Guest post by Gail Tverberg of Our Finite World:
A person might think that oil prices would be fairly stable. Prices
would set themselves at a level that would be high enough for the
majority of producers, so that in total producers would provide
enough–but not too much–oil for the world economy. The prices would be
fairly affordable for consumers. And economies around the world would
grow robustly with these oil supplies, plus other energy supplies.
Unfortunately, it doesn’t seem to work that way recently. Let me explain
at least a few of the issues involved.
1. Oil prices are set by our networked economy.
As I have explained previously,
we have a networked economy that is made up of businesses, governments,
and consumers. It has grown up over time. It includes such things as
laws and our international trade system. It continually re-optimizes
itself, given the changing rules that we give it. In some ways, it is
similar to the interconnected network that a person can build with a
Thus, these oil prices are not something that individuals consciously
set. Instead, oil prices reflect a balance between available supply and
the amount purchasers can afford to pay, assuming such a
balance actually exists. If such a balance doesn’t exist, the lack of
such a balance has the possibility of tearing apart the system.
If the compromise oil price is too high for consumers, it will cause
the economy to contract, leading to economic recession, because
consumers will be forced to cut back on discretionary expenditures in
order to afford oil products. This will lead to layoffs in discretionary
sectors. See my post Ten Reasons Why High Oil Prices are a Problem.
If the compromise price is too low for producers, a disproportionate
share of oil producers will stop producing oil. This decline in
production will not happen immediately; instead it will happen over a
period of years. Without enough oil, many consumers will not be able to
commute to work, businesses won’t be able to transport goods, farmers
won’t be able to produce food, and governments won’t be able to repair
roads. The danger is that some kind of discontinuity will occur–riots,
overthrown governments, or even collapse.
2. We think of inadequate supply being the number one problem
with oil, and at times it may be. But at other times inadequate demand
(really “inadequate affordability”) may be the number one issue.
Back in the 2005 to 2008 period, as oil prices were increasing
rapidly, supply was the major issue. With higher prices came the
possibility of higher supply.
As we are seeing now, low prices can be a problem too. Low prices
come from lack of affordability. For example, if many young people are
without jobs, we can expect that the number of cars bought by young
people and the number of miles driven by young people will be down. If
countries are entering into recession, the buying of oil is likely to be
down, because fewer goods are being manufactured and fewer services are
In many ways, low prices caused by un-affordability are more
dangerous than high prices. Low prices can lead to collapses of oil
exporters. The Soviet Union was an oil exporter that collapsed when oil prices were down.
High prices for oil usually come with economic growth (at least
initially). We associate many good things with economic growth–plentiful
jobs, rising home prices, and solvent banks.
3. Too much oil in too short a time can be disruptive.
US oil supply (broadly defined, including ethanol, LNG, etc.) increased by 1.2 million barrels per day in 2013, and is forecast by the EIA
to increase by close to 1.5 million barrels a day in 2014. If the issue
at hand were short supply, this big increase would be welcomed. But
worldwide, oil consumption is forecast to increase by only 700,000
barrels per day in 2014, according to the IEA.
Dumping more oil onto the world market than it needs is likely to
contribute to falling prices. (It is the excess quantity that leads to
lower world oil prices; the drop in price doesn’t say anything at all
about the cost of production of the additional oil.) There is no sign of
a recent US slowdown in production either. Figure 2 shows a chart of
crude oil production from the EIA website.
4. The balance between supply and demand is being affected by many issues, simultaneously.
One big issue on the demand (or affordability) side of the balance is
the question of whether the growth of the world economy is slowing.
Long term, we would expect diminishing returns (and thus higher cost of
oil extraction) to push the world economy toward slower economic growth,
as it takes more resources to produce a barrel of oil, leaving fewer
resources for other purposes. The effect is providing a long-term
downward push on the price on demand, and thus on price.
In the short term, though, governments can make oil products more
affordable by ramping up debt availability. Conversely, the lack of debt
availability can be expected to bring prices down. The big drop in oil
prices in 2008 (Figure 3) seems to be at least partly debt-related. See
my article, Oil Supply Limits and the Continuing Financial Crisis.
