December 17, 2007


The Coming Oil Crash: Crude at $100 a barrel makes good headlines but ignores basic economics. Why oil prices are in for a 50 percent drop. (John Cassidy, January 2008, Portfolio)

[T]he experts who are predicting the worst, based on geology and geopolitics, are missing the crucial role that economic incentives play in determining the price of crude. The tripling of oil prices since the summer of 2003 has unleashed forces that within the next two or three years will bring oil prices tumbling back down to below $50 a barrel. Looking even further ahead, prices could easily fall to $30 a barrel or even lower. So before you trade in your Cadillac Escalade for a Toyota Prius, think twice: $1.50-a-gallon gas might not be gone forever.

The key to understanding where prices are headed is distinguishing between the short run and the long run. In a time frame of anything shorter than five years, the supply of crude is more or less fixed. Drilling for oil is an arduous and unpredictable process. Even after a new hydrocarbon reservoir is discovered, ramping up output takes years. Current production capacities reflect investment decisions made in the late 1990s or earlier.

Today, OPEC has the ability to produce about 35 million barrels of crude a day; the rest of the world can produce perhaps 50 million barrels a day. As recently as 2003, this seemed like plenty. Since then, though, global demand has grown rapidly, and a series of catastrophes—some natural (hurricanes Rita and Katrina), some man-made (war in Iraq and unrest in Nigeria and Venezuela)—have curtailed production, causing supply to dip below demand. In September, the global demand for crude reached 85.9 million barrels a day, whereas global supply was just 85.1 million barrels a day, according to I.E.A. figures.

When shortages emerge in any market, prices spike. If the imbalance is expected to continue, speculators move in and drive prices even higher. Oil is no exception. In the fall, as crude inventories declined and the rhetorical battle between the U.S. and Iran escalated, trading volume shot up.

With prices close to the inflation-adjusted record, energy companies and governments are investing heavily in facilities that generate crude and crude substitutes. Consumers of fuel oil and gasoline are starting to economize, and over time, these changes in behavior will shift the balance of power in their favor. When that happens, an oil glut will emerge, and the price will plummet.

...that if two bits of easily imagined news--a goat herder from Tora Bora turns up with OBL's corpse and Mahmoud Ahmedinejad is removed from office--occurred on the same day, even though neither had anything to do with oil supplies, the price per barrel would pancake.

Posted by Orrin Judd at December 17, 2007 9:30 PM
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