Oil prices

How Low Can Oil Prices Go?

The tricky geopolitics of tumbling demand and rising supply

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The price of oil in global markets has plunged by nearly 45 percent over the past six months. As a result, the price of a gallon of regular gasoline in the U.S. dropped from $3.68 in June to $2.37 in late December. In June, the U.S. Energy Information Administration had projected that a gallon of gas would average $3.48 per gallon in the second half of 2014. What happened? And where might oil prices go in the next two to five years?

We are awash in crude oil even as the world economy is slowing down, leading to lowered demand for crude. The glut in global production stems largely from the fracking boom in the United States, which has seen domestic oil production rise from 5 million barrels per day in 2008 to over 9 million barrels per day in November 2014. The predictable result of increased supply of petroleum is that the price is down: A barrel of benchmark West Texas Intermediate crude hovered around $55 at the end of December.

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 the goal is to keep global oil prices low, thereby 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.

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 he says sustained lower prices are likely to cut future drilling investments by 10 to 15 percent, even that has an upside, because slackening demand for drilling rigs and crews will lower the costs for new fracked wells. In addition, technological improvements along with offsetting increases in production are reducing fracking costs by something like 10 to 20 percent annually. 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-edge private oil companies might be enticed back to rescue the heroically mismanaged petroleum fields of certain oil-rich hellholes.

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 with the benefit of more knowledge and modern technology, 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. So much for "peak oil."

During the last decade the alarums about the advent of peak oil grew ever more frenzied. For example, back in 2007 the Germany-based Energy Watch Group declared that the world's oil production had peaked in 2006 and predicted that it would drop by around 3 percent a year. By 2030, fearmongers predicted, the global availability of oil would be half of what it was at its apex.

Instead, world oil production 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 in spring 2015, 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 oscillate around $60 per barrel and could conceivably drop to $40 per barrel within five years. 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.

At $40 per barrel today, the price of oil would, in inflation-adjusted dollars, just about equal the annual average price of $17 per barrel in 1998. Interestingly, in an interview with the Middle East Economic Survey, Saudi Arabia's oil minister, Ali al-Naimi, said OPEC's output would still not be cut. "Whether it goes down to $20, $40, $50, $60, it is irrelevant," he declared.

In a December Reuters op-ed, oil analyst Anatole Kaletsky divided the history of global oil prices over the past four decades into three eras. In Kaletsky's analysis, OPEC maintained pricing power from 1974 to 1985 and the price of oil bounced between $48 and $120 in inflation-adjusted dollars. This provoked more exploration and production that eventually broke OPEC's dominance, ushering in a period of competitive pricing between 1986 and 2004 where the price of crude ranged from $21 to $48 per barrel. As demand grew and supplies tightened, OPEC regained pricing power after 2004 and prices again fluctuated between $50 and $120 per barrel.

So has the global oil market reverted to competitive pricing of oil? Kaletsky is agnostic on that question, but he suggests that if the price remains at or below $50 per barrel for a year, it would indicate that we have returned to a competitive market and therefore that we'll see lower prices for many years to come.

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. The recent period of sustained high prices encouraged drivers to buy more energy-efficient vehicles and to limit the amount of fuel they burned. U.S. gasoline consumption rose to 142 billion gallons in 2007 but 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 then. (Lynch muses that low oil prices means we might "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 reach its zenith. But not because we ran out of the stuff.

Science Correspondent Ronald Bailey (rbailey@reason.com) is the author of the forthcoming The End of Doom: Environmental Renewal in the 21st Century (St. Martin's).