Supply and Demand Plus Speculation 101
Oil recently hit $108 barrel (every additional day it takes me to write this the price goes up another notch). There are several good reasons why this is happening. The first is the most obvious: while demand continues to rise, production has peaked. For those of you who need a refresher, peak oil is that point at which half the total resource has been extracted. It’s also the high point on a bell curve: after the peak, production can only go down.
The US government, several big oil companies, other entities in various stages of retardation will tell you the world has another 30 years supply of crude oil. They speak as if we will extract the current nearly 90 million barrels a day for 30 years, then on day one of year 31 the wells literally dry up. Too bad the world doesn’t work that way.
What really happens was most succinctly analogized some years ago by noted environmentalist, Amory Lovins. Imagine a pearl necklace that breaks over a deep shag carpet. When you bend down to pick them up, the first are clearly visible right on the surface. Once you’ve got the easy pearls, it becomes increasing difficult to locate additional ones. By the time you’ve recovered half, you start to have to spend a good deal of time searching out each remaining pearl. The last few could take hours to find, some might never be recovered.
The pearls visible on the surface are equivalent to wells in Texas where the oil was only a few feet below the surface. Those have nearly all been depleted. Sadly (and what a sweet comeuppance to the state that gave us the thief at the White House) modern methods of extracting the most oil out of each well have led to widespread contamination of groundwater, in many cases making it totally unusable - forever.
We are now at the half way point where all the easy ones have been found and exploited and all new discoveries involve going very deep underground or working in very harsh environments. In order to find oil that’s two miles under the surface of the ocean in the frozen Arctic you must spend a lot of time and money; moreover, once you’ve found it, it’s very expensive and energy consuming getting it out.
The next 30% is going to make for very expensive oil, indeed; especially since supply is not going to meet demand. Consider lowly Cambodia: electricity demand, 90% of which is currently produced with fossil fuels, is rising 25% a year. This dynamic isn’t just from the developing world; America is fast increasing its consumption because of its people’s propensity to own giant vehicles which are used to access monster houses located far out in the exurbs.
The last ten or twenty percent may never be economically recoverable: here the concept of net energy enters the picture. At a certain point it may take more energy to extract the oil than the energy you can derive from it. Some years ago there was talk of oil in Oregon, but it was