One of the central issues facing policy makers in Washington and around the globe in 2005 is the prospect of further instability in world oil markets. This new reality carries both economic and security risks. Another oil shock could tip the world economy into a premature recession, while the massive flow of oil revenues into the Persian Gulf and Russia threatens to derail economic reforms and foment political unrest.The dramatic rise in oil prices from US$24 per barrel in 2002 to between $40 and $55 in late 2004 stems in part from a sharp increase in consumption in China and the United States. But it also reflects the fact that for the first time in more than two decades, there is virtually no spare oil production capacity left — with far-reaching implications for national security, economic stability, and all of our pocketbooks. Although oil prices have fallen over the past month, this is likely to prove a brief respite from the oil escalator we’re now riding. Already, oil production is falling in 33 of the world’s 48 largest oil producing countries, including 6 of the 11 members of the Organization of Petroleum Exporting Countries (OPEC). Among the countries where oil production is declining are Great Britain and Indonesia. In the continental United States, oil production peaked at 8 million barrels per day in 1970, and has fallen to just 2.9 million barrels per day in 2004. In this year of soaring prices, only Russia and the Persian Gulf countries have been able to increase production significantly — and they are now pressing against their current limits. The urgent question is whether the recent difficulty in boosting oil production represents a temporary challenge or something more basic. Many government agencies still believe that there is plenty of oil left, and that higher prices will open the floodgates. They argue that there is enough for world oil production to keep rising for the indefinite future –reaching 115 million barrels per day by 2020, or more than 40 percent above the current level according to the International Energy Agency. However, a growing number of geologists question whether remaining oil reserves are sufficient to keep production going up much longer. For the past three decades, they argue, oil companies have not been finding as much oil as they have been extracting-a gap that has widened in the past ten years. Royal Dutch Shell’s repeated downgrades of its estimated reserves over the last year have raised further alarms, as have figures showing that even the limited exploration that is being done is no longer very productive. These developments suggest that the stable oil prices of the past two decades may soon be a distant memory. PFC Energy, a Washington-based oil forecasting group, has carefully analyzed global reserve figures, and concluded last month that world oil production might be unable to meet projected demand as early as the middle of the next decade. PFC and a growing number of other forecasters now project that world oil production will peak in the next 10-15 years. Some believe it could happen even sooner. In the past, it was assumed that if oil supplies got tight, Persian Gulf countries would quickly and easily provide whatever oil the world needs. But today, the ability of countries like Saudi Arabia and Iraq to raise production substantially is in doubt. Some of the largest oil fields in the Persian Gulf are aging rapidly, according to experts, and no independent verification of their claimed oil reserves has been permitted for decades. The oil industry is hitting the wall at a bad time for the world economy. Demand is surging in developing countries — particularly in China and India — adding to the market pressures generated by the huge fleet of gas-guzzling SUVs already on U.S. roads. China in particular has been building factories, houses, roads, and virtually everything else at a furious pace, scouring the world for resources. China’s oil consumption went from less than 5 million barrels per day in 2002 to 6.2 million barrels per day in 2004, a 24 percent increase. Two decades from now, China could be importing as much as 10 million barrels of oil per day — as much as the U.S. now imports or Saudi Arabia now produces. It is time for political leaders to recognize — as former U.S. President Bill Clinton did last week when he called for efforts to reduce U.S. reliance on unstable Middle Eastern sources of oil — that an oil-hungry world is on a collision course with an overstrained resource base — laying the stage for a period of instability in energy markets. Among the potential impacts: – Economic growth will slow and inflation will rise if oil prices stay at or above their current level of more than $40 per barrel. The United States will spend roughly $160 billion on oil imports this year, and many oil-dependent developing countries could soon fall into recession if prices stay high. – Growing dependence on Persian Gulf oil will alter the international balance of power, flooding those countries with extra cash. If the past is guide, these growing revenues may delay economic and political reforms, and further line the pockets of a wealthy elite. – Dependence on Russia, the one other country where production is growing substantially, will also grow dramatically, shifting the international balance of power. With China rapidly rivaling the United States as the world’s largest oil importer, international pressures will grow. – Additional airline bankruptcies are likely given the oil intensity of the industry. A major shakeup in the automobile industry is also possible. Companies such as Toyota that have pioneered highly-efficient hybrid-electric cars may benefit, while some of the U.S. companies that have relied heavily on SUVs for their profits may be in trouble. The bottom line for consumers, industries, and governments alike is the urgent need to conserve energy and step up efforts to develop new energy sources. Among the urgent priorities that could make a difference: – Update car and truck fuel economy standards, which have been static in many countries for a decade or more. It is essential that SUVs, which comprise a growing share of auto fleets, be covered by these standards. The rest of the world would do well to follow the lead of China and California, both of which announced new standards this year. – Provide incentives for accelerated introduction of a new generation of fuel-efficient cars. Hybrid-electric drives; clean, efficient diesel engines; and light-weight composite frames and bodies have the combined potential to nearly double the fuel economy of cars — but manufacturers need additional motivation to develop and market them. – Speed up the use of “bio-fuels” — ethanol that can replace gasoline, and vegetable oils that can substitute for diesel fuel. Already, government incentives are spurring market growth in Europe, Brazil, and the United States. – Raise automotive fuel taxes in countries like the United States, where they are too low. Higher gasoline taxes will promote conservation, and will tend to smooth out the likely roller coaster in fuel prices in coming years. The higher cost to drivers can be mitigated by offsetting reductions in income taxes. About the author… Christopher Flavin is president of the Worldwatch Institute and author of Power Surge: Guide to the Coming Energy Revolution. He is co-author of the chapter “Changing the Oil Economy” in State of the World 2005, to be released January 12, 2005. The Worldwatch Institute is an independent research organization that works on environmental, resource and economic issues. By providing compelling, accessible, and fact-based analysis of critical global issues, Worldwatch informs people around the world about the complex interactions among people, nature, and economies.