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A market adjustment is coming: Oil prices are about to fall

By Dominick T. Armentano
web posted June 23, 2008

Bold economic predictions are dangerous, and I've been wrong before, but here goes: Oil prices are about to tumble.

There are several important reasons to believe that crude oil prices of roughly $130/barrel are simply not sustainable.

  • Worldwide economic growth, and hence the demand for crude oil, has slowed markedly due to the credit crunch and the bursting real estate bubble.
  • The Federal Reserve has finally decided to stop lowering interest rates and/or creating credit as if it were the Tooth Fairy; a stronger dollar will mean lower oil prices.
  • The already record high crude oil and gasoline prices have created strong incentives for consumer and business conservation and that have lowered overall demand.

Yet the most fundamental reason to expect prices to fall is that the gap between the price of crude oil and the cost of producing it is way too large to be sustained in the long run.

Since 1980, the cost (in constant dollars) of finding, lifting, and storing onshore domestic or foreign oil has been about $20 per barrel; between 2004 and 2006, that average cost rose to about $25 per barrel and is slightly higher now. (The cost of producing offshore oil is more than double onshore costs). Yet the price of crude oil has risen to about $130 per barrel (doubling in the last year alone), creating large profits for most producers and integrated oil companies.

Marginal suppliers around the world with costs above $30 per barrel but still far below current prices now have overwhelming incentives to uncap wells, engage in secondary and tertiary techniques to recover more oil from existing wells, drill additional wells, and otherwise expand production. (Houston is currently booming with oil production investment, as is Brazil). Any serious output expansion will take time, but the increasing supply, coupled with lower demand will lead inexorably to lower prices; indeed, sharply lower prices.

To be sure, speculators have helped bid up the price of crude oil. Most of the speculation centers on legitimate concerns about "supply disruptions" and some wider war in the Middle East Gulf region. My guess is that roughly 25 percent of the current price is a supply disruption premium, while another 15 percent is associated with our own debasement of the currency (the dollar) by our own central bank. (This can be proven by comparing oil prices in dollars with oil prices in Euros). When -- or if -- these speculations prove unwarranted, oil prices will decline sharply into (my guess) the $80 per barrel range.

Public policy can encourage this bursting-bubble scenario. The Democrats want to tax the oil companies or use the antitrust laws against them. Big mistake. More taxes get you less oil and "concentration" in the oil industry is not really the problem. The ongoing congressional hearings "investigating" oil prices and profits is a charade, purely political theater. The same federal and state governments that complain about high oil prices continue to tax gasoline at a rate (40 cents per gallon) far higher than the profit rate for the oil companies. So much for government concern about consumers.

On the other hand, public policy can and must change to allow energy companies to explore for and develop domestic and offshore supplies of crude oil. Obstacles to expanding and building new oil refineries domestically must be removed, and quickly. Alternative energy sources, if they are cheaper, must be allowed to proceed (including and especially nuclear) but direct subsidies to all energy companies (including to oil companies, if any) should end. We need the contributions of wind, solar, etc. -- but only if and when their real costs and prices are comparable with oil and natural gas.

Competitive energy suppliers will work to produce in our interest if we free up the markets and let them. ESR

Dominick T. Armentano is professor emeritus in economics at the University of Hartford (Connecticut) and a research fellow at The Independent Institute in Oakland, Calif. He is author of Antitrust & Monopoly (Independent Institute, 1998)


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