The Coming Oil Price Decline

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Oil prices have finally reached $100 a barrel. I now hear predictions of $200 a barrel. People who make forecasts like round numbers.

I do not expect $200 oil any time soon. I expect $85 oil first, and $70 oil first, and $50 oil first.

I do not believe in doomsday scenarios that relate to the earth’s resources. There are phenomena in the universe that can end the earth or human life on it. They do not include running out of energy because we lack resources.

Some predictions of $200 oil rest on the idea of peak oil. I am not betting on $200 oil any time soon because of peak oil. Peak oil rests on the assumption of depleting a known stock of oil. It is logical that as a fixed supply declines and demand rises, the price of oil will rise. The supply of oil will rise as its real price rises, however. New oil fields are being discovered all the time. Oil exploration companies are hard at work. Oil drilling service firms are hard at work. They are looking for employees across the board. Supply won’t stay fixed as the peak oil idea requires. Neither will demand. As oil price rises, demand for oil will be curtailed, and people will turn to alternative sources of energy.

Even if the oil price does rise to $200 at some date, doomsday need not also occur. That’s because there are many alternative sources of energy. In fact, $200 oil (in real terms) is such a high price that entrepreneurs will be working feverishly to bring more oil to market and to bring to market other sources of energy.

The only doomsday energy scenarios that I see as possible are those in which our and other governments prevent entrepreneurs from bringing new and economical energy supplies to market. If the U.S. government continues to insist that we use corn and ethanol to make fuel, or insists on subsidizing particular energy sources, or directly controls energy supplies and demands, then those actions can bring us doomsday. We can get doomsday courtesy of the U.S. government. It can force us all to suffer. But it would have to keep energy-saving innovations off the market, and these can come both from domestic and foreign sources. I don’t think that our government can and will do that. Such a backward policy will lose too many votes.

We got a taste of a government-made energy doomsday when we had price controls on energy in the 1970s. People waited in line for gasoline. They became very upset. We are getting a taste of that now as we still have a cabinet-level Department of Energy, and its regulations are raising prices and interfering with supplies. The taste of doomsday is a very unpleasant taste. It makes for a very inconvenient life. My guess is that its unpopularity will not let draconian energy measures prevail. Some politicians will run on a platform of bringing down energy prices and people will vote for them. Or else there will be enough loopholes in the regulations that doomsday never quite arrives. I could be wrong.

When I guess that $200 oil won’t arrive soon, and that when it does arrive eventually that it will be a non-event, I am banking on the operation of free markets in energy. They do not have to be fully free. There can be OPEC and an oil cartel. However, as the real price of oil rises, the incentive to find more oil and bring it to market rises. And, what is even more important, the incentive to develop other sources of energy that compete with oil rises. The key element of a free market that works to hold down the price rise in oil and prevent doomsday is the profit motive. If the price is higher than cost, the companies will search for more oil. They will search for more ways to extract existing oil at lower cost. They will bring new energy-saving devices to market, because consumers, faced with higher prices, will be looking for ways to economize on energy expenditures. The entire structure of location and travel will alter as prices rise so that less travel is necessary. The entire manner of building new buildings will alter to make them more energy-efficient. All of this is going on already. Some of it goes on accompanied by government action, but much of it goes on regardless of government or with government trailing behind.

OPEC controls something like 40 percent of world oil and gas production. Its market share is declining. Cartels cannot control the production of nonmembers who are outside the cartel. Cartels often have a hard time controlling the production of members of the cartel. OPEC surely cannot control the oil and gas exploration activities of nonmembers. It surely cannot control the many companies that want to bring to market alternative sources of energy altogether. The free market has a way of seeping in around the edges of a cartel and corroding its ironclad pricing. Cartels break down.

Oil prices can rise as the value of the dollar declines, but I am talking here about the real price of oil. I am not forecasting the course of the dollar in this article.

Oil has been a cyclical commodity. This does not mean that it follows any kind of regular cycle. The business cycle is not a regular cycle. It means that the oil price has with an irregular periodicity displayed some large and noticeable fluctuations. It goes up, and it falls substantially.

A few years ago, the price dropped to $15 or so from $40. In recent decades, the fluctuations had a mean of about $25 a barrel. Over longer periods, the price has been lower than that, around $17 a barrel. These averages have perhaps risen as other prices have risen. Perhaps oil has a kind of normal or average value of $35—$50 a barrel. The $100 oil we now see is quite unusual. Perhaps shifts in demand from new market buyers in countries like China and India have shifted the price up. That is plausible. But, historically, new supplies have come to market and offset the rising demands of industrializing countries. It’s a reasonable bet that the same thing will happen now, and that argues for stabilization and decline in the $100 price of oil.

The rapid pace of industrialization has been driven in part by easy-money policies, as in China. The China boom will come to an end, just as the U.S. expansion now is slowing and the stock market falling. Those slowdowns will place some short-term downward pressure on oil prices.

But I stress that, although recession may trigger lower prices, it is not at all the reason for my forecast. I am stressing the standard free-market industry dynamic. Higher prices call forth greater supplies with a time lag. These supplies drive prices down, often to a surprising degree. Free markets work. The cyclicality of oil prices does not coincide with the business cycle. It has to do with the activities of entrepreneurs in bringing more oil supply to market. Entrepreneurs also bring to market new ways to make devices more energy-efficient, and they conceive of altogether new sources of energy. All these activities bring the price of oil down. It has happened before. I expect it to happen again.

I expect oil prices to decline in the coming months, perhaps between now and several years from now. I don’t know if $100 is the top price or not. No one can forecast the exact top. It’s foolhardy to try. But since I am forecasting price decline, I may as well spell out that implicitly this means that I expect further upside progress in the price of oil, if it occurs, to be labored, limited (say 10 percent), and short-lived. The next move of substantial magnitude that occupies a substantial amount of time I expect to be down.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

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