Oil Prices: What Goes Down Must Come Up

We all remember the high school economics lesson on the law of supply and demand. It taught us that when demand is low and supply is high, prices fall; when the opposite is true, prices rise.

Since supply and demand is a law of economics and we must assume that energy-sector experts understand this, predicting oil prices, at least in the macro sense, should be a breeze for the experts who come before television cameras to make pronouncements about what is happening.

The funny thing about the experts is that they’ve been almost universally wrong. As recently as this October, when oil was trading at about $82 per barrel, they collectively took to television and print to declare that oil was priced below production costs and there could be little doubt that prices would soon stabilize and probably rebound.

By Dec. 18, the price of crude slid to $56 a barrel, causing many to declare that the bottom is probably going to be around $40 a barrel, which begs the question: How could so many be so wrong, and what can we expect?

The Supply Facts

According to the U.S. Energy Information Administration, the average cost to produce a barrel of domestic oil is about $31.38 for onshore sources and $51.60 for offshore. Other regional producers around the world have costs that range from a low of $16.68 for Middle Eastern oil to $45.32 for African oil.

That places the average cost to produce a barrel of oil at about $29.50. Production costs include finding and extracting the oil from the ground. It’s also important to note that new technologies and techniques have been lowering production costs.

OPEC, which represents 12 oil-producing countries and controls 40% of the world’s production of oil, sets production limits for members. At the most recent meeting on Nov. 27, they failed to reach an agreement to limit production and reduce supply. That means members are free to keep their oil spigots wide open.

Speculation about the reasons for OPEC’s failure to cut supplies vary from market-driven concerns to the conspiratorial. For example, U.S. oil production has jumped from a 50-year low of less than seven million barrels a day in 2008 to a 30-year high of 10 million barrels a day in 2013, adding to the global supply. Conspiracy theorists believe the Persian Gulf states want to lower prices as a means of cutting off funding for ISIS, which sells oil on the black market.

The Demand Facts

Worldwide consumption of oil and its derivatives is down. While oil consumption in Asia — especially India and China — has skyrocketed, the high per-barrel cost has caused them to rely even more heavily on coal, a deluge of inexpensive natural gas, and the development of alternative sources of energy. This spurs the very real fear that oil is pricing itself out of viability.

Unlike Asia, the U.S. and EU have both experienced a marked decrease in recent years. U.S. consumption has declined from a high of about 21.5 million barrels per day in 2006 to about 18.5 million barrels in mid-2010, and consumption appears to be continuing its downward trend.

The reason for the drop on the consumer side is dominated by higher fuel-efficiency standards for cars and trucks, slowing economic activity in Europe, and lower prices for natural gas that have resulted in a boom of oil-to-gas conversions for home heating. This overarching trend further blunts the lower winter demand.

The Past Is Prologue

If history repeats itself with regard to precipitous drops in the price of oil since 1946, you can bet the farm that this fall will be followed by a nearly as dramatic rise in price.

Are things different this time around? Yes. New technologies have made finding and extracting new sources of petroleum easier and less expensive. Worldwide demand for oil continues, on average, to be trending down. New technologies for producing solar and wind energy are contributing to still greater decreases in demand, along with the fracking revolution that is transforming the energy landscape.

Still, history is a demanding mistress that is ignored at our peril. If history is once again our best benchmark for the future, we’d best heed its lessons or suffer the consequences — because what goes down will surely go back up again.

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