March 13, 2008
The Collapse of Oil Prices
Five years ago, the great run up of global oil prices began. From under 30 dollars a barrel, the price steadily climbed throughout 2004, and spiked higher into 2005 with a pronounced spike during Hurricane Katrina and its aftermath. 2006 and 2007 saw further upward price pressure, as the price crossed a hundred dollars per barrel in late 2007, then a final surge in the first 7 months of 2008 took the oil price above 150 dollars. Since then a crash in the oil markets has dropped the price back to 40 dollars. Adjusted for inflation, it is not much higher than it was in early 2004.
As the surge in prices began, I wrote a column predicting it would not last. For the last several years, events did not follow that prediction. Instead of coming back to Earth, prices kept going higher and higher. What drove this manic process, and where do we go from here?
There were several factors driving the price surge. First was the rapid growth in Third World demand. China was growing 10% per year, and importing vast amounts of oil to fuel that. India too was sucking up imports, and the Middle East oil states were selling gasoline so cheaply in their domestic markets that this was boosting internal consumption dramatically. In fact, oil was subsidized in many Third World countries that imported oil, including China. This additive effect pushed demand higher and faster than the global oil industry expected.
Demand in the industrialized nations was also growing rapidly. The main force remained autos and trucks, especially the love affair in America with gas guzzling SUVs. There was little or no attempt in the last decade to limit demand growth anywhere, and the inevitable result was a steady pressure on supplies.
While demand was surging, suppliers had failed to keep pace. The low prices of oil in the 1990’s and the early years of this decade convinced many suppliers that there was little return to investing in expanding production. Politics played a big role in this. The Western oil companies were shut out of most of the world’s largest oil fields, as the OPEC nations relied mainly on national oil companies to produce. Without access to these cheaper fields, Western oil companies were faced with having to extract hard to reach and expensive oil, such as deep offshore wells in the Gulf of Mexico. Meanwhile, OPEC nations, while retaining their sovereign control, lacked the advance production techniques that were needed to expand production and raise output.
In addition, the age of great new finds of oil was over. No major new deposits have been discovered in years, and mega-fields are unlikely to be found in the future. Going forward, oil production increases will rely on technology and efficiency rather than dramatic new finds.
But eventually the same economic forces that resulted in the collapse of oil in the late 1980’s returned to affect the oil price today. As the price of oil got high enough, consumers finally changed their behavior. Americans began to drive less, and stopped buying SUVs like mad. China stopped subsidizing oil, and saw a slowing of demand growth. Suppliers on the other hand had responded to the high prices by ramping up production and exploration. Alternative sources of oil, such as the tar sands in Canada began to come online and provide significant new supplies. And finally, the high oil prices contributed to the onset of a global recession that has collapsed demand growth entirely for oil. As demand began to fall, the high prices could not be sustained. Even repeated cuts in output by OPEC could not prop up the market. Oil came back down to 40 dollars in just a few months. 150 dollars per barrel seems like just a bad dream. For nations like Iran, Russia, and Venezuela, where budgets were predicated on 80 dollars per barrel, economic hard times are in store.
These dramatic shifts in oil prices beg the question: what is the “ correct” price of oil? There is an economic answer to that question. The correct price for any commodity, whether it be oil, or wheat, or orange juice, is the marginal cost of production. That means that oil should sell at the price that allows the most expensive producer to bring their oil to market and cover their costs of production. Saudi Arabia produces oil for less than 10 dollars per barrel, and they are the world’s lowest cost producer. To produce the 80th million barrel per day, which is what is needed to meet global demand, costs about 40 dollars per barrel. This means that based on pure economics, oil costs what it should.
