Excellent Article on the "New Oil Reality"

The main point, which is absolutely correct, is this: "World oil prices are being driven overwhelmingly by 'the larger forces of supply and demand.'" On the supply side, "Some analysts argue that peak oil production has already been reached" while "[o]thers say the peak remains a ways off but perhaps not very far."  Also on the supply side, it was the "low prices of the late 1990s [that]...dampened the impetus for finding new supplies."  

In other words, the current situation with oil prices is not mainly about "manipulation" or "anxiety" or whatever, but instead is mostly a reaction to the price collapse we saw a decade ago, which at one point saw crude oil on the NYMEX trading at just $10 per barrel. Actually, I'd go back even further, to late 1985/early 1986, when the world saw the first major oil price collapse following the 1970s and early 1980s oil price spikes. The 1985/1986 price collapse ushered in a 15-year era of low oil prices, booming oil demand, and sluggish exploration for oil supplies, the ramifications of which are being felt today.

On the demand side, the oil price collapses of 1985/86 and the late 1990s helped - among other things - to fuel the SUV craze and a slowing or reversal in energy efficiency gains we had seen in the late 1970s and early 1980s.  According to the Washington Post article, "Those low prices sent the wrong signals to consumers and oil companies alike." You can say that again!

Demand for oil jumped as U.S. sales of gas-guzzling cars soared and China's breakneck economic expansion picked up pace.

Daniel Yergin, a historian of the oil business and head of Cambridge Energy Research Associates, said that over the five years from 1998 to 2002, world oil demand grew 1.1 percent annually, raising daily consumption by 4.2 million barrels. But in the following five years from 2003 to 2007, world oil demand grew 2.1 percent annually, boosting consumption by about 8.2 million barrels per day.

Draw yourself a simple supply and demand curve, with supply nearly vertical and demand shifting up rapidly, and see what that does to the price of oil (or anything, for that matter). That's exactly what has been happening the past few years - surging demand encountering constrained supply, resulting in spiking oil prices.

In addition, one of the first lessons I learned when I joined EIA in the late 1980s was that oil prices reacted to something called a "capacity utilization ratio."  An internal assumption we used - among many other tools - was that when world spare oil production capacity fell below 10 percent of total production capacity, oil prices would tend to rise.  The lower that percentage got, the faster and higher oil prices would tend to spike.  Today, as the Post article notes, world spare production capacity is just "2 percent beyond the world's total daily consumption of 85.5 million barrels." In other words, the "capacity utilization ratio" is around 98%, which implies rapidly spiking oil prices.  Exactly what's happening now.
Actually, I question whether or not the world has even 2% spare capacity, as I'm highly skeptical of the Saudis' production capacity claims.  For more on this subject, see Matthew Simmons' book "Twilight in the Desert", and also ask yourself why, if the Saudis really have excess oil production capacity, it's not worth their while to produce it at $130 per barrel.  Perhaps they don't really have it after all?

So what do we do about this situation?  To some extent, high prices will cause "demand destruction" that could eventually cause somewhat lower prices. However, as the Post article accurately notes, "this oil shock is different," with "little prospect that drivers will ever again see gas prices retreat to the levels they enjoyed for much of the last generation." That's largely because of two factors we can't do much about: 1) on the supply side, we're at or near "peak oil" (which by the way doesn't mean the world has run out of oil, simply that "it's not going to become available as fast as uninhibited, unrestricted demand"); and 2) on the demand side, growth in places like China and India (combined population: well over 2 billion) is highly likely to continue, with India's Tata rolling out its version of the Model T - the "Nano."  

Imagine if 2 billion Chinese and Indians owned (and drove) cars at anything approaching U.S. rates?  I did this calculation back in the early 1990s, and remember laughing incredulously at the impossible result: with 4 times the U.S. population, China and India combined would consume around 80 million barrels per day, 4 times U.S. oil consumption and more than the entire world consumed at the time. Obviously, since that was never going to happen, something would have to give. It looks like it's "giving" now.

So, what we do is simple: get off our oil addiction as fast as possible.  What we don't do is also simple: gimmicks like releasing oil from the Strategic Petroleum Reserve, a "gas tax holiday," etc., which will do absolutely nothing to ameliorate the underlying oil supply/demand situation, but instead will exacerbate it, to the extent that whatever very small and very short-term price reductions we see from using the gimmicks will put a break on "demand destruction," thus slowing the end of our "oil addiction."  The completely wrong way to proceed, in other words.

What about the supply side?  The bottom line, even if one puts aside all environmental issues, is that the United States is a "mature oil province," well past peak, meaning that the marginal cost to produce a marginal barrel of (probably marginal quality) oil is higher than in many places around the world.  Another way of putting it is that the United States no longer has a "comparative advantage" in producing oil, as it did in the early- to mid-20th century. That "comparative advantage" isn't coming back again, so to focus on this area would be extremely unwise, purely from an economic perspective. Instead, we should focus in the area where we DO have a comparative advantage - capital, aka new technologies for saving and producing energy - which obviously means a focus on energy efficiency and renewable energy.  

Add in the issue of global warming, and it's crystal clear where we should be headed.  At least, it should be clear to anyone who looks at this with an accurate understanding of what's going on -- not just a "New Oil Reality" but a "New Energy Reality" more broadly.  We'll see how fast the pandering dumbasses in Washington politicians figure this one out.

P.S. The expression "There are none so blind as those who will not see" suddenly springs to mind.

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