Oil Prices in the Years to Come

I guess it takes a fair degree of audacity to speculate on the pricing of oil in world markets several years out, but I think that in a journal devoted to alternatives one needs to undertake the exercise.

In previous articles on the price of petroleum I have tried to examine both the historical data going back to the beginning and the perturbations and disruptions in what has been a remarkably stable commodity heretofore. In constant dollar terms, crude oil has remained in the $20 per barrel range over the most of the period in which it has been produced. Gasoline has been less stable, commanding relatively high prices at the beginning of the century, but has generally not fluctuated a great deal afterwards.

The exceptions of course have been the times of world crises, namely, the World Wars and the several wars, revolutions, and insurrections that have occurred in the Middle East—the source, unfortunately, of an increasing proportion of all oil produced. Indeed, every previous oil spike without exception has been associated with a dire geopolitical event.

Now one could certainly argue that the current situation in the Middle East is hardly one of peace and stability, but that situation is arguably far less grim than was the protracted war between Iran and Iraq, which saw the worst previous oil price spike, or the brief but unsettling OPEC embargo in 1973 following hard on the heels of the Yom Kippur War. Nevertheless, one can detect a certain lack of congruence between oil prices and tension levels at the present. If the past were any guide, oil should have reached its highest point right after U.S. invasion of Iraq, or, alternately during the worst days of the uprising there in 2005 and 2006. But that was not the case. Nor did oil spike significantly during the first Gulf War in 1991, but we'll ignore that for the time being.

What we're seeing today appears to be a clear break from the past, and perhaps a decisive change in the historical price of oil.
I have previously reviewed what I believe are the factors influencing price, and I have no really original insights here. I believe that the flattening of world production and a steady increase in demand—in other words, the fundamentals—are chiefly behind the rise, and that uncertainties concerning future events in oil producing regions also plays a part, though probably a smaller part. I do not believe that the effects of speculation can be easily separated from the second factor since uncertainty essentially drives speculation.

Where Do We Go from Here?

World oil production is faltering and has been for the past three years. It actually dropped at the beginning of the decade in the wake of the financial crash in the U.S. involving the tech sector. There is no precedent for what has happened in the present decade with respect to production. Only in times of war and revolution has oil production paused in its relentless upward climb.

Why now and why in the light of current accelerating demand?

Robert Kaufmann, a petroleum economist whose teleconference I attended recently, believes that the cost of putting new production on line will be such that overall revenues would actually decline for the oil producers, and that consequently oil producers have no incentive to increase production. According to his calculations, the price of oil would plunge to the extent that the sale of the additional oil produced would not compensate for the expense of producing it, and one will have arrived at a classic instance of marginal profits in manufacturing. But Kaufmann also suggested that perhaps OPEC, to which most of the few remaining swing producers belong, might not be capable of increasing production significantly.

Such musings are increasingly common, and one was published by the online investment journal Energy & Capital last week. Long time readers of this journal know that I myself subscribe to such beliefs. Kaufmann, however, did not want to dwell on this possibility which he labeled a Doomsday scenario. I can understand his reluctance, but if one really wants to know the future, then one must explore that possibility and its full implications.

So let us run ahead of time and sprint into the ensuing years and see what lies in wait for us.

Black Swan Rising

First let us consider the one eventuality that would be almost wholly attributable to the actions of one man, namely the current President of the United States. If President Bush attacks Iran, a massive oil spike on top of the current high plateau is highly likely, indeed almost certain according to almost every authority who has considered the possibility. Will such an event occur? In entertaining the possibility it is best to consider President Bush as a classic black box where only the inputs and outputs are knowable, not the inner processes within the box.

What we can say with entire certainty is that George W. Bush is extremely non-risk aversive in his behavior and not given to lengthy considerations of the consequences of dangerous actions. Moreover, his arousal point is extremely low. Definance on the part of unfriendly states is invariably met with reprisals. Furthermore, he will not deviate from a course of action once he undertakes it. Perhaps for these reasons, Bush for all of his personal resources, has not been a very successful investor. He is incapable of hedging or otherwise limiting exposure. Every wager is go for broke. In a casino setting he would attempt to utilize martingales and other doubling down strategies, strategies of proven ineffectiveness in a commercial gambling establishment where house limits are in place, but which may possible on the stage of international geopolitical where he plays, given the seemingly infinite resources the United States commands. We shall see.

