What will happen to oil prices?

This is the first of a regular series of columns from economist Tim Leuning.

January is the time for predictions. Every year economists make them. Sometimes we are right, and sometimes wrong. Some predictions, like inflation, are easy, but others are not. The oil price is not.

For fifty years, 1921-71, the oil price was fairly stable at c. $20 a barrel (in today’s terms). That was surprising: the price yo-yoed in the mid-nineteenth century and was fairly volatile 1880-1921. But neither the booming 20s nor the great depression, a world war, nor a post-war boom seemed to affect oil prices at all. Oil prices were one thing you just did not have to worry about.

That changed in the 1970s. Oil rose first to $50, and then to $100 in today’s terms. The effects were huge and many policy makers handled it badly. By the 1990s oil seemed to settle down again, with prices remaining around $20 in the mid-90s, rising to the mid-$20s as the century ended. And then, from 2002 we have 5 years of relentless rises to reach $100 again.

So the question is, will it continue? And why aren’t we suffering as we did in the 1970s? The first question requires a prediction, the second an explanation.

My prediction is that oil prices will not end 2008 materially higher than they are today, and that they will be at least a third lower in 5-10 years. The second prediction is the stronger. Oil prices at today’s level are unsustainable because there is plenty of non-OPEC oil in the world that is highly profitable to extract at $100 to the barrel – indeed, there is plenty that is profitable to extract at $50 to the barrel. Canada has the second highest oil reserves after Saudi Arabia, but Canadian oil is in oil shale, which costs $40 a barrel to extract. For years Saudi Arabia made good money extracting oil for a $1 and selling it at $20; if the oil price were $60 then Canada could make similar money. The fact that Canada can produce oil profitably at $50-60 makes it hard for oil to stay above $60 in the medium term. If we know that oil prices will be lower in 2013-2018 than they are today, the question is, when will they turn?

That one is harder. But there are three reasons to think that the turning point will be soon. First, the global economy is softer, and the strength of demand pressures has been one of the biggest causes of rising oil prices. Second, the current US administration will become increasingly powerless as the year goes on, and will be replaced by a less militaristic one in November. That will reduce fears about Middle-Eastern security, and also about Venezuela. Brown appears less militaristic than Blair, and Sarkozy’s approach to Russia shows that he is keen on energy flowing. China will not destabilise an oil country. The big risk, as ever, is that Saudi Arabia, or another major Middle-Eastern oil producer could fall victim to terrorist attacks, either in the oil fields, or at national level. But it is not a large risk.

So why are Western economies not suffering from the $100 barrel? There are two reasons. First, the energy intensity of the economy has fallen dramatically. British output per head doubled between 1970 and 2001, but our energy use per head rose only 6%. Broadly speaking we halved the economy’s energy intensity, so that an oil price shock hits us only half as hard as it once did. Oil would need to hit $200 a barrel to have the same effect now as $100 did in the 1970s. That is very unlikely. Second, the original price spikes came when OPEC turned the taps off, and decided to auction the oil they had. This price spike comes primarily because of high demand, mainly from China. But high Chinese oil demand stems from China growing quickly, and that reduces inflationary pressures, since cheap Chinese goods are replacing more expensive goods produced elsewhere. The lack of oil-led inflation means that central banks have not had to increase interest rates and that we have avoided recession. Indeed, all the talk is of interest rates coming down, not going up. Interest rates coming down below 5% with oil at 1970s levels, and without an inflationary boom? We live in a different world to that which Antony Barber and Denis Healey had to deal with. And three cheers for that!

Dr Tim Leunig teaches at the London School of Economics. His predictions, along with those of other economists, can be found here.

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15 Comments

  • What concerns me about extraction of oil from oil shale is the environmental costs, particularily the carbon dioxide emissions. Is this why the Canadians did not sign Kyoto?

  • Tim Leunig makes the basic mistake of presuming that all that is needed to ensure a sufficient supply of oil is to assure themselves there is oil in the ground. The size of reserves, even where these reliable, is irrelevant. The problem of oil is production rate.

