Could Oil Prices Ever Fall Below $20/ Barrel?

The crash and then partial rebound in oil prices from $145/ barrel to $35/ barrel and now back to $80/ barrel today has inevitably renewed speculation as to where oil prices are headed.

The strength of the recovery, restocking of depleted inventory, and Opec agreements on volumes of sales are all key factors in the short to medium term.

Most prognostications seem to veer on the side of a continued soft recovery and equally flat to soft oil prices six months to a year from now, perhaps in the $70-$85/ barrel range.

Before the crisis, going back to the early 1970s and the first Opec oil shock the historical experience has been sharp increases followed by a plateau to down for several years; first with a quadrupling in the early ‘70s, then a near doubling in the early ‘80s, and then a sharp rise in the 3 years before the crisis.

The presumption had been that over the long haul oil prices were headed remorselessly higher since oil is a non-renewable resource which we would eventually deplete.

The economics of this were set out in 1931 by a famous US economist Harold Hotelling in a paper which contained the first statement of what came to be called “Hotelling’s Rule”.

In this paper Hotelling argued that resources (that is – oil) in the ground are an asset held by investors in their portfolio of stocks along with financial assets. Companies may own the rights to extract oil, but investors own the stocks.

Oil in the ground, unlike financial assets, does not earn a direct monetary return as a profit, dividend, or royalty.

The return to the investor accrues in the form of a capital gain as the price of the resource appreciates. If assets, as a simplification, have similar risk characteristics and ignoring all complications for now of different tax treatment of capital gains and other returns, then the return to investors should be the same on all assets.

Were this not the case, investors would switch into the higher yielding asset until returns became equalised. It therefore followed that the prices of resources (oil) must increase through time to match the monetary return on plant, equipment, machinery and other capital that generated profits and dividends for investors.

This logic seemed implacably and irrefutably sound up to a few years ago, and so the prognosis accepted was for ever increasing oil prices. The challenge to this today comes from a number of quarters.

The first is the complications from global warming. If increasing extraction and burning of fossil fuels progressively increases the concentration of carbon emissions in the atmosphere, and with this global warming accelerates, then a likely policy response is to allow a price to be set on carbon emissions which restrains the use of fossil fuel.

This would likely progressively increase over time as growth occurs in China, India, and elsewhere. This increasing price of carbon would be partly shifted to consumers in the form of higher prices of products, but also partly shifted back to owners of oil in the ground through lowered prices.

Thus oil prices could continue to increase due to the Hotelling effect, but also progressively fall due to the carbon pricing effect. The net effect could be for oil prices to fall.

The second is what is happening in energy markets through substitution out of fossil fuels as part of the global move to a decarbonised economy. The EU, China, and the US have all adopted targets for percentages of energy production to come from renewable sources by various dates. The EU’s is 20 per cent of energy from renewables by 2020. This is to involve wind power, solar power, thermal and tide power.

Currently, putting nuclear on one side, the fractions coming from these sources are very small but growing rapidly.

In Europe (especially Germany and Spain) there are significant subsidies applying for the adoption of solar power. And the costs of energy conversion to using solar power, in particular, are dropping quite rapidly. Some estimates are that, at current rates of decline, costs of energy production from solar could be lower than oil/ coal fired power plants by 2013.

The third is what is happening on the extraction and discovery front. True, the presumption has been that with a finite Earth, oil supplies must ultimately be finite and non-renewable.

But recent deep water discoveries in Brazil and the Gulf of Mexico suggest that with new drilling technologies there is still a lot of oil to be discovered which is viable for production at $75/ barrel of oil. This may take 5-10 years to come on stream, but by coming on stream it will further be depressing prices.

These three factors can together act as a significant damper on oil prices over the long haul.

Could oil prices ever fall below $20/ barrel? It may seem like a long odds bet, and maybe it is, but if there is accelerating climate change and a policy response, and substitution into ever-cheaper solar, in a world awash with oil discovered on the premise prices would soar above $145/ barrel again, who knows?

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