In any case, a devastating air attack on Iran would almost surely result in a temporary price of oil that would be multiples of the current price. Few doubt that. Such an eventuality could only be avoided by the virtual destruction of the Iranian populace and the armed occupation of Iranian oil lands by U.S. troops—courses of action with their own sets of serious risks, and ones from which even the highly non-risk aversive Bush might shrink.

So why would the President even contemplate such an attack, and we know of a certainty that he has. One cannot ascribe motives to black boxes, only patterns of activity. One can only say that an attack would be entirely consistent with past patterns of activity. There is however a rationale for prosecuting such a strategy. There is a strong possibility that the electorate would rally behind Bush and the Republican Party after the commencement of an attack, particularly if it were justified with a pretext. Political leaders, however unpopular, are almost never repudiated upon launching a war. It is only when the fortunes of war go against them that support diminishes. The President might be under considerable pressure from his own party to initiate such an attack for that reason. That would be an input going into the black box that is George Bush, an input whose corresponding output is war.

I see some likelihood of such an attack occurring, though I hope I'm wrong. If it does, the effects could be near cataclysmic and there is little possibility of an early positive outcome with respect to oil prices.

A Bear Market for Oil

If an attack on Iran does not take place within one year of this writing, we will probably see a plunge in crude oil prices, particularly if the Iran crisis is resolved. Tensions will abate and with them the pressure to take long positions on oil. Sell offs could conceivably bring oil prices back to the $80 per barrel range, reflecting speculation in short rather than long positions.

The effect of such a bear run would be to lull politicians and their constituents into a false state of confidence. The business press as a whole would loudly proclaim that oil prices had returned to their historical levels, and people as a whole would be inclined to believe them.

Would that in fact happen?

The chances are, if not infinitely remote, extremely remote. For a return to historical levels, i.e. $20 a barrel, one would have to experience simultaneously a collapse in demand and a massive production increase. And what are the chances of that? I have seen certain editorials in conservative business journals proclaiming that huge increases in production could be achieved simply by lifting environmental restrictions in the United States, but such pronouncements simply don't bear close scrutiny. Even if there were an ocean of oil waiting to be tapped just offshore and in the National Parks, we operate in a global oil market and it is absolutely inconceivable that renewed production efforts in the U.S. could push world production upward to any considerable extent. Are environmental restrictions what are holding back oil production elsewhere in the world? Is that the reason why almost every oil producing nation in the world has passed peak production? It's all Green Peace's fault?

And as for demand collapsing, the rapid growth in the world car market would seem to preclude that eventuality.

So what's ahead? If production continues to stagnate or actually declines, prices will keep going up. The response will be different within different countries but eventually demand will fall. Back in April, CIBC, a major investment bank, explored the consequences of $10 per gallon gasoline in the North American markets in a position paper, and concluded that major demand collapse would occur at that point and Americans would radically alter their driving habits and eventually their transportation systems. The analysts who produced the bank's position paper predicted gasoline prices that high by 2012. So do I.

If and when oil production begins to decline, it will probably decline relentlessly as it has in every individual oil producing nation. Prices simply cannot avoid steady upward pressure in the face of a steady production decline unless other energy sources are substituted.

With current technology there is only one conceivable replacement, and that is grid supplied electricity, or, alternately, electricity provided by remote private power sources such as residential or community solar installations. But augmenting the grid to meet transportation needs as well as running residential appliances and industrial facilities would require tens of trillions of dollars of investment, and that industrial societies would agree to embark on such a course is by no means certain. We agree with the twenty-six elder statesmen and Washington power brokers who today issued a letter to the nation and the world warning that an energy tsunami is on the way.

Earlier this week the first Nissan GT-R was sold in North America, that marvelous 500 horsepower wondercar that represents the summit of performance automotive engineering and was designed with no regard for fuel efficiency at all. Buy one if you can. Years hence you will go out to your garage and gently lift the cloth cover and take the car on its monthly excursion, pouring several hundred dollars of fuel into it, and thundering past the silent fleets of electric cars with your turbos screaming and tires squealing, and all will remember the century long reign of the internal combustion engine. Then you will return, knowing that you have something that will never be duplicated, a testament to ingenuity and engineering prowess, which, however well suited to its purpose, is now entirely irrelevant.