Oil Shocks: Are We Headed for More of Them?

This article is from the RIIB blog of July 30, 2009.

Do you recognize any of the following news excerpts?

Four leaders of America’s energy business yesterday warned of a relentless rise in fuel prices, possible industrial collapse, massive electrical blackouts and a “fairly deep and continuous recession” without a commitment to such alternative energy sources as nuclear power or synthetic fuels.

Congressional Panel Forecasts Little Boost in World Oil Output

Conventional world oil production will show little or no increase over the next 20 years while US production will decline sharply, according to a congressional study released yesterday.

A Scramble for Crude Oil Boosts Prices

The scramble for crude oil within the United States among major oil companies, independent producers and refiners has triggered a “gas war in crude oil – only the prices are going up, not down”, says the oil purchasing director for one of the nation’s major oil companies.

Oil Supply Running Out

Warning that global oil reserves are running out at “an alarming rate”, Saudi Oil Minister Sheikh Yamani proposed yesterday an urgent international energy program which “could move our world away from the edge of an abyss”.

If these stories sound familiar, you might be thinking that they’re from last summer. In fact, all of these stories are from 1980. That same year, a respected oil industry analyst predicted that world oil prices would be somewhere in the $100 to $150 range by the year 2000. In fact, oil prices bottomed out at about $10 a barrel in late 1998 / early 1999 – a post-war low when adjusted for inflation – and averaged about $25 a barrel in the year 2000.

Why bring all of this up now? As the world’s economies come out recession later this year and begin to grow again next year, predictions about the future path of oil prices will no doubt be making headlines once again. Will we see the return of $150 oil prices? Will prices be much higher, possibly $200 and beyond? Since none of us has a crystal ball, predicting the future is always a dicey business; however, there are some simple economic principles that we can use to guide our thinking about how oil prices might play out. The experiences of the last 30 years in the oil market are a useful illustration of these principles.

Until about 1974, post-war oil prices were quite stable in real terms, hovering around $22 a barrel (in 2008 dollars). Oil prices rose sharply through the late ‘70’s and early ‘80’s, with the average real price of oil topping out at almost $100 a barrel in 1980. Real oil prices remained above $50 a barrel through 1985. This sharp rise in prices had a dramatic impact on oil consumption. Whereas over the decade of the 1970’s, oil consumption rose about 40 percent, consumption declined over the first half of the 1980’s and didn’t return to its 1979 level until the end of the decade.

The simple economic principle at play here is this: a huge price run-up creates incentives for consumers to conserve. During the 1980’s, drivers bought more fuel-efficient automobiles, homeowners insulated their houses and purchased energy-efficient appliances and utilities turned to other energy sources to generate electricity. At the same time, the dramatic increase in prices created incentives for oil producers to find new sources of oil and to develop new technologies to recover oil more effectively. This is the second economic principle at play. Together, the increased supplier incentive to produce oil and the increased consumer incentive to conserve oil resulted in dramatic increases in oil reserves. In contrast to the 1970’s, when oil reserves essentially didn’t grow at all, over the decade of the 1980’s reserves increased by about 50 percent. The doomsayers and forecasters turned out to be wrong.

So what happened recently? Part of the explanation for the oil price run-up in 2007 – 2008 is just the other side of the same coin. Over the 1990’s oil prices declined steadily – not a surprise given the huge increase in reserves – and remained at or below $30 a barrel through the first several year of the 2000’s. The result of the low oil prices was that consumption rose sharply, increasing about 25 percent from 1990 to 2003. Incentives for conservation were diminished. In 1980, only about 15 percent of new vehicle sales in the US were light trucks – SUV’s, minivans and pick-up trucks. By 2003, virtually half of all new vehicles sold in the US were light trucks. As a consequence, the average fuel efficiency of all new vehicles sold in the US in 2003 was about the same as it was in 1980. Low energy prices also helped fuel the growth of China and other developing countries.

On the production side, the low prices meant that oil producers had little incentive to search for new sources of oil. Who’s going to search for oil when it’s selling for $10 a barrel? Combined with the growing consumption, this meant that, much as in the 1970’s, oil reserves barely increased at all through the decade of the 1990’s and into the early 2000’s. Not surprisingly, then, we saw upward pressure on prices beginning in 2004. It’s the same economic principles at work. Even with that, though, don’t forget that, as late as May 2007, oil prices averaged only about $60 a barrel. The doubling of prices one year later was not because of some huge spike in oil demand from China and India. There were other forces at play driving the price increase.
So where are prices headed in the future? We can all speculate on the answer to this question and intelligent people can come to different conclusions. One thing is sure, however. Rising prices will reduce consumption growth and increase growth in production. Together, these twin effects must ultimately put downward pressure on prices. So, don’t bet the farm on prices being high and rising forever. If oil prices are so high that no one can afford to buy oil, prices will come down.