Oil prices are inching upwards again. Just as last year, some people are starting to tell fairy tales instead of facing the reality of limited oil supplies.
If my car mechanic explained that my car was overheating because of fairies and pixie dust, I’d take my business elsewhere. I expect my mechanic to know the fundamentals of how the radiator works. Yet senators, fuel dealers, and editorial writers seem to believe in pixie dust.
For example, the Times Argus editorial writer (June 11) concluded that speculators were behind last year’s dramatic rise in oil prices. Why? The oil price dropped from near $150 a barrel to under $40, and “(t)he recession decreased demand, but not by two thirds.”
The writer apparently assumes that oil prices have a one-to-one relationship with demand: double demand, and you can expect the price of oil to double. Halve demand, and the price of oil halves, too.
The oil market doesn’t work that way. Oil is a classic example of a price-inelastic commodity. That’s economist talk for saying that demand doesn’t change much when prices go up or down.
Introductory economics classes even use oil to illustrate the concept. When oil prices jump, people still commute alone in cars, drive kids to soccer practice, and heat their homes. Oil prices increased nearly 15 times over the last eight years, yet demand didn’t drop. Instead, it increased.
The potential oil supply became maxed out over this period. The spigots were open as wide as they would go, yet people kept consuming more oil. In reaction, the price just kept climbing.
What would a price spike driven by speculators look like? Only through storing oil can speculators make money by driving up prices. If speculators had been responsible for last year’s price spike, we would expect to see increases in stored oil. In fact, the opposite happened. World oil consumption exceeded production in 2007 and the first half of 2008. Inventories were drawn down. At least, that’s what happened to the inventories we have records for.
Paul Krugman, winner of last year’s economics prize in memory of Alfred Nobel, brought up the concept of hidden inventories last June to explain why speculators were not responsible for the run-up in prices. He calculated that for speculation to have driven the price spike, someone would have to be buying and hiding 84 million gallons of oil each and every day. That would take a lot of fairies and pixie dust!
What about this year? How come prices are rising now, when oil inventories are higher than usual and OPEC has been scrambling to reduce production? Morgan Downey, author of “Oil 101,” an authoritative overview of all aspects of the oil industry, points to the fundamentals. “The thing that annoys me about those sorts of articles [blaming speculation] is that it says oil demand is down and so price should not be rising. Since the beginning of 2009 demand is down year on year by 2 million barrels per day but supply is down over 3.5 million barrels per day (due to OPEC cuts).”
Ah, have we found a real culprit at last, in OPEC? Well, yes, but only for the time being. Without OPEC production cuts, prices would surely be lower this year. Last year, not so much. Every oil producer in the world was producing at or near capacity.
In the near future, prominent third-party observers expect a new oil production shortfall. They include the US Department of Energy, the International Energy Agency, and the International Monetary Fund. Each year, depletion in existing oil fields reduces available oil by 4 million barrels per day. That means that within five years, the equivalent of two new Saudi Arabias need to be brought on line, just to keep world production from dropping.
Meanwhile, with the easy oil gone, it costs a lot more to find and develop new oil. The 2008 cost doubled, to over $50 per barrel, from the three year average, according to a study released this month by Ernst & Young. Yet investment is falling, not rising. Already this year, investment in new oil fields has dropped by $100 billion.
The third-party observers expect the economy to recover in a year or two, leading to increased oil consumption. And then the world smashes right into the ceiling of limits to production again.
Good energy policy will only occur if people are willing to face these hard facts and drastically cut dependence on oil. Trying to rid the world of fairies and pixie dust just guarantees a repeat of the oil price pain of 2008.
Carl Etnier, director of Peak Oil Awareness, blogs at vtcommons.org/blog and hosts radio shows on WGDR, 91.1 FM Plainfield and WDEV 96.1 FM/550 AM, Waterbury. He can be reached at [email protected].
