08/21/2008 08:58 pm ET | Updated May 25, 2011

Why McCain's "Drill Here, Drill Now" Proposal Fails the Supply/Demand Reality Check

There were two reasons why the Truth-O-Meter at CQ Politics gave a "FALSE" rating to John McCain's "drill here, drill now" proposal for reducing oil prices: supply and demand. The impact on supply, achieved years after oil companies greenlighted any new development projects, would be at most "a couple of hundred thousand barrels a day" or about the same amount that Saudi Arabia promised to add in the next few months. That's well below 1% of today's global production. The impact on satisfying new demand, driven primarily by economic growth in Asia, would be nothing more than a rounding error. McCain's rhetoric on global oil, like the mainstream media narrative, seems stuck in the mid-1980s, when the U.S. produced as much oil as Iran, Iraq, Kuwait and Saudi Arabia combined.

Things were far simpler in 1986, when Saudi Arabia racheted up its oil production to 5.2 million barrels a day, up from 3.6 million daily barrels in 1985. Oil nosedived from $28 a barrel in 1985 to $15 a barrel a year later. But those days, when our good friends the Saudis could easily turn on the spigot to change the supply/demand balance, are long gone. To understand oil prices today, you need look beyond the U.S. and the Persian Gulf, to places where the U.S. has limited influence, places like Nigeria and China and Mexico.

And until we start dealing with the basics of global supply and demand, our political dialogue will be clouded with more empty rhetoric.

Global Oil Supply: A Quick Overview

Back in the 1980s, when three broadcast networks dominated the news business and three Detroit companies dominated automobiles, the majority of the world's oil production came from three major sources, the Soviet Union, the U.S. and the Middle East. But the U.S. oil production has experienced a long steady decline, one comparable to the declines experienced by the networks and the auto companies. After Communism collapsed, so did oil production in the former Soviet states, although things turned around beginning in 2000. Up until a few years ago, most of the growth in global oil production came from the Middle East.

Oil Production

[millions of barrels a day]
Soviet Union 12.0
USA 10.6
Middle East 10.6
Worldwide 57.5

Former Soviet Union 11.6
USA 8.9
Middle East 17.5
Worldwide 65.5

Former Soviet Union 7.4
USA 8.4
Middle East 20.1
Worldwide 67.1

Former Soviet Union 8.0
USA 7.7
Middle East 23.5
Worldwide 74.9

Former Soviet Union 11.4
USA 7.2
Middle East 24.8
Worldwide 80.3

Former Soviet Union 12.8
USA 6.9
Middle East 25.2
Worldwide 81.5

Saudi Arabia's announcement that it may increase its daily production by 200,000 to 500,000 barrels was greeted with great fanfare in the press, but as the Financial Times rightfully pointed out, those gains could be wiped out by political violence in Nigeria. According to the BP Statistical Review of World Energy June 2008, the source of all numbers used herein, Saudi production in 2007 declined by 440,000 barrels a day when compared with 2006. Also in 2007, Saudi consumption of oil increased by 148,000 barrels a day from a year earlier, the biggest increase of any country other than China and India. In other words, we cannot count on the Saudis to provide any solutions to global shortages.

Here are some basics known to everyone in the oil industry.

Largest Oil Producers in 2007

[millions of barrels a day]
1. Saudi Arabia 10.4
2, Russia 10.0
3. US 6.9
4. Iran 4.4
5. China 3.7
6. Mexico 3.5
7. Canada 3.3
8. UAE 2.9
9. Kuwait 2.6
10. Venezuela 2.6
Worldwide 81.5

Countries which Experienced
the Biggest Declines in Oil Production

[Change from 2004 to 2007, millions of barrels a day]
1. Norway 0.63
2. UK 0.39
3. US 0.35
4. Mexico 0.35
5. Venezuela 0.29
6. Saudi Arabia 0.23
7. Indonesia 0.16
8. Nigeria 0.15
9. Syria 0.10
10. Vietnam 0.09
Total 2.73

Many of the world's top oil producers have experienced declining or stagnant production.
On a combined basis, the U.S., Mexico, Venezuela, and Saudi Arabia produced 1.2 million fewer barrels on a daily basis in 2007 than in 2004. The reasons:

Natural declines: North Sea oil production (Norway and the UK) has been falling off precipitously. As is true everywhere, the oil in the ground is finite and it comes out at a much faster rate in the early years of a well's productive life. No one anticipates that this natural decline will be reversed. The same applies to Indonesia and, many believe, Saudi Arabia.

Lack of investment and mismanagement: The national oil companies of Mexico and Venezuela have their investment budgets set by the government. Because of a lack of investment and poor management, those countries have been unable to exploit there domestic reserves efficiently. Petroleos de Mexico is forbidden by law to enter into joint ventures with large private oil companies that could share access to the latest most sophisticated technologies. About 10 years ago, Petroleos de Venezuela had independent management and was considered one of the best run oil companies in the world. But Chavez replaced management with his cronies, and the company's operations have deteriorated.

