Less is more - the economics of oil supply and demand

Materials World magazine
8 May 2011

The American publisher Alfred A Knopf is quoted as saying ‘An economist is a man who states the obvious in terms of the incomprehensible’. But one economic theory that most of us can comprehend is the law of supply and demand. As demand increases, the price goes up, attracting new suppliers, who in turn increase the supply and bring the price back down. Similarly, if supply is restricted, the price will rise until demand is reduced and the price falls. Nowhere is this better illustrated than in the minerals and mining industries, and in particular the cost of oil.

The current oil price is higher now, in real terms, than at any time since the fall of the Shah of Iran in 1979 and the Iran-Iraq war that followed. The reasons are similar – market fears over security of supply arising from current and unprecedented tension, unrest and revolution in parts of North Africa and the Middle East. Making the problem worse is the realisation that oil reserves elsewhere in the world are becoming harder to find and extract, a fact brought sharply into focus by last year’s events in the Gulf of Mexico. Meanwhile, demand from non-Western economies such as India and China continues unabated.

This makes the UK Chancellor George Osborne’s budget decision to reduce fuel duty while increasing the supplementary charge on oil and gas production from 20 to 32% seem short sighted. The UK Continental Shelf oil and gas tax regime is fiendishly complicated, but essentially this change will result in the overall rates of tax on income arising from oil and gas production increasing to 81% on mature fields, that is those given development consent prior to 1993 and subject to Petroleum Revenue Tax. It will increase from 50 to 62% on the rest.

By comparison, the one pence per litre reduction in fuel duty reduces the total tax and duty by less than 0.5%. Taking a typical pump price of 130p per litre, approximately 45p is the cost of oil and 80p is tax and duty, leaving a mere five pence for refining, transportation and profit. But while I may not be popular for saying so, high fuel prices are a necessity to curb demand, reduce unnecessary journeys and make us consider alternatives. Oil is a strategic and finite resource to be used wisely rather than profligately.

At the same time, oil companies operating in the UK need incentives to squeeze every possible drop of North Sea oil from current and future developments. Why bother risking capital to increase recovery if the Government is going to take over 60% of the profit? The oil price may be approaching record highs, but so are North Sea finding and lifting costs, and capital expenditure is readily transferable. If the risk/reward balance is unfavourable, companies will simply invest in more profitable projects elsewhere.

Rather than increasing the Supplementary Charge, the Government should be reducing it to encourage the development of new fields and enhanced oil recovery from mature assets. Instead of doing nothing to tackle the rising and unsustainable demand for fuel, the Government should promote alternatives, not try to improve opinion poll ratings. Less will definitely lead to more, in every sense.