From the August 2012 issue of Research Magazine • Subscribe!

July 26, 2012

Pop That Oil Bubble

Policies should aim at pushing oil prices down.

The oil market has been in a bubble stage for a decade. With skewed oil prices sending inaccurate market signals to producers and consumers, a demand imbalance has developed, which is about to result in a major correction. Unlike the dot-com and real estate bubbles, the economy may benefit when this bubble bursts. The U.S. government should adopt policies to help push oil prices down, and keep them low for the remainder of the decade.

A market economy is cyclical. Timely central bank intervention, gradually raising interest rates in expansions and easing in downturns, helps smooth its natural cyclicality and prevent overheating and severe imbalances. Over the past century, the typical expansion lasted some four years, according to the National Bureau of Economic Research, followed by a recession averaging about 12 months.

Over the past decade and a half, however, the economy stopped being cyclical and has been characterized instead by successive asset price bubbles. Bubbles have been seen in high-tech, real estate, government bonds and gold, to name a few. They have been popping regularly, and the largest, when deflated, triggered economic slumps. After the market for mortgage-backed securities collapsed, the world economy suffered the worst recession since the 1930s. A solid economic recovery has not materialized. On the contrary, other bubbles have deflated in the aftermath of the subprime mortgage debacle. In 2010, the euro-zone government debt bubble burst, and we’re still dealing with its consequences. Meanwhile, regional bubbles are starting to pop in China, India and Brazil.

The oil bubble seems to be next in line. After setting a price record for winter in February, at $110 per barrel, oil shed a quarter of its value by mid-year.

Oil prices have been remarkably steady throughout history. For nearly a century starting in 1870s oil traded steadily at $15-30 per barrel measured in 2010 dollars. The 20th century saw dramatic economic growth, invention of the automobile, development of aviation, mechanization of the armed forces and advent of electricity. It was also an age of political upheavals, wars and the twilight of European colonial empires. World oil consumption went from under 2 million barrels per day (mbd) to nearly 60 mbd during this period.

In the 1970s, when all commodities experienced their first major bubble, analysts predicted that oil would be depleted by 2000. But oil production has grown to around 80 mbd by 2011, and so-called peak oil (a point at which world production reaches its peak before starting to fall off) has been pushed further into the future. But even if we could calculate the exact year when the last drop of oil comes out of the last oil well, there is no reason why today’s oil prices should be affected. Even though we know that the Rolling Stones will eventually stop performing and its members will die, their concert tickets don’t get any more expensive.

Rising demand for oil, especially from China, was a factor in pushing oil prices higher before 2008. Oil demand from developing countries rose by 15 mbd since 2000. Over the past four years, however, new demand has been partially offset by a 5 mbd decline in demand from rich countries. The oil price rally since 2008, and especially its peaks in early 2012, is indicative of the bubble stage. Moreover, recent price records came against the background of a weakening world economy.

Distorted Message

Bubbles are dangerous because they distort markets. Unreasonably high prices send a wrong message to all market players. Inflating real estate values in the U.S. prior to 2008 encouraged people to buy homes with no money down and huge mortgages, on hopes they would build up equity quickly. Banks were happy to lend on a similar assumption. Meanwhile, homebuilders were inundating the market with fresh supply, overwhelming demand.

The oil bubble has had a similar dynamic. Different players have made decisions based on oil at $100 per barrel or higher. First, investment in upstream oil production rose. New deposits were discovered, technologies developed to extract oil from shale and deep underwater and more efficient production methods introduced. Canada is a good example. Its shale sand oil, the third largest oil reserves in the world behind Saudi Arabia and Venezuela, has only recently become recoverable. Last year, Alberta produced 1.6 mbd from oil sands, and output is forecast to reach 5 mbd by 2030. Brazil is making a massive investment into offshore oil production. It now produces 2.6 mbd, a tenfold increase over 30 years, and its national oil company, Petrobras, expects to pump some 6 mbd by 2020.

Another group of players are alternative fuel producers. Ethanol may be a non-starter (and the cut in federal subsidies last year triggered output cuts), but natural gas and coal liquefaction may prove viable, especially as new technologies are developed and plants are built around the world.

Consumers, meanwhile, have responded to overpriced oil the way Economics 101 says they would: by cutting oil use. New energy-efficient technologies have been developed and both companies and individuals have been hard at work to reduce consumption. Walmart, the world’s largest retailer with over 8,000 department stores worldwide, has invested $500 million into energy saving. After the 1970s oil crisis, per capita oil consumption around the world fell from 5.5 barrels annually, to 4.5 barrels, where it has stayed since. In the U.S., the use of oil products per unit of GDP (which measures energy efficiency) was steady through mid-1970s, and since then has declined by half. In China, a similar process is underway.

Finally, oil producers have become hooked on petrodollars, importing foreign goods and starting white elephant projects. Russia, which vies with Saudi Arabia as the world’s largest producer, can now balance its budget only if oil prices stay around $100 per barrel. It exported some $300 billion worth of oil last year and, if oil prices tank, it will likely start pumping oil all-out in order to capture more revenue.

A Soft Market

Demand for oil, then, is softening because the global economy is weakening and consumers are reducing their oil use on a more lasting basis, even as greater supply is coming on line, from projects begun before 2008 and from producers eager to protect their market shares.

Oil prices are set by futures markets and therefore fluctuate with traders’ psychology, speculation and liquidity. That means oil prices tend to overshoot. Just as they rocketed prior to 2008 and again in early 2012, driven by rising demand as well as various political concerns and fears, so a softening demand could push oil even below its long-term inflation-adjusted equilibrium price range of around $20-40 per barrel.

It happened in the mid-1990s (when the world was growing rapidly and the U.S. had full employment). It could happen again. But, unlike the popping of previous speculative bubbles, if the oil bubble bursts, the consumer sector is likely to benefit. In the U.S. in particular, the process of deleveraging after the excesses of the early years of the 21st century has been taking shape. If consumers spend less to gas up their cars and heat their homes, they could unleash their pent-up demand at shopping malls.

The U.S. government should encourage lower oil prices. Domestic oil production has been on the rise, in particular in North Dakota, where output quadrupled since 2008 and now accounts for some 10% of total U.S. oil output of 6.25 mbd. There should be more tax incentives for “drill, baby, drill,” at least in the short term, but it should be balanced by continued incentives for oil alternatives. Saving energy should also be a priority. The U.S. lags behind Europe’s average of over 40 miles per gallon, but by 2015 its own automotive fleet should achieve at least 35 miles per gallon.

The auto industry should not be the only sector where energy-use standards are mandated. There should be requirements to make homes more energy-efficient and to build “green” houses that use only 10% of the energy used in conventional dwellings. This could not only result in major energy savings but give a boost to the U.S. construction industry.

Alexei Bayer is an economist and author based in New York City.

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