The Fall of Oil
By Nayyer Ali MD

Oil prices collapsed in 2014, and have fallen further in 2015 to levels not seen in over 10 years.  This has represented a huge transfer of wealth to oil consumers away from oil producers, and has impacted politics around the world.  But will prices surge back up again in the near future, or has there been a long-term change in the oil markets?

Crude oil was the fuel that made industrialization possible in the 20 th century.  Oil powered all forms of transportation, from cars and trucks, to ships and planes.  It was the most precious and valuable natural resource, and access to it was among the most important shapers of geopolitics.  But if we look at oil prices over the last 70 years, since the end of World War II, we can see several distinct eras of low and high oil prices that lasted for significant periods of time.  Because inflation makes the listed price of crude oil in the past seem lower than it really was, I will refer to all prices in inflation adjusted terms using 2015 prices. 

Crude oil was discovered first in the US, and the early oil industry was centered in Pennsylvania in the late 19 th century, mainly producing kerosene for lamps.  But that changed with the invention of the automobile, as America began to embrace a car culture in the early 20 th century, long before Europe, which was just not as wealthy.  By the 1930’s the US was the world’s largest producer and consumer of crude oil.  In addition to cars and trucks, ships converted from burning coal to oil, and the early aircraft industry also used oil as a fuel.  In 1940, the US was producing 4 million barrels of crude oil per day, amounting to 60% of world production.

American oil resources played a big role in winning World War II.  Plentiful American oil provided the fuel the Allies needed for their trucks, tanks, ships, and planes.  In contrast, Germany lacked oil resources, and was constantly facing oil shortages that hampered its military.  An American oil embargo was among the triggers that convinced the Japanese to go to war in order to seize the oil fields of what is now Indonesia.  When the war ended, the international oil markets were dominated by seven massive oil firms known as the “Seven Sisters”, five of whom were American, the other two being British Petroleum and Royal Dutch Shell. 

Because oil production was in the hands of private firms mostly working in the US, prices were very low during this time as competition kept supplies well ahead of demand.  Oil prices were about 20 dollars a barrel or less from 1920 onward.  This era of very cheap oil helped create a massive economic boom in the industrial countries after World War II.  A mass car culture took shape in Europe and Japan, and cheap oil fueled a massive rise in living standards. 

Oil production soared to keep pace in the decades after World War II.  While US production rose to 10 million barrels per day, most of the demand was actually satisfied by massive new oil fields found in newly independent Third World countries, many of them in the Persian Gulf region and North Africa.  World oil production doubled from 10 million barrels per day in 1950 to 20 million by 1960, and then surged to 60 million barrels by 1970.  Suddenly, the US no longer dominated the oil markets, and new players emerged to dominate global production.  A group of Third World producers of oil banded together to form OPEC, a cartel that was meant to help them maximize oil revenues.  During this time, many of these countries took control of their oil resources back from the Seven Sisters.  Surging demand and an assertive OPEC finally collided in the oil price shocks of 1973 and 1979, during which oil prices jumped to 100 dollars a barrel briefly, and mostly stayed above 60 dollars.  A new era of high oil prices transformed the economics of oil. 

But to the disappointment of OPEC, the era of high prices did not last forever.  The world adapted to high oil prices by slashing consumption.  Countries switched electric power plants from oil to coal-burning, gas mileage of cars was raised sharply, and new oil fields added to global supply such as the North Sea and Alaska fields.  OPEC could only sustain high prices by cutting its productions, and the Saudis did most of the cutting.  By 1986, Saudi Arabia had slashed its production from 10 million barrels per day to 2 million, in order to prop up the price, and then suddenly they gave up and opened the spigots.  Oil prices collapsed to under 30 dollars a barrel, and a second era of low oil prices had begun.

This lasted for 15 years, but around 2002 oil prices began climbing again.  This time it was not surging demand in the developed world, but rather new demand from the developing countries, particularly China, that drove consumption higher.  Oil prices began a long climb, peaking at 140 dollars per barrel in the summer of 2008.  The financial crisis caused prices to plummet briefly to 40 dollars, but they rapidly recovered, and have stayed around 80-100 dollars until 2014.  This long period of rising oil prices from 2002 onward contributed to the revival of Russia, and the popularity and success of Putin, and also made Hugo Chavez a popular leader in Venezuela, as he used oil dollars to provide social benefits.

This second era of high oil prices is now at an end.  Oil prices have fallen from 100 dollars per barrel to 35 dollars presently, and may trend even lower.  What caused the price collapse?  The same factors as last time.  Consumers of oil reacted to high prices by reducing demand.  Higher mileage cars, and even electric cars took to the road.  Other vehicles began to run on natural gas.  One of the biggest factors, the rapid growth of China, also eased up in the last few years, as Çhina’s economic growth rate finally began to slow down.  A prolonged period of slow growth after the Great Recession in both Europe and the US also dampened demand.  In addition to less demand, new supplies came on line.  The shale oil revolution, using a technique called “fracking” resulted in a surge in US oil production by 5 million barrels per day.  The oil markets were well supplied, and the Saudis again decided that they would not give up market share to American oil producers, so they let oil prices slide but maintained production.  With the nuclear deal with Iran set to lift sanctions in a few months, Iran will start pumping much more crude onto the market.  Meanwhile, Iraq is determined to raise its production.

Will we see another era of high oil prices?  Almost certainly not.  To keep American fracking off the market, the Saudis need to keep oil under 50 dollars a barrel.  But beyond that, the main consumer of oil, the auto, is beginning a period of rapid change.  Vehicle gas mileage is rising quickly, and in the US is mandated to reach 54 mpg by 2025.  Electric vehicles are almost certainly where the future of the auto is heading.  The concerns about global warming will also create incentives to get the global economy off oil.  Oil demand in the rich countries peaked in 2005 and has headed down since then.  It will likely peak for the whole world in the next 10-15 years, and then begin a long slide.  This future should cause the governments of all the oil producers to think carefully how to manage this transition.  If oil is no longer of much use in 2050, what will sustain the living standards of the Gulf Arab states or Russia or the other Third World oil producers?  They all need to diversify and modernize their economies now, while they still have time.

 

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Editor: Akhtar M. Faruqui
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