Oil Panic Attack

After having mostly yawned our way through the first half of oil's amazing six-year ride, we now watch its movements as intently as any futures trader, and our level of concern seems to be building towards a national anxiety attack. Since 2002 we've seen the price of West Texas Intermediate Crude Oil rise from the mid-$20's to the mid-$70s, then retrace to $51 in early 2007, before beginning its remorseless climb past $100 and every other logical stopping point. Some industry analysts are predicting $200 per barrel oil, and warnings of $6, $10, or even $12 gasoline are treated seriously, bolstered yesterday by a new suggestion from the normally-conservative International Energy Agency that we may be approaching a global production plateau. My crystal ball isn't working any better than anyone else's, and thankfully I'm not paid to forecast oil prices. If we want to understand where we're headed, though, we should examine where we've been.

Until fairly recently, oil was regarded as a cyclical commodity, though its cycles didn't necessarily coincide with those of the global economy. It's also an industry that values experience, so its management includes many who have seen several of oil's up and down sequences. That means the senior members of the tribe can recall from personal experience--even if it was early in their careers--the collapse of oil prices in the mid-1980s after the lagged responses to the first energy crisis took hold. Then came the even more devastating drop in 1998/99, in tandem with the Asian Economic Crisis, when WTI bottomed out at just over $10/bbl, pushing the price of most grades of oil into single digits. Many projects that were planned in the late 1980s, when oil finally reached $20/bbl again, started up in a down market that destroyed billions of dollars of net present value. At the same time that oil companies were learning these painful lessons, the OPEC countries that hold most of the world's known oil reserves were attending a similar school, particularly with regard to the perils of over-capacity. The oil price collapse of the late 90s that squeezed the stock prices and investment budgets of the international oil companies created large external deficits for OPEC's members.

Next consider the unexpectedly large expansion of demand. Between 1998 and 2006, global oil demand grew by 10 million barrels per day. At the same time, the natural decline of mature oil fields would have required the industry to replace somewhere between 1.5 and 3 times that much output, just to stay even, in a period when an increasing proportion of the best opportunities were not available to the companies with the biggest incentive to grow production, and the big producing countries were starting to learn that selling more oil may be a less effective way to make more money than selling less, or at least holding output steady in the face of rising demand.

As a result of these factors, when prices began to rise again, breaking through $30 in 2000, oil companies and producing countries had good reasons to be skeptical that the fundamental relationship between supply and demand was on the verge of a permanent shift. That resulted in a crucial delay in funding new projects--crucial because of the time lags involved in the planning, permitting, procurement and construction stages of such projects. In the interim, most of the world's spare production capacity was tapped, and the industry seems unlikely to catch up, short of a global recession that would halt demand growth in its tracks.

Throw in a few other key factors, such as the dollar's decline, an increase in commodity speculation, and the artificially-low petroleum product prices in a number of developing economies, and we have all the necessary ingredients for the quintupling of oil prices that we have experienced in the last six years--doubling in just the last year. Getting out of the deep hole we have dug will require a combination of higher fuel efficiency, increased non-efficiency conservation, more drilling, greatly expanded non-food biofuels and synfuels output, and the partial electrification of personal transport. With the exception of conservation, none of these solutions will make a dent in the problem in this decade.

No one can predict with certainty where oil prices will go from here. It could be to $200, or back below $100. The market is flirting with contango, suggesting it is reasonably well-supplied for now. Despite this week's 5 million barrel drop in US crude oil inventories, days' supply of crude and gasoline are at a fairly healthy 22 days each. Yet the momentum of this market seems unshakable. In the meantime, I suggest prudent conservation and the avoidance of panic. $200 oil would not mean $12 gasoline. In fact, unless refining margins suddenly came back to life, it might not even get us to a $6 national average retail price for unleaded regular. That's not very reassuring, going into the Memorial Day weekend that signals the start of the peak driving season. Our enjoyment of the summer could depend on our level of stoicism.