Political instability: Rest assured, Exxon desperately wishes that our government. could exert more influence in Nigeria, the single country where it produces more oil than anywhere outside the United States. Nigeria is case study in what can go wrong when a country fails to use its mineral wealth to promote a greater social good.

And of course, there are a number of other countries that have not begun to attain their potential in terms of oil production because of a combination of local mismanagement and political instability, i.e. Iraq, Iran, Sudan and elsewhere.

Where is oil production ascendant?

Countries which Experienced
the Biggest Gains in Oil Production

[Change from 2004 to 2007, millions of barrels a day]
1. Angola 0.75
2. Russia 0.69
3. Azerbaijan 0.55
4. Brazil 0.29
5. China 0.26
6. UAE 0.26
7. Libya 0.22
8. Canada 0.22
9. Qatar 0.21
10. Kazakhstan 0.19
Total 3.65

As you can see, countries that make up the former Soviet Union (Russia, Azerbaijan, Kazakhstan) produced about 1.4 million barrels a day more in 2007 than they did in 2004. This represents a shift of strategic power back to Russia. Putin exerts a stranglehold over Russia's mineral resources and he will not hesitate to use them as a political and strategic weapon. And Russia exerts a lot more influence over its oil producing neighbors than we do.

(An aside: The price of oil was a central cause of the fall of Communism, the breakup of the Soviet Union, Yeltsin's failure and the ascendance of Putin. It's remarkable how many books and articles on Russia are written by authors who fail to grasp this basic point.)

Can the U.S. restore its production to 1980s levels the way Russia has? Not likely. U.S. reserves have been efficiently exploited with the best equipment and technology for many years. Until recently, Russia's oil and gas has been underdeveloped because of lack of investment, backward technology and poor operating practices.

Bottom Line on Supply: More than ever, the world is susceptible to supply shocks because of political circumstances over which the U.S. has no control and very limited influence.

Global Oil Demand: A Quick Overview

In 2007, the United States consumed as much oil as the next five largest consuming nations combined. Put another way, 304 million people living in America consumed as much oil as 2.8 billion living in China, Japan, India, Russia, and Germany.

Largest Oil Consumers in 2007
[millions of barrels a day]
1. US 20.7
2. China 7.9
3. Japan 5.1
4. India 2.7
5. Russia 2.7
6. Germany 2.4
7. South Korea 2.3
8. Canada 2.0
9. Brazil 2.2
10. Saudi Arabia 2.2
Total 50.1

The chart below explains the commonly accepted view of the global economy: China and India are the economic engines that have driven both global economic growth and the run-up in all commodity prices. In other words, if we asked China to consume less, we would be shooting ourselves in the foot economically. Not that China, which consumes on a per capita basis a tiny fraction of the oil we do, believes that we have standing to criticize others. China and India have been very willing to do business with countries considered pariahs by the U.S., countries like Iran, Sudan and Venezuela.

Countries which Experienced
the Biggest Increases in Oil Consumption

[Change from 2004 to 2007, millions of barrels a day]
1. China 1.08
2. Saudi Arabia 0.35
3. Brazil 0.19
4. India 0.18
5. Singapore 0.17
6. Mexico 0.11
7. Chile 0.11
8. UAE 0.10
9. Russia 0.08
10. Poland 0.07
Total 2.44

One trend that we have overlooked: The developed world is taking steps to reduce its consumption of oil. In Germany, where they love cars and love to drive fast on the autobahn, consumption has declined by 9% over a three year period. Since per capita consumption of oil is about 1.3 gallons a day in Germany, compared to 2.9 gallons a day in the U.S., and because the depreciation of the dollar is reasonably correlated to price increases in oil, we are becoming less economically competitive than other developed nations like Germany.

Countries which Experienced
the Biggest Declines in Oil Consumption

[Change from 2004 to 2007, millions of barrels a day]
1. Germany 0.24
2. Japan 0.23
3. Italy 0.13
4. UK 0.07
5. Indonesia 0.07
6. France 0.06
7. Philippines 0.04
8. Turkey 0.02
9. Portugal 0.02
9. Switzerland 0.02
Total 0.88

What about speculators? This topic warrants another piece for a full analysis, but most of the evidence suggests to me that this hypothesis is overblown. Players like Enron were able to manipulate the price of electricity and natural gas because they figured out how to create and exploit distribution bottlenecks in comparatively small regional markets. It is much harder to have a similarly large impact on the global oil market.

The Bottom Line on Demand: In terms of energy security, and in terms of altering the supply/demand balance, our biggest bang for the buck will come from reducing domestic consumption through new technologies. We hesitate at our economic peril.