Oil prices tumbled in the second half of 2014, losing more than half of their value from their peak. It was the industry’s worst year since 2008, and the tumble continued into 2015. The speed and severity of the decline took most analysts by surprise. Last May, Citigroup raised its forecast for Brent crude to $109 per barrel from $103 for 2014 and to $105 from $95 for 2015, stating that “earnings headwinds in the sector look considerably less than they have for some time.” Oil prices began to tumble a month later.
The price drop may prove short-lived. Various supply and demand factors have come into play over the past several years, with new crude coming from America’s shale deposits, Canada’s shale sands, Brazil’s deep-water drilling and elsewhere even as economic growth in China and Europe slows. Now, high-cost sources of supply may be shaken out, whereas the world economy may benefit from cheaper oil. Last October, Citigroup predicted a $1.1 trillion annual boost for the global economy. While more cautious now, forecasters therefore see a return to $80 per barrel oil some time later this year.
However, the oil market has gone through a structural change and the era of expensive oil is over. Oil prices are now going to be weak for a very long time—if not for good.
Economic history is a story of the development of technology and its impact on the production of goods and services.
The most primitive economic activity was hunting-gathering, and all proceeds from the labor went to the hunters and gatherers themselves. Once agriculture and animal domestication emerged around 12,000 years ago, producers started to use tools, an early form of technology. A portion of the harvest had to go to producers of tools, and the more complicated they became, the more farmers had to pay for this technology.
Today’s agriculture is highly productive. American farms produce 260% more output than in 1950. During the same time period, the agricultural workforce dropped from 12% of the total U.S. workforce to less than 2%. This increase in yields and productivity has been achieved by a massive deployment of advanced technology, such as better fertilizer, hardier seeds, smart combines for more targeted planting, and information links to global markets.
Without technological advances, food prices would have been extremely volatile and prohibitively high; worse, Malthusian predictions of massive food shortages would have long ago come true. As things stand, food prices are remarkably stable and food is affordable for most of Earth’s population, except in the poorest nations.
The story of the economic evolution of agriculture is highly relevant for another commodity industry, oil. Demand for oil is a relatively recent phenomenon, dating back to the end of the industrial revolution in the mid-19th century. Oil has been a dominant commodity only for around 120 years, since the development of the chemical industry and the invention of the internal combustion engine. For most of that period, oil producers were the equivalent of hunters and gatherers, pumping oil out of the ground wherever it was plentiful, easily accessible and relatively cheap to produce.
Oil prices remained remarkably stable for a long time, despite growing demand. During the first 70-plus years of the 20th century, crude oil averaged less than $25 per barrel in today’s dollars. Even the 10-year spike after the 1973 Arab oil embargo and the 1979 Iranian Revolution didn’t move the average price for the century much higher. Moreover, by the close of the century, crude fell to $10 per barrel, well below its historical average.
But then came the 21st century, which opened with a 15-year stretch of record oil prices. Even though $147 oil was seen in mid-2008, peak annual averages were actually registered after the global financial crisis, in 2011–13, when crude averaged around $110 per barrel.
The most important factor, of course, has been the emergence of newly industrialized economies in Asia, notably China and, to a lesser extent, India. China’s growth and demand for industrial commodities and food boosted incomes across Latin America and Africa, and it all translated into higher demand for oil. The number of cars on world roads hit 1 billion earlier in the century and that is projected to double by 2020. Since 2000, oil consumption increased by around 15 million barrels per day (mbd), to approximately 90 mbd. The new demand, coming fast and furious, put a strain on the oil market, especially since new sources of supply were no longer as easily accessible or as cheap as they had been before.
Underlying the rapid growth of China and other emerging economies have been low interest rates and easy monetary policy pursued by the U.S. Federal Reserve. The United States went on a credit-financed consumer binge, which sucked in imports. The U.S. provided an enormous export market and funneled dollars to exporters through its current account deficit, and those dollars funded the exporters’ economic development. As a result, they had enough dollars to pay for overpriced oil. The oil market was one of several bubbles that have been inflating and bursting periodically over the past decade and a half.
Paying for Tech
Conventional economics asserts that cheap money is bad in the long run because it stimulates consumption and can lead to inflation. But since the early 1990s, the U.S. has also experienced a technological revolution and an unprecedented entrepreneurial boom. Easy, plentiful money has been used highly productively to fund remarkable scientific and technological progress. Technological advances have been especially significant in the oil industry, where they were stoked also by high oil prices.
After the experience of the 1970s, and the oil market bust in the 1980s and 1990s, the Saudis have been wary of expensive oil—and with good reason. The current situation illustrates why. After 15 years of costly oil, technology has fully compensated for the oil shortages that drove up oil prices earlier in the century. Advanced production methods now help pump more oil from conventional deposits, extending their useful life. Exploration methods have improved. Moreover, new technologies make commercial production of previously unrecoverable oil feasible, such as oil from Canadian shale sands and deep-water fields.
Meanwhile, technology has revolutionized energy efficiency. Back in the 1970s, energy conservation efforts were feeble: Americans were forced to limit driving speeds to 55 miles per hour and encouraged to take public transportation. Now, energy efficiency is a multibillion business with many established high-tech firms and startups looking for ways to make cars lighter and their engines less gas-guzzling. Gasoline use peaked in 2007, and hybrid, electric, biofuel and other technologies have been rising. By 2025, Washington will require carmakers to get gas mileage up to 54.5 miles per gallon for the cars they sell, from 26 mpg currently.
During the first century of oil’s dominance in the global economy, massive revenues went to oil-producing countries and to oil companies. Over the past 15 years, because oil supply was inelastic and demand spiked quickly, oil prices have been exceptionally high and the traditional beneficiaries enjoyed a huge petrodollar windfall. However, this windfall also encouraged the development of new oil exploration and production technologies and boosted energy efficiency, to the point where technology started to regulate both demand and supply for oil.
The producers and owners of technology will now get a growing portion of oil revenues, while oil-producing countries and traditional oil companies get less. Moreover, as technology gets steadily cheaper, oil prices will now be under constant downward pressure.
The oil market has been in a bubble stage because this new reality was slow to sink in and because the Fed and other major central banks continued to pump liquidity into the global financial system. But once the bubble burst, the oil market as it existed before the technology revolution became as much a thing of the past as the world of typewriters and teletype machines.