Oil prices were brought back up to a more normal level by ramping up
debt–increased governmental debt in the US, increased debt of many kinds
in China, and Quantitative Easing, starting for the US in November
In recent months, oil prices have been falling. This drop in oil
prices seems to coincide with a number of cutbacks in debt. The recent
drop in oil prices took place after the United States began scaling back its monthly buying of securities under Quantitative Easing. Also, China’s debt level seems to be slowing. Furthermore, the growth in the US budget deficit has also slowed. See my recent post, WSJ Gets it Wrong on “Why Peak Oil Predictions Haven’t Come True”.
Another issue affecting the demand side is changes in taxes and in
subsidies. A change toward more taxes such as carbon taxes, or even more
taxes in general, such as the Japan’s recent increase in sales tax,
tends to reduce demand, and thus give a push toward lower world oil
prices. (Of course, in the area with the carbon tax, the oil price with
the tax is likely to be higher, but the oil price elsewhere around the world will tend to decrease to compensate.)
Many governments of emerging market countries give subsidies to oil products. As these subsidies are lessened (for example in India and in Brazil)
the effect is to raise local prices, thus reducing local oil demand.
The effect on world oil prices is to lower them slightly, because of the
lower demand from the countries with the reduced subsidies.
The items mentioned above all relate to demand. There are several items that affect the supply side of the balance between supply and demand.
With respect to supply, we think first of the “normal” decline in oil
supply that takes place as oil fields become exhausted. New fields can
be brought on line, but usually at higher cost (because of diminishing
returns). The higher cost of extraction gives a long-term
upward push on prices, whether or not customers can afford these prices.
This conflict between higher extraction costs and affordability is the
fundamental conflict we face. It is also the reason that a lot of folks
are expecting (erroneously, in my view) a long-term rise in oil prices.
Businesses of course see the decline in oil from existing fields, and
add new production where they can. Examples include United States shale
operations, Canadian oil sands, and Iraq. This new production tends to
be expensive production, when all costs are included. For example, Carbon Tracker estimates that most new oil sands projects require a price of $95 barrel
to be sanctioned. Iraq needs to build out its infrastructure and secure
peace in its country to greatly ramp up production. These indirect
costs lead to a high per-barrel cost of oil for Iraq, even if direct
costs are not high.
In the supply-demand balance, there is also the issue of oil supply that is temporarily off line, that operators would like to get back on line. Libya is one obvious example. Its production was as much as 1.8 million barrels a day in 2010. Libya is now producing 800,000 barrels a day,
but was producing only 215,000 barrels a day in April. The rapid
addition of Libya’s oil to the market adds to pricing disruption. Iran
is another country with production it would like to get back on line.
5. Even what seems like low oil prices today (say, $85 for
Brent, $80 for WTI) may not be enough to fix the world’s economic growth
High oil prices are terrible for economies of oil importing
countries. How much lower do they really need to be to fix the
problem? Past history suggests that prices may need to be below the $40
to $50 barrel range for a reasonable level of job growth to again occur
in countries that use a lot of oil in their energy mix, such as the
United States, Europe, and Japan.
Thus, it appears that we can have oil prices that do a lot of damage
to oil producers (say $80 to $85 per barrel), without really fixing the
world’s low wage and low economic growth problem. This does not bode
well for fixing our problem with prices that are too low for oil
producers, but still too high for customers.
6. Saudi Arabia, and in fact nearly all oil exporters, need
today’s level of exports plus high prices, to maintain their economies.
We tend to think of oil price problems from the point of view of
importers of oil. In fact, oil exporters tend to be even more affected
by changes in oil markets, because their economies are so oil-centered.
Oil exporters need both an adequate quantity of oil exports and adequate
prices for their exports. The reason adequate prices are needed is
because most of the sales price of oil that is not required for
investment in oil production is taken by the government as taxes. These
taxes are used for a variety of purposes, including food subsidies and
new desalination plants.
A couple of recent examples of countries with collapsing oil exports
are Egypt and Syria. (In Figures 5 and 6, exports are the difference
between production and consumption.)
