For a long time, the world oil market was pretty simple: World demand was lashed to US demand–part of that whole “the US uses 25% of the world’s oil” thing we hear all the time, and and Saudi Arabia had both the spare production capacity and the willingness to be the “swing producer”, the exporter that throttled its production up or down to keep the market relatively calm. But paradigm shift happens, and as I type this we’re just beginning to test drive the new energy world.

What makes this new world so new is far more than current oil prices, but a combination of perceptions and economic realities that could have profound effects on those prices and everyone who pays or is dependent on them, which is, well, almost everyone on the planet.

As I see it, the defining characteristics of the new energy world order are:

• OPEC’s shifting perception means it’s no longer both willing and able to be as compliant as it was in the past.
• New customers: The rise in oil consumption in China, India, and some oil exporting countries.

OPEC’s perception

You can find all the arguments you could possibly want online about whether OPEC (and in particular, Saudi Arabia) has any appreciable spare production capacity. Put another way, we don’t really know if their newfound resistance to calls for more oil, including visits from George Bush, hat in hand, is a reflection of their ability or their willingness to pump more oil. My blatant guess, which is just as blatant as anyone else’s regarding the enigma lasagna that is OPEC, is that they do have some spare capacity, perhaps two or three million barrels per day, but that they’ve had a significant shift in their perception of the market, which is making restraint far easier than it has been in the past.

What could suddenly influence OPEC in this way? Two things:

First, and of lesser importance, is the fact that the world’s largest oil importer (I’m looking at you, America) has not exactly been the most stable or friendly of neighbors for years, at least since about March 2003 when that whole “we have to blow the hell out of Iraq because they have WMD’s and unmanned drones that can reach the US” thing erupted onto the world stage, fully formed, from the fertile little minds of certain people. Honestly, if you had a dwindling resource that a vastly larger and more powerful country was painfully reliant upon, and that country was acting the way the US has, how much incentive would you feel to keep their oil bill and your revenues low by depleting that resource quicker than necessary?

Second, even OPEC doesn’t have an infinite amount of oil, and they have very likely reached a critical stage in the history of the oil market: They can restrict supply and let prices float to previously unimagined heights without fear that the US and other importers will wean themselves from the devil’s tears, as oil is called in parts of Asia. OPEC knows it will take the US years to transform its economy to one that uses vastly less oil, and once we are closer to the world peak of oil production than the US’s transformation time, there’s no point in being quite so compliant. Suddenly, OPEC has immense incentives to trim output and support much higher prices. They make far more money, they extend the production lifetime of their oil fields (which maximizes their power and earnings in the future when oil becomes truly scarce), and they can even tell themselves that they’re doing the importing countries a favor–higher prices pre-peak mean the transition away from oil starts sooner and reduces the risk of a major economic collapse (or yet another oil war), which would be bad for the importers as well as the exporters’ business. They get to enhance their position now and in the future, and they can tell themselves that they’re doing the whole world a favor. What could be better?

New customers

Looking at the BP Statistical Review of World Energy, we see that from 1996 to 2006 oil demand in China grew by 101% (3.702 million barrels/day to 7.445), India’s grew by 51% (1.700 to 2.575), and the entire Middle East’s grew by 35% (4.370 to 5.923). By comparison, oil consumption for all of Europe and Eurasia grew by 5% (19.555 to 20.482), and the US’s grew by 12% (18.309 to 20.589).

When domestic oil demand rises in an exporting country (often due to very high subsidies that make gasoline extremely cheap), that means less oil on the open market for importers to buy. A far bigger impact is emerging from China and India, however, for reasons that involves a little economics theory. (Don’t worry, it won’t hurt.)

China has a population of roughly 1.3 billion people, while India’s is about 1.1 billion. Large portions of those immense populations are just entering what most people would call a consumer or middle class society. As a result, they have more money than ever before, and they’re spending it on cell phones, more and better food, and, most pertinent for our purposes, their first cars. None of this is news to most people who follow energy and environmental issues, but there’s an economic subtlety that is almost never mentioned: Consumer surplus.

I’ll spare you the supply-and-demand graph, but basically consumer surplus says that if the overall market is willing to buy X units of some product at price Y, then a lot of people are getting bargains–they would be willing to buy as much (or very nearly so) as they do now at a price higher than Y, but they don’t have to because the market has settled on a price of only Y. These are the people who derive more utility/dollar from buying their share of those X units than other consumers do, so they’re willing to pay more. (Think about the classic “early adopters” who line up to buy the latest iPhone or PlayStation. They derive a lot of utility from not just using the item, but from being known as one of the first people to own it. Not only do they pay the day one price, before it has a chance to decline, but they also incur the cost of standing in line outside the Apple’s store all night.) These are the people buying their first cars in China and India. They will not be easily turned away from driving, and certainly not from car ownership, by a rise in gasoline prices.

Our brave new oil market

So, where does that leave us? The old paradigm would tell us that when the US goes into a recession, as it is in all but official pronouncement right now, and when gasoline prices contribute to a reduction in US driving, as it has already has, then world demand for oil declines, the price drops, and if the situation becomes extreme enough OPEC reduces output a bit.

This time we have an entirely different scenario unfolding. US demand drops, and those early adopters in China and India, plus the growing domestic consumption in some oil exporters and OPEC’s eagerness to keep the market tight as a drumhead, greatly reduce the odds of a major oil price correction in the short run. The slack created by reduced US demand will be taken up by other consumers around the world, to the extent that it survives changes in the supply of oil. In other words, the US is now at the economic mercy of other countries’ oil consumption, just as they have been influenced by ours, including the knock-on effects on our foreign policy, for decades.

How confident can we be that this new energy model accurately describes our world? Opinions are all over the map, no pun intended. You can find pundits and analysts claiming that the decline in US demand will have anywhere from a major to precisely no effect on oil prices, beyond localized blips like the drop yesterday and today. The rules of the game are changing before our eyes, and there’s more fundamental uncertainty in the world oil situation than at almost any time since World War II.

I’m sure of one thing, though: In the next year or so we’ll live through one hell of a market experiment and get a lot of answers, some of which might not be good news.