How Low Can Oil Prices Go?

Peak oil? What peak oil?


Pro Fracking

The price of oil in global markets has plunged by nearly 40 percent over the past six months. As a result, the price of a gallon of regular gasoline in the U.S. has dropped from an average of $3.68 in June to $2.74 this week. In June, the U.S. Energy Information Administration had projected that a gallon of gas would average $3.48 per gallon this month. What happened, and where might oil prices go in the next two to five years?

What's going on is that the world is awash in crude oil while the world economy is slowing down. Demand for crude has dropped, yet supplies are increasing; the predictable result is lower prices. A huge part of the glut in global production stems from the fracking boom in the United States that has seen domestic oil production rise from a low of 5 million barrels per day in 2008 to over 9 million barrels per day in November.

Over the Thanksgiving holiday, the Organization of Petroleum Exporting Countries (OPEC) declined, reportedly at the behest of Saudi Arabia, to reduce its members' production. Some analysts have suggested that this strategy aims to keep global oil prices low with the goal of killing off fracking in the United States and preventing the drilling technique's spread to other parts of the world. It costs less than $10 per barrel to get oil out of the ground in most Middle Eastern countries, whereas production costs hover around $65 per barrel for U.S. fracked wells.

Oil Price Chart December 2014

Michael Lynch, an analyst at Strategic Energy and Economic Research, thinks this strategy is unlikely to work. Lynch estimates that most fracked wells in the U.S. break even below $60, although sustained lower prices will likely cut future drilling investment by 10 to 15 percent. But even that has upside because slackening demand for drilling rigs and crews will lower the costs for new fracked wells. In addition, technological improvements are generating something like an annual 10 to 20 percent reduction in fracking costs and offsetting increases in production. In any case, owners will pump oil from wells already drilled as long as production covers their variable costs.

Lynch argues that during the first decade of this century, oil prices were affected by the perceived threat to production capacity caused by strife in places like Iraq, Nigeria, Iran, and Venezuela. In effect, purchasers paid a security premium. He now believes, despite the continuing turmoil in the Middle East, that the geopolitical risk premium has abated somewhat. If that's true, leading technologically savvy private oil companies might be enticed back into certain oil-rich hellholes to rescue their heroically mismanaged petroleum fields. The sad fact is that nearly 80 percent of the world's oil reserves are in the hands of government-owned companies. It's not too far-fetched to believe that, if properly handled, the combined additional production from Libya, Iraq, Iran, Russia, Nigeria, Venezuela, South Sudan, and Mexico might amount to an extra 10 to 15 million barrels per day. 

In the meantime, budget shortfalls stemming from lower oil prices might encourage unsavory petro-state regimes—Russia, Venezuela, Iran—to be more tractable. Furthermore, the International Monetary Fund estimates that lower oil prices will goose U.S. economic growth from 3.1 percent to 3.5 percent next year.

During the last decade, even as alarums about the advent of "peak oil" grew ever more frenzied, world oil production actually increased from 77.6 million barrels per day in 2003 to 86.8 million barrels per day in 2013. Lynch's book The "Peak Oil" Scare and the Coming Oil Flood, scheduled for publication this coming spring, predicts even larger leaps in the global production of crude. Lynch thinks world oil production will increase to around 110 million barrels per day during the next decade. In the meantime, global oil prices will hover around $60 per barrel over the next couple of years and conceivably drop to $40 per barrel in five years. At $40 per barrel, the price of oil would, in inflation-adjusted dollars, just about equal the annual average price of $17 per barrel in 1998.

I asked Lynch if this meant oil markets might be in for a replay of the price collapse that occurred in the 1980s. He replied that he thought so. In inflation-adjusted dollars, the price of oil reached its peak annual average of $106 per barrel in 1980 and then collapsed to an annual average of $30.80 per barrel in 1986.

Another factor to consider when attempting to project future prices is that demand for oil appears to have peaked in the United States and Europe. This is due in large part to the recent period of sustained high prices that encouraged drivers to buy more energy-efficient vehicles and to conserve the amount of fuel they burned. U.S. gasoline consumption peaked at 142 billion gallons in 2007 and has since fallen by 6 percent to 135 billion gallons in 2013. In the European Union, transport fuel consumption has fallen by 8.4 percent since peaking in 2007. In addition, the total estimated vehicle-miles traveled by Americans has dropped by more than 2 percent since 2007. (Lynch muses that low oil prices may mean we'll "see the death of the electric car" once again.) Finally, if the big industrial countries do get serious in the next decade or so about cutting carbon emissions, that too will tank demand for oil.

In other words, oil consumption may well eventually peak. But not because we ran out of the stuff.

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