The Oil Price Bubble Bursts

And prices are falling a dollar a day

Oil prices have dropped by 60 percent since July. And they fell without the benefit of a gasoline tax holiday, new anti-speculator regulations, or a windfall profits tax on oil companies. A year ago, crude oil was going for $88.00 per barrel and gasoline cost an average of $2.76 per gallon. Over the following months, the price soared, reaching an inflation-adjusted record high of just over $147 per barrel in July. Then the bottom fell out. Yesterday, the price was hovering around $58, up from a recent low of $53 per barrel. The result is gasoline prices plummeting from a national average of $4.11 per gallon in July to below $2.07 per gallon now. So what happened?

First, just as one would expect, higher prices led to lower demand. U.S. demand for petroleum in 2008 was 5.4 percent lower than in 2007, falling by 1.1 million barrels per day (bpd) from 20.7 million to 19.6 million barrels per day. As prices rose Americans curtailed their driving. The Federal Highway Administration reported that in August 2008, Americans drove 15 billion fewer miles, or 5.6 percent less, than they did in August 2007. On the other hand, recent high prices have called forth new sources of supply. For example, Canadian oil sands now produce 1.1 million barrels per day. And new deepwater offshore production rigs like the Thunder Horse (250,000 barrels per day) and Tahiti (125,000 barrels per day) platforms are coming online. Falling demand and increasing supply mean lower prices.

In addition, a good portion of the lower demand for oil is the result of the global economic slowdown. "This time the usual petroleum boom/bust cycle lined up on top of the business cycle," said Tim Evans, an energy futures analyst at Citigroup's Futures Perspective. In March 2008, Evans warned that we were in the midst of a bubble and that oil prices would drop. When the investment firm Goldman Sachs suggested the possibility of $200 per barrel oil, Evans predicted that prices would fall to $60 to $70 per barrel. He observed presciently that "this is the riskiest time to be long in crude oil since 1980."

So as prices drop will demand increase? Yes, but Evans believes that U.S. demand will rise slowly. Why? In part because various federal government policy responses to recent high oil prices are unlikely to be reversed. For example, the Federal government has mandated that Corporate Average Fuel Economy standards for automobiles rise from 27.5 miles per gallon now to 35 miles per gallon by 2020. Evans thinks that hybrid automobile technology may look economically attractive even at current prices. Plug-in hybrids like the Chevy Volt should use about 2 cents of electricity per mile compared to 12 cents per mile of gasoline. In addition, Evans says, "The biofuels initiatives aren't going to go away. Even if they are not economically smart, the votes are there to make sure that we stick with these programs." So subsidized biofuels will displace some demand for gasoline, putting downward pressure on the price of crude oil.

On the supply side, those "windfall profits" that oil companies have been earning in the last couple of years are paying for exploration and development of more oil supplies. It is true that the oil companies have been using their record profits to buy back stock and thus increase shareholder value. Some members of Congress believe that the oil companies should spend their profits on alternative energy projects that the companies don't believe can be justified economically. And if the oil companies don't stop enriching their shareholders, Congress will see to it that the "windfall profits" are taxed away and spent by government bureaucrats on alternative energy projects. It is possible that the members of Congress know better how to spend oil company profits than do their executives, but the Federal government's record in this area is not impressive.

Naturally, suppliers don't like lower prices, so the members in the Organization of Petroleum Exporting Countries (OPEC) want to drive up prices by restricting supply. In October, OPEC members pledged to cut oil production by 1.5 million barrels per day beginning on November 1. They plan to hold another meeting later this month to discuss further reductions. Even as consumers enjoy lower prices at the gas pump now, analysts at the International Energy Agency fret that they will lead to underinvestment in oil production capacity, resulting in a crude oil supply crunch by the middle of the next decade. Disturbingly, 80 percent of the world's known oil reserves are owned by government oil companies whose revenues are looted rather than reinvested in production. In any case, lower prices and the credit crunch are already causing oil companies to shelve some projects. Alternative energy promoters also fear lower petroleum prices because they make their projects even less economically feasible. Some are advocating a higher gasoline tax in order to counteract the deleterious effects of lower crude oil prices on the glorious alternative energy future.

So what's next for oil prices? For the coming year, Evans thinks that the price of oil will bounce around in a trading range of $50 to $90 per barrel, averaging around $70 per barrel.

Ronald Bailey is reason's science correspondent. His book Liberation Biology: The Scientific and Moral Case for the Biotech Revolution is now available from Prometheus Books.

Disclosure: Yes, I still own those 50 shares of XOM that I bought with my own money. The shares are down 12 percent from their high this year.