from non-traditional sources, primarily deepwater oil. The Alberta oilsands are expected to add about 150,000 barrels a day for the next few years, expanding rapidly to about 500,000 barrels a day by 2010.

The new supplies will come onstream as prices rise in response to supply and demand constraints, and extraction projects that were once unaffordable become more economically viable. This is key, as untapped energy sources will require massive investment. The IEA forecasts total energy industry infrastructure investment requirements in the next 25 years will be US$17 trillion.

Higher prices should help finance innovation and exploration for new sources of oil, but other constraints must also be addressed. For one, TD points out that there is a severe shortage of refining capacity. Other industry experts say the premium being placed on developing new supplies is driving up labour and construction costs, as there is a shortage of capacity to meet the industry’s need for new infrastructure.

Obviously, demand cannot grow inexorably. As it outstrips supply, prices must increase, which should ultimately constrain economic growth and demand for energy. So far, this hasn’t happened, particularly as China has proven to be particularly insensitive to prices. At some point, as higher energy costs are passed on to customers, demand will surely ebb. As a result, central bankers and others have cited continued high energy prices as a key downside risk to the global economy in the years ahead.

Notwithstanding the short- to medium-term constraints, the potential for increasing capacity in the longer run should enable demand to grow as well. In its baseline scenario, the IEA projects that global primary energy demand will grow by an average 1.6% a year to 2030, an increase of more than half from current levels, and it predicts that more than 60% of the demand growth will be for oil and natural gas.

Increased pollution

The direct consequence of such growth in demand is comparable to increases in pollution. Currently, the IEA reports, global energy-related emissions of carbon dioxide grow at about the same rate as primary energy use. If emissions track projected demand increases of 1.6% a year until 2030, carbon dioxide emissions are projected to increase by about 52% from current levels in that period.

The scenario assumes that fossil fuels will remain the dominant energy source, accounting for 83% of the increase in energy use to 2030. Although natural gas demand is expected to grow quickly, the IEA projects that oil will still be the largest individual fuel source by the end of the period. It says shares for coal and nuclear power will decline slightly. Renewable forms of energy will grow rapidly, but they will start from a small base and will still account for less than 2% of primary demand in 2030.

Faced with the prospect of much higher pollution levels in the years ahead, fears about climate change are motivating efforts to curtail demand voluntarily.

The Kyoto protocol is one initiative to combat greenhouse gas emissions, by requiring signatories to reduce their emissions to 5% below 1990 levels by 2012. Even if this is achieved, it represents a drop in the bucket compared with the emission increases projected by the IEA. Significantly, major polluters such as the U.S. have not signed on, and Kyoto protocol does not apply to developing nations that are the primary source of rising energy demand, such as China and India.

Canada is a signatory to Kyoto, but under the previous Liberal government. It is not yet clear how the Conservative minority government will respond to the country’s treaty obligations. While in Opposition, the Conservatives were stridently opposed to Kyoto, but they appeared to have softened their stance in the run-up to the last election, pointedly avoiding any mention of the treaty.

So far, new Environment Minister Rona Ambrose has yet to do much to clarify the government’s intentions. The party’s platform pledged a cleaner environment based on reducing emissions through a “made in Canada” solution focusing on new technologies. It also promised legislation to reduce smog-causing pollutants, such as sulphur dioxide and nitrogen oxides, and require 5% renewable content, such as ethanol or biodiesel, in gasoline and diesel fuel by 2010.

Whatever action the developed world takes to combat climate change, that alone is unlikely to do much to curb the growth of carbon pollution or global energy demand. The IEA projects that even with policy action in the First World, such as that promised by the G-8 at a summit in mid-2005, global demand will increase by 37% by 2030, and emissions will be up another 30% in the same period.

Oil will remain the biggest fuel source, with the biggest emission reductions coming from curbing the use of coal in power generation. Renewable sources, such as biofuels, would probably be beneficiaries.

Failure to take even more direct action on climate change could result in Mother Nature imposing her own capacity constraints. One of the anticipated consequences of global warming is more volatile weather patterns, the sort of weather that produced the string of devastating hurricanes that hit the U.S. last year, wiping out a significant chunk of refining and delivery capacity.

Ultimately, it appears, something has to give. Although current supply and demand trends may enrich Alberta and other resources-rich parts of Canada in the medium term, tapping new fossil fuel sources is not a long-term solution to the fundamental challenge of climate change. IE