Oil Uncertainties

Depending on who you read, oil prices are either in the stratosphere because of commodity speculation and the weak dollar, or else oil prices are becoming permanently high due to steadily increasing demand alongside production stagnation. One also reads that the US should drill more in Alaska wherever possible on shore and off shore to increase domestic supplies, and that failure to do this has created this problem. Trying to figure out the future of the oil market, even for the purposes of whether one should lock in a fuel oil price of $4.20 a gallon or so now, or gamble on the future, is tough. So what do we know?

1. There is commodity speculation and the dollar is weak. This suggests that the price could be inflated. It doesn’t mean it is inflated; speculation occurs in part because investors expect it to make money. As we’ve seen in the recent property and stock market bubbles, that often fails spectacularly. But it succeeds quite a bit too. And if it is inflated, it’s hard to know how much. Back in the 90s anyone looking at valuations of stocks knew that the market was overpriced. The property bubble was being proclaimed ready to pop for a full two years before it actually did. Here, we don’t know.

2. Demand is increasing rapidly, production has not been increasing. Saudi production has been decreasingly slightly for two years, and in general production has leveled off world wide. This plus increasing demand clearly explains a lot of what’s happening. Beyond that, most OPEC states are producing at capacity, suggesting that there may not be a lot of excess production capacity available. Only Saudi Arabia is thought to really be able to add a lot of oil to the market, but we know little about the real condition of Saudi oil reserves. Iraq could put a lot of oil on the market, but it would take stability and a lot of investment — both of which are years, maybe decades away.

3. Saudi Arabia has shifted policy away from being clearly pro-American (increasing production when prices rise, pressuring other OPEC states to be more friendly to American concerns) to one unafraid to counter the US, both on oil and on issues like Iraq or their relationship with Iran. This signals a weaker US hand in the region and less influence on oil prices, thanks in large part to the fiasco in Iraq.

4. Even if we drilled in Alaska wherever we could, and went into extensive off shore drilling operations, it’s unlikely we’d really change the basic situation. There simply is not enough oil there to alter world production capacities, and we’d use it up quickly (indeed, perhaps the smartest thing about not drilling more in Alaska now is that when we get around to drilling there, oil will be really valuable). There could be a surprise find that would shock the market, but from what I’ve read, geologists think that’s unlikely. Still, in the trade off between economics and the environment, we may be nearing a point when the economic necessity of buying time to transition to alternates makes environmental sacrifices worth the cost. This isn’t a clear, objective point in the process, but rather a political one.

5. Domestic oil goes on to the international market, so we are misguided if we focus too much on domestic production. If we produce more here, we’d still pay world market prices, and while we’d buy less on the world market, that would open up that oil to be purchased by others. It would increase supply, but given the cost and time of bringing new facilities on line, probably not by enough to fundamentally change the market.

6. The Mideast remains in turmoil. Al qaeda is as strong as pre-2001, according to the CIA, the war on terror has so far had limited success. Iran is an emerging powerhouse, but the US is threatening it. The centerpiece of all this is Israel, and with recent actions by Hamas and Hezbollah, it’s likely the area will remain hot. If it nonetheless remains peaceful, the risk premium in the price is likely to remain large. If things get worse, then the price could spike significantly.

7. If prices get high enough there will be a deep world recession, one that could spiral down into depression. The good news on that is that this will then ease pressure on oil prices and moderate them, perhaps significantly. It will also reduce fossil fuel emissions and their impact on global warming. But those are thin silver linings and an otherwise dark cloud.

Taking all of this into account, its seems rational to conclude that high oil prices are here to stay. Never again are we likely to see $.89 or even $1.89 gas. But there could be considerable fluctuation in prices, and a drop of price by $30 – $50 a barrel is conceivable, especially if the dollar strengthens. But $200 a barrel oil within two years, a recent prediction by some analysts, is just as likely. So I’d say take this seriously. Take into account when you purchase a car or decide whether or not to have a long commute to work. Be prepared to find alternate ways to heat your home, perhaps start a garden — high oil prices mean expensive food too. This isn’t Y2K, this is something based on how markets function, and the fact that oil is a non-renewable resource, one that has given us a century of the cheapest energy one could imagine. We’ve built our culture around it (something I thought about while watching Cars, the Disney movie, with my five year old the other day). I doubt this will lead to a complete breakdown of society, however. But we need to start thinking about the choices we need to make in order to be able to deal with the oil uncertainties that drive our economy and our politics.

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