Why Oil Prices Keep Going up - Part II

In the first segment of this two part series I examined oil prices from a historical perspective and sought to identify the factors influencing price. Here I linger over the last few years, the opening years of this century, when the established order of pricing and production appears to be undergoing fundamental changes, changes that do not conduce to promoting the national welfare, I'm afraid.

There are lots of pricing mechanisms at play in the production and distribution of refined petroleum products as the crude oil completes its long journey from the reservoirs to one's fuel tank, but the overall supply relative to the number of buyers and the psychological dimension arising from perceptions as to the security and availability of future supplies are the key determinants of prices for refined petroleum products. Or to state it more concisely, supply relative to demand, and the degree of perceived insecurity.

With the exception of the brief oil shock of 1914, all of the other price spikes and plateaus of the twentieth century involved both fear and doubt and actual reductions in production of several percent, perhaps as high as 10% during the dreadful shock of 1979.

As indicated in the previous piece, the present situation is marked by static rather than falling production. It is, however, also characterized by elevated and rising demand. More people are bidding for oil resources than in the past, with China and India being the new power users, though they are certainly not alone. All across East Asia the production and sale of motor vehicles is rising rapidly, and all those novice car and motorcycle owners need fuel for their new wheels. And these societies, newly rich from the export of manufactured goods to the U.S. and Europe, have the money to play in the international petroleum market. Indeed, China has succeeded in obtaining long term contracts giving it the entire output of certain production facilities, mostly in Africa, and it also has big ongoing contracts in place in Iran and Canada.

Naturally, the question of whether production can be substantially increased arises in this context. Politicians and political commentators are, for the most part, quick to insist that plenty of reserve capacity exists and that the situation could quickly be righted if the goddamned enviros would shut up and let the oil producers drill wherever, and the treacherous Saudis would just open the spigot a bit.

Listen to the pundits of the Right, and you'll hear statements to the effect that the U.S. is sitting on 350 billion barrels of oil, inconveniently located offshore or in protected wilderness areas, and that we only await an act of Congress or a Presidential executive order to get it flowing.

Unfortunately, such pronouncements are largely based on fantasy, outright deception, or on profound misunderstandings of how oil is produced.

Now it is true that the U.S. has a lot of oil remaining underground and that some of these unclaimed resources have grown more attractive of late. And some in fact are in protected areas. But the idea that there is something akin to the old Texas giant fields residing in our national parks is just plain poppycock. The only possibly sizable resource of conventional light crude left untapped is located in, you guessed it, the Alaska National Wildlife Refuge.

How much is there is a matter of dispute. The Federal government claimed last week that the resource could support daily production of nearly 800 thousand barrels per day for a couple of decades, but one is not necessarily inclined to accept the pronouncements of this Administration in regard to energy at face value.

And if the resource were so large and so accessible why didn't President Bush simply issue an executive order to develop it previously, and damn the environmentalists. He's certainly taken equally high handed actions in other areas, and moreover, Clinton did open part of ANWR during his Administration without a lot of adverse political fallout. Why let an impotent Democratic Congress stand in the way? And why not have moved in that direction years ago when the Republicans controlled all branches of the Federal Government?

The likely answer to that question is that Bush knew that the amount of crude available was insufficient to make much of difference in long term pricing and wouldn't make a damned bit of difference in short or mid term pricing. Why spend political capital on the issue when there were more important battles to be waged like privatizing Social Security?

And, in any event, ANWR is more useful to conservatives in an untapped rather than a developed state. As long as environmentalists rise to this particular bait, which they always will, the Republicans can continue to blame the Democratic Party which has consistently courted this constituency. Just keep insisting that radical environmental activists are responsible for the price shocks by their intransigence in this regard. This tactic should work admirably for at least another two years.

So how much oil is really available in the U.S.?

The broad consensus among oil geologists is that the overall volume of recoverable conventional oil in the U.S. was over 250 billion barrels in 1859 when exploration began and perhaps as high as 350 billion barrels—as great or possibly greater than the resources on the Arabian Peninsula. But a hundred fifty years of frantic production makes a difference, and that figure has been reduced by at least 70%. Just as accelerated production will make a difference on the Arabian Peninsula except that our friends in that oil rich region will not enjoy a century and a half of production and profits. They're depleting their resource base far too rapidly at present, and it will largely cease to exist within a span of decades unless they sharply curtail production.