    Existing oilfields are depleting at 5% to 6% a year. we need to bring onstream at least 5 million barrels a day of new oil wells just to stand still. New oil fields are increasingly small and expensive to find and develop. The costs of exploration are rising at a frightening rate with massive shortages of all requirements including trained personnel. Despite massive increases in exploration and development investment money by the major international oil companies the actual exploration and development being done has stayed still. Given the greater difficulties of finding a given quantity of oil it is not surprising that they have not been able replace loss in production due to depletion of their existing reserves.

    We are running up a down escalator and it is getting ever faster. We will inevitably fail to keep up soon.

    Canadian tar sand developments have struggled for three years to increase production from 1 million barrels a day to its present 1.5 million barrels a day, barely sufficient to cover production drops of Canadian conventional oil. It has just been admitted that hopes to expand this to 5 million barrels a day by 2015 is unrealistic.

    To think that Canadian tar sands, however big the deposits, will compensate for the loss in production elsewhere in the world in the medium term is to misunderstand the problem. To think they will effect the 2008 prices is ridiculous. They are operating flat out and nothing can be done to increase the production rate this year or probably next.

    I despair that the Liberal Democrats that should be leading in the campaign to recognise this huge challenge should be dishing up primitive economist’s models that bear no resemblance to reality.

  • Nick is right. This is the big issue and one which the Lib Dems ought to be leading on.

    I first began reading about ‘peak oil’ around 10-15 years ago. Then petro-geologists like Colin Campbell were predicting that oil prices would hike up dramatically around 2005. Predictions from mainstream energy organisations like the International Energy Agency, which governments listen to, were blind to this.

    Why the difference? For me a big difference is whether one looks at oil as if it were a manufactured commodity or a finite resource. The difference between the economist’s view and the engineer/scientist’s understanding.

    Various bodies have done sound research into the availability of oil and the ability to deliver oil to the market. See for example reports on the energy watch group’s website http://www.energywatchgroup.org or other websites by ‘powerswitch’, theoildrum or the association for the study of peak oil (aspo) (their newsletters often have particularly interesting items). The ‘alternative’ view gives better predictions, and is based on factual science, not optimistic economics.

    It’s not just the price of oil that determines whether it is viable to extract it, it is also the energy balance; the net energy available. An oil gusher takes little energy to get the oil to market, but once the well needs pumping or (worse) pressurising to get the oil out the net energy is lower. Then if the oil is heavy or sour (say with lots of sulphur) processing also will also take more energy.

    Price is obviously determined by supply and demand. This is why gas and oil (and to a lesser extent coal) prices are so closely linked. If the oil price creeps up, people invest in gas heating/generation/etc.. The oil price has currently risen to a level where the market can be supplied as some users have dropped out. This is why we’re entering a recession – businesses are struggling.

    If too many go out of business, demand will fall, and for a while oil supplies may be sufficient so prices will also fall.

    We ought to be recognising what is happening and altering our society to be increasingly independent on all non-renewable energy. We need to do this to prevent climate change, but understanding ‘peak oil’ provides a stronger economic and social driver for change.

    This is the big issue we need to discuss, and have policies to address. How do we make it top of the agenda?

  • Just for info, re comments 1 and 4 – Canada has both signed and ratified the Kyoto Protocol.

  • James Graham 10th Jan '08 - 12:45am

    “This is the big issue we need to discuss, and have policies to address. How do we make it top of the agenda?”

    Sadly, it will probably manage to do that itself soon enough.

  • Mary Matthews 27th May '08 - 1:00pm

    We’re half way through the year almost. My reaction is “Boy, did you get it so wrong”. Economists cannot predict the future and trying is a waste of time.

  • Economists may not be able to predict the future, but petro-geologists have been predicting this for the last 10 years. They used their knowledge of the oil in the ground, available technologies and the history of oil exploitation to anticipate what would happen – and have been remarkably accurate.
    We should now listen to the scientists and engineers, environmentalists and sociologists to learn how we need to modify society to make the transition as painlessly as possible to a new sustainable world. Then we can use economics to help that transition – though it will need to be a new economics, not the constant growth of the past!

  • Obviously there is still a long way to go, but I note that the price of Brent Crude has dropped below $100.

    http://www.bloomberg.com/energy/

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