With oil prices down over half in six months, oil exporting governments in the Middle East have less than half as much revenue for military and welfare spending, development projects, and funding Islamic extremism around the world. How much further will oil prices fall? Or will they start back up soon?
It is valuable for debaters to gain a sense of the uncertainty of predicting any natural resource prices. The dynamics of supply and demand are in play. As economies expand, they usually consume more of every natural resource. Increased demand bids up resource prices. But higher prices encourage producers to bring new supplies to market, and invest in new technologies to find, develop, refine, and distribute a resource. Plus higher prices signal the search for substitutes, such as aluminum jumper cables when higher copper prices raise the cost of copper jumper cables. Substitutes are everywhere, and higher prices encourage innovation across all supplier, producer, and consumer markets.
As higher prices attract new investment and new resource supplies, plus encourage innovations to reduce consumption and find substitutes, prices start falling. Falling prices start the next dynamic wave of increased resource use, and reduced efforts to increase supplies and conserve use. And so the back and forth continues over the years, decades, and centuries.
The Economist in 2005 reported on the episodic fall of commodity prices over 160 years, “
The Economist’s commodity-price index160 years on.”
“Our species is better off in just about every measurable material way,” he says. “Just about every important long-run measure of human material welfare shows improvement over the decades and centuries, in the United States and the rest of the world. Raw materials – all of them – have become less scarce rather than more. The air in the US and in other rich countries is irrefutably safer to breathe. Water cleanliness has improved. The environment is increasingly healthy, with every prospect that this trend will continue.
Back to the Oil Industry
Investors and entrepreneurs on the supply side are resetting oil development search parameters.
As noted in an earlier post, expensive deep-water and Arctic projects are the first to be put on hold. Less expensive shale ventures will economize in various ways as their costs fall with continued innovation plus slack demand for production labor and resources. But we don’t know yet which projects will be profitable at $50 or $60 a barrel oil.
Best estimates of future oil prices should be informed not only by past prices, but also by the errors of past prognosticators. Energy and technology lessons since at least the late 1700s: high prices and profits attract the attention of investors, innovators, and entrepreneurs. Energy costs fall over time as technologies and skills advance.
High prices and profits wave a red flag before the eyes of energy and technology bulls around the world. Rising oil prices since 2003 and high prices since 2006 attracted more and more investment and innovation into oil exploration and development. Even higher oil prices in 2008, then again in 2010, 2011, 2012, and 2013, plus zero interest rates, pulled even more investment and expertise into oil exploration and development.
On the demand side, these high, higher and highest prices drew billions of investment dollars into all manner of energy efficiency ventures and technologies, including higher-tech car and truck engines, hybrid engines, and no gas at all electric and hydrogen cars. State and federal governments added a web of energy efficiency regulations and myriad alternative energy subsidies, but that only slowed the price-driven advances that curbed energy use across the U.S. and other developed countries.
Total U.S. energy consumption is down since 2007, even as population expanded by over 20 million. Energy consumption dropped to 312 million BTUs per person in 2011, the lowest since 1983.
In the mid 1800s whale oil prices rose in response to American whalers decimating whale populations around the the world. Higher prices encouraged innovation and investment dollars flowed into alternatives, like oil bubbling up in salt marshes. Chemists searched for ways to distill kerosene from Pennsylvania oil (and later to find uses for distillation by-products like gasoline). Pennsylvania soon ran out of easy to drill crude and Standard Oil bet the farm on high-sulphur oil in Ohio (Rockefeller threatened to go it alone if Standard’s board didn’t agree to invest in exploration and the hundreds of chemists needed to figure out how to transform high-sulphur crude to kerosene).
Fast-forward to 1972 and the high oil prices from 1973 to 1985. OPEC oil embargo pushed prices way up and spurred huge exploration budgets that were soon pumping North Sea and from the North Slope of Alaska.
Chart below of imported oil prices (real and nominal) since 1968 is from Energy Information Agency’s Real Prices Viewer page.
The steep drop in oil prices over the last six months should make a few realities clear. Few predicted oil prices would fall this far this fast.
I’ve made this prediction in past posts, but have made them often and for many years. I based my past predictions on the reality that oil exploration is a computer processing and technology business, and processing costs continue to fall as drilling and other technologies advance. Oil supply disruptions and Middle East risk premiums came with the 2003 Iraq war, pushing oil prices up and up. And they stayed up, except for a brief fall in 2008.
A nice illustration from the shale oil industry shows the way advancing technology can quickly boost oil production, keeping downward pressure on prices. Shale oil production technologies and processes are less than a decade old. It is a very young industry still with much to learn. This Energy Information Agency article and chart shows progress over just the last five years. No wonder the Saudis are running scared.
Increased drilling and improved drilling efficiency have led to significant crude oil production increases in the Eagle Ford region in southern Texas. These increases have occurred despite the region’s relatively high well decline rates. However, by offsetting the natural declines through the use of new recovery techniques, further production increases are possible.
As higher prices attract new investment and new resource supplies, plus encourage innovations to reduce consumption and find substitutes, prices start falling. Falling prices start the next dynamic wave of increased resource use, and reduced efforts to increase supplies and conserve use. And so the back and forth continues over the years, decades, and centuries. The Economist in 2005 reported on the episodic fall of commodity prices over 160 years, “The Economist’s commodity-price index160 years on.” 
