Higher Oil Prices Now, Lower Oil Prices Later?

Posted by Steven Zweig on October 22, 2009 at 3:15 pm

Offshore oil rig. It takes high oil prices to make adding new rigs worthwhile. (image: evworld.com)

Within reason, higher prices for oil may be a good thing because it takes a certain price to make oil exploration and development worthwhile. Ongoing exploration and development is vital: all oil-producing assets, be they individual wells or entire fields, decline in output over time. For example, the US is long past its peak of oil production; from 1984 to 2005, US oil production declined by over one-third. Without constant development of new fields, oil production will fall—and reduced production equals less supply, which (unless demand falls by an equal amount) will push up prices.

However, oil exploration and drilling are immensely expensive undertakings. To provide some sense of the costs involved, consider that Shell paid $2.1 billion just to acquire offshore Arctic drilling leases (just for the leases—not even to sink a single well!). Given how expensive it is, no one would commit these kinds of sums unless they expected a good return, which means at least moderately high oil prices.

The comparatively low prices that dominated the first half this year were a source of concern to industry figures. The heads of major French and Saudi oil companies identified prices too low to incentivize new production as a threat to future oil supplies.

However, as was reported Wednesday by the Associated Press, recent higher oil prices have encouraged energy companies to “dust off” idle rigs and increase production. Prices above $80 per barrel make increased drilling worthwhile; the CEO of Nabors Industries, which operates oil rigs worldwide, remarked that, “We are in an extraordinarily good position to prosper by the recovery [in oil prices].”

If the current higher prices encourage more oil discovery and production, then that will help maintain the oil supply in the future. In that way, today’s higher prices hold down tomorrow’s oil price.

A major issue, though, is the sustainability of the prices. As a number of industry observers have noted, prices are holding above the levels dictated by consumption and production. Even as oil inventories remain high and growing (showing that production is outpacing demand), benchmark crude contracts climbed from $48.39 per gallon on April 1 to $70.61 per gallon on September 30—an increase of 46 percent at a time when global demand remained essentially flat. The increase has been driven in large part by the decline in the value of the US dollar—since oil is priced in dollars, as dollars decline in value, it takes more and more of them to purchase a barrel of oil.

Clearly, any increase owing to currency arbitrage is susceptible to reversal for the same reason: if the value of the dollar should start to climb, that would exert downward pressure on the price of oil. At the same time, the other forces cited for the oil price run-up of the last few months—speculation, and carry-over momentum from the equity markets’ climb—are also susceptible to sudden reversals. Indeed, if there’s any lesson that 2008’s burst equity, real estate, and oil bubbles has taught us, it’s that high prices based on psychology, momentum, and speculation, rather than on solid economic fundamentals, can deflate with the suddenness of a popped balloon. With oil prices held up by everything but economic fundamentals, prices are “bubbling again”—and bubbles can burst. Some analysts believe that if prices were set by production and consumption, we’d have prices in the $50s per barrel, or 60 percent lower than current prices.

If the current increase doesn’t have legs, then the impetus for increased development will be withdrawn. That could lead to rigs being idled again, leading to prices rising again when supply shrinks in the future.

So one concern is whether today’s higher prices are sustainable enough to support vital forward-looking development. Another concern, identified by Energy Secretary Steven Chu, is whether higher prices will choke off or delay any economic recovery. As a Fellow at the James A. Baker III Institute for Public Policy observed, “If I’m spending more on energy, that’s less I’m going to commit on impulse spending.” The more consumers have to pay to heat their homes and drive their cars, they less they can spend on other things. That in turn will depress economic activity, which then will depress—you guessed it—oil demand. And a reduction in oil demand will reduce prices, leading to less exploration…leading to higher prices later.

What’s the bottom line? Sustainable and moderately high prices are probably in everyone’s long-term interest. Too low a price and we pocket money now, while setting ourselves up for less oil in the future. Too high a price now and we hurt the recovery. If around $80 per barrel is the right balance—and give or take a little, it might be—then we should hope that’s a sustainable price.