What You Need to Know About Oil

If you are curious about why oil prices have changed so much recently (or even if you think you know), read this article in the Times. If you don't have time, I have highlighted the main points below. If you don't even have time for that, then I would send you away with this main point: Current capacity for the production of oil is flattening while global demand is rapidly increasing. Because of oil futures speculators, prices will fluctuate, but in the long term, prices will rise. We need to decrease our consumption and find alternate sources of energy. The author believes (as does Thomas Friedman, and as do I) that we should create an artificial price floor (through taxes) to accomplish this because every time prices decrease, we forget and we stop conserving.

Those Damn Speculators

According to skeptics like George Soros and Michael Masters, a hedge-fund operator, the only thing wrong with the oil market is the market itself. Speculators, they say, drove the price away from its "fundamental" value; worse, a new breed of institutional investor has been buying oil futures, hoarding the supply.

On the other hand:

Of course, capitalism demands that people, or at least investors, make bets. That is how resources are allocated and money is invested where it is needed; high prices communicate scarcity. You could even say the oil market has performed a vital service to the country by telegraphing the need to conserve and to develop alternative supplies.

Recent History of Oil Prices:

The reason that the history of oil is basically one of attempted price fixing is that, as technology has improved, drilling costs have fallen, meaning that prices have been under near-continuous downward pressure. Like most commodities, oil should sell for whatever the cost of producing one additional unit is — in this case, one more barrel. Economists call this the "marginal" cost. If someone charges much more than that, a competitor can offer to sell it more cheaply.

It’s only when oil is scarce that things become interesting. If there isn’t enough to go around, then the marginal cost no longer matters because, at the margin, there is no more oil to produce. Under such conditions, oil will rise to the price at which people stop using it — either because they drive less or because they find another energy source. This is called the price of demand destruction. Think of that as the upper bound on the price. With the twin shocks of the ’70s — the Arab embargo and the Iranian revolution — oil did reach an upper bound, jumping tenfold to $40 a barrel in 1981. Demand quickly collapsed, and the price eventually sank all the way back to the marginal cost, $12.

Low prices were good news for consumers but a mixed blessing for society. Since it takes time for oil companies, as well as consumers, to react to price changes, markets tend to respond with a perilous lag. In the ’80s, oil companies were spending billions looking for oil, and Detroit was retooling its plants to make smaller cars, even as the price of oil was collapsing.

In the mid-1980s the oil industry suffered a terrible slump. Thousands of petroleum engineers were fired or left the business. Congress lost interest in energy conservation, and projects to develop shale oil and other alternatives were dropped. In Europe, high fuel taxes meant that people still had an incentive to conserve. In America, families became unwilling to ride in anything but trucks.

Even as oil prices rose in this decade, big oil companies — still responding to the price signal of an earlier period — plowed most of their cash flow into dividends and stock repurchases rather than risk it on exploration. State oil companies overseas, like Saudi Arabia’s, which control four-fifths of the world’s reserves, refused to make the investment to develop their fields to full potential for fear of flooding the market (another reaction to low prices). For similar reasons, there was a lull in building critically needed refineries.

By the time oil companies woke up to the consequences of low prices, it was in some sense too late. There was "a missing generation of engineers," according to Daniel Yergin, the chairman of Cambridge Energy Research Associates and the author of "The Prize," a history of the oil industry. There was also a lack of drilling rigs and men to work them. Drilling costs soared, and equipment was often unavailable. Also, countries where oil is abundant, like Russia and Venezuela, were increasingly chauvinistic and hostile to foreign operators. Civil unrest set back production in Nigeria.

By the middle of this decade, various big oil regions — Mexico, Nigeria, the North Sea, Colombia, Venezuela — were experiencing production declines.

The lesson here is that a high price of oil is the only thing that forces us to conserve and invest in alternate energy. Hence the need for an artificial price floor.

Also, if you think compressed natural gas (CNG) is the solution to our problems, read this article. Basically, if we really want to decrease our dependence on foreign oil and fight global warming, we need to decrease our consumption, not change the form of our consumption.