Saudi Arabia has had flat exports in recent years (green line in
Figure 7). Saudi Arabia’s situation is better than, say, Egypt’s
situation (Figure 5), but its consumption continues to rise. It needs to
keep adding production of natural gas liquids, just to stay even.
As indicated previously, Saudi Arabia and other exporting countries
depend on tax revenues to balance their budgets. Figure 8 shows one
estimate of required oil prices for OPEC countries to balance their
budgets in 2014, assuming that the quantity of exported oil is pretty
much unchanged from 2013.
Based on Figure 8, Qatar and Kuwait are the only OPEC countries that
would find $80 or $85 barrel oil acceptable, assuming the quantity of
exports remains unchanged. If the quantity of exports drops, prices
would need to be even higher.
Saudi Arabia has set aside funds that it can tap temporarily, so that
it can withstand a lower oil price. Thus, it has the ability to
withstand low prices for a year or two, if need be. Its recent
price-cutting may be an attempt to “shake out” producers who have
less-deep pockets when it comes to weathering low prices for a time.
Almost any oil producer elsewhere in the world might be in that
7. The world really needs all existing oil production, plus more, if the world economy is to grow.
It takes oil to transport goods, and it takes oil to operate
agricultural and construction equipment. Admittedly, we can cut back
world oil production with lower price, but this gets us into “a heap of
trouble”. We will suddenly find ourselves less able to do the things
that make the economy function. Governments will stop fixing roads.
Services we take for granted, like long distance flights, will
A lot of people have a fantasy view of a world economy operating on a
much smaller quantity of fossil fuels. Unfortunately, there is no way
we can get there by way of a rapid drop in oil prices. In order for such
a change to take place, we would have to actually figure out some kind
of transition by which we could operate the world economy on a lot less
fossil fuel. Meeting this goal is still a very long ways away. Many
people have convinced themselves that high oil prices will help make
this transition possible, but I don’t see this as happening. High prices
for any kind of fuel can be expected to lead to economic contraction.
If transition costs are high as well, this will make the situation
The easiest way to reduce consumption of oil is by laying off
workers, because making and transporting goods requires oil, and because
commuting usually requires oil. As a result, the biggest effect of a
cutback on oil production is likely to be huge job layoffs, far worse
than in the Great Recession.
8. The cutback in oil supply due to low prices is likely to occur in unexpected ways.
When oil prices drop, most production will continue as usual for a
time because wells that have already been put in place tend to produce
oil for a time, with little added investment.
When oil production does stop, it won’t necessarily be from high-cost
production, because relative to current market prices, a very large
share of production is high-cost. What will tend to happen is that
production that has already been “started” will continue, but production
that is still “in the pipeline” will wither away. This means that the
drop in production may be delayed for as much as a year or even two.
When it does happen, it may be severe.
It is not clear exactly how oil from shale formations will fare.
Producers have leased quite a bit of land, and in some cases have done
imaging studies on the land. Thus, these producers have quite a bit of
land available on which a share of the costs has been prepaid. Because
of this prepaid nature of costs, some shale production may be able to
continue, even if prices are too low to justify new investments in shale
development. The question then will be whether on a going-forward
basis, the operations are profitable enough to continue.
Prices for new oil development have been too low for many oil
producers for many months. The cutback in investment for new production
has already started taking place, as described in my post, Beginning of the End? Oil Companies Cut Back on Spending.
It is quite possible that we are now reaching “peak oil,” but from a
different direction than most had expected–from a situation where oil
prices are too low for producers, rather than being (vastly) too high
The lack of investment that is already occurring is buried deeply
within the financial statements of individual companies, so most people
are not aware of it. Dividends remain high to confuse the situation. By
the time oil supply starts dropping, the situation may be badly out of
hand and largely unfixable because of damage to the economy.
One big problem is that our networked economy (Figure 1) is quite
inflexible. It doesn’t shrink well. Even a small amount of shrinkage
looks like a major recession. If there is significant shrinkage, there
is danger of collapse. We haven’t set up a new type of economy that uses
less oil. We also don’t have an easy way of going backward to a prior
economy, such as one that uses horses for transport. It looks like we
are headed for “interesting times”.