I believe that a go-for-broke, heavily subsidized assault on ANWR, the Rocky Mountain oil shale beds, and the considerable amounts of bitumen and extra heavy oil in Utah and California combined with coal-to-liquids production could eventually yield as much as ten million barrels a day, less than half of what is consumed at present in the U.S. But it would take many years to reach that level, assuming that the national will existed for proceeding in that direction. And of course once you've depleted these supplies you're probably at the end of the line unless methane hydrates can be brought into production.

Regarding the contribution of biofuels, there is little possibility that grain derived ethanol or soy based biodiesel could effectively substitute for petroleum on a massive scale. Conceivably certain forms of advanced second and third generation biofuels could play a significant role in our fuel portfolio, but this is uncertain.

The real issue now is how constrained are oil resources elsewhere. Most oil geologists believe that almost all of the oil producing nations have already reached peak capacity and that the majority are in decline. Saudi Arabia may still have appreciable swing capacity but that is not certain. Some petroleum industry heavyweights, such as Houston investment banker Matthew Simmons, believe that the Saudis may be at their production peak now. If that is so, there may be nowhere to turn but the hard to get and hard to process unconventional resources.

In the meantime, the energy press is replete with accounts of undiscovered super giant fields under the arctic ice or in the Bakken formation of North Dakota or in the Deccan region of India or in Nevada, the land of the big gamble. Trillions of barrels of untapped oil, we are told. The Saudis are even talking about a new super giant in the Empty Quarter which they've known about all along ,but which hasn't been deemed a cost effective source in the past. But now, of course, everything is changing.

The problem is that virtually all of the big recent finds have been either unconventional forms of oil requiring much expensive processing for the production of gasoline or have been located in areas where customary recovery techniques simply don't work very well.

For instance, the Bakken formation, which is now subject to a frenzy of financial speculation, could contain in excess of 200 billion barrels of oil, some of it, unfortunately, in the form of kerogen or shale oil which is quite difficult to process. The rest resides in impermeable rock strata where ordinary drilling techniques are not efficacious. Does that mean it won't be developed? Not necessarily, but it probably means that this huge reserve will be difficult and expensive to work and that it won't bring back two dollar a gallon high test.

I believe that we're looking at constrained supplies from now on. And that means sustained high prices at the pump from now on.

The Weak Dollar – the Double Whammy

We've been there before. The oil shocks of the seventies occurred at a time of rampant inflation in the U.S., double digit at times. High oil prices contributed to inflation which in turn drove oil prices still higher as oil producers demanded more and more inflated currency to pay for their products. Needless to say, wages did not keep pace. They never do. And to further the irony, oil producers, particularly the Saudis, were routinely demanding that dollars be redeemed in gold (the U.S. was still on the Gold Standard in 1973). This led to the Nixon Administration taking America off the Gold Standard and allowing the dollar to float. Which made inflation still worse.

Nineteen seventies inflation was to some extent the result of what was known as the "guns and butter policy" at the time. The term was coined during the Johnson Administration, but the policy itself extended through Nixon's first term. In essence the nation was living beyond its means, or at least beyond its tax revenue stream, financing a growing range of government services while at the same time attempting to pay for the ruinously expensive Vietnam War—all without significant tax increases. Now, of course, we're seeing a similar situation, although government public services are remaining static while almost all of the increases in spending are occurring in the war torn Middle East where, by further irony, they are supposed to provide us with energy security! And that increase in spending is paid for by the sale of Federal bonds which the Government is in no position to honor under stated terms unless it depreciates the currency. Which is precisely what has happened, and is why the dollar is so weak.

Both Jimmy Carter and Ronald Reagan, who were not as far apart on fiscal policies as their partisans imagined, were willing to support draconian anti-inflationary measures to rectify the situation, essentially initiating a severe recession by manipulation of the prime rate. At the time I thought what they were doing was nothing less than economic warfare against the majority of American citizens, but I now believe they were right, and that those brutal tactics were a necessary corrective. Better though, that Johnson and Nixon respectively had not created and perpetuated the mess in the first place.

Will the next Administration take a similar course, and will we thereby enjoy a similar decline in gas prices such as occurred in the early eighties?

I think that it is possible that President McCain might attempt to follow such a course, which would result in at least some decline in oil and gasoline prices, but were he to attempt to maintain a similarly high level of military activity as his predecessor, strong inflationary pressures would still be present. And it would be difficult to do so, given the current fiscal predicament of the Federal Government. Already Asian financial institutions are becoming loath to purchase further Government securities. And since the President can't raise taxes, where would he go for money? He could of course attempt a radical reduction in the size of the civilian government, eliminating essential and inessential services. And perhaps that is the likeliest course though the longer term political repercussions could be dire.

An interesting historical example is provided by the Spanish Crown during the seventeenth century. Spain was the world's pre-eminent military power at the beginning of the century, and in the decades that followed waged numerous wars even while its own economic base was shrinking. The State was in a condition of almost constant financial turmoil, borrowing money on whatever terms it could get, depreciating the currency, and taking vital land out of food production to permit the raising of sheep which provided Spain with one of its few dependable exports and a source of revenue for further wars. Crushing defeats by the Dutch and the French eventually ended Spain's military adventures, but not before the economic devastation of the Kingdom was complete.

Whether the current recession will significantly curb inflation and restore the strength of the dollar remains to be seen. Economic downturns are generally seen as deflationary, but inflation and recession went hand in hand in the seventies, giving rise to the term "stagflation". Ominously, the Federal deficit is far larger than it was at its worst during the seventies, and there is no sign that military expenditures will go down as they did after the conclusion of the Vietnam conflict. And as for raising taxes to shrink the deficit, even to suggest such a measure today is political suicide. One can logically argue that inflation itself is a form of taxation since it reduces one's purchasing power just as surely as an outright exaction, but very few individuals can understand that. And, in any case, the Federal government can and does massage its fiscal reporting to suggest that inflation is moderate (rising fuel prices, for instances, are not included in the reckoning).

It may also be politically impossible to reduce military expenditures, and in that manner balance the budget and avoid the need to print more money, precipitating yet more inflation. Although much military spending is now off budget, we may surmise that military accounts in one way or another for over ten percent of overall economic activity in the United States. And the irony is compounded by the fact that the expansion of the military has been most enthusiastically supported by rib rock conservatives who claim to wish a smaller government, as if the military were not part of the government and were some self financing business consortium.

At any rate, if one were to begin to abolish military programs and to curtail military purchases and expenditures, the uproar would be deafening inasmuch as the corporations providing goods and services to the Armed Forces and to various reconstruction projects in occupied Iraq and Afghanistan would see their own revenues diminish alarmingly, never mind that these are paid for out of the public purse. The various branches of the Armed Services would be similarly exercised.

The Way Forward

History never quite repeats itself, and I do not expect to see a repetition of the soft landing of the middle eighties when oil prices collapsed and the U.S. enjoyed a brief but exuberant financial boom and it was morning in America. Oil prices will rise and dip as the current decade wanes, but they will continue to trend ever upward. It is almost inconceivable that they will collapse to typical historical levels again.

Almost inevitably rising fuel prices will exert a tremendous drag on the economy because their effects are so pervasive. Riding a bicycle to work may slash one's personal expenditures for motor fuel, but no matter how much automotive travel is restricted, the country will still be dependent on the petroleum fueled trucking industry for the delivery of goods. So you end up paying more and more for everything from food to flat screen TVs.

That's pretty obvious after even a moment's reflection, but another disturbing consequence of steadily rising oil prices is not so obvious, and that is the fact that increases in vehicle efficiency can't possibly keep pace with increases in fuel prices.

Let's say the automotive industry collectively decides to embrace the most fuel efficient design using current technology, which would be a plug-in two stroke diesel hybrid using ultra-light weight body construction. One could conceivably quadruple fuel economy with respect to petroleum by this means.

The phase in of such an ultra efficient vehicle and the phase out of the existing fleet would take time even with the powerful incentive of rapidly rising fuel prices, however. And likely there would be a transition period when vehicles only incrementally more efficient than the standard designs of today would be offered to the public. In fact our ideal ultra efficient vehicle is probably a good seven years off, best case. If we assume a best case scenario where fuel prices go up only 10% a year, they will be four times as high as they are now in less than fourteen years from now, well before the new fleet is in place. And that is best case. According to the National Energy Commission, a 4% shortfall in supply relative to demand could drive prices up 177%. I don't know how exactly that figure was derived, but we're certainly seeing annual increases of considerably more than 10% now without a real decline in production.

At some point a demand collapse occurs, and it may be at only double the current fuel price for ordinary motorists. But what about commercial shipping and transport companies? At what point will they cease to ship necessities because the profits derived from doing so will be too scant to justify continued operation?

Long before that point is reached the railroads would seek to revive themselves, perhaps with new designs of engines that can run cleanly and efficiently on pulverized or gasified coal or, alternately, on grid supplied electricity. Perhaps the same development would occur in maritime transport as well. Air travel is the real conundrum here. Very recently the airlines have been seriously investigating biofuels. My guess is that a turn to coal based synfuels is more likely in the long run.

So to sum up, the situation is really quite serious—too serious for us to focus exclusively on ANWR. But that is probably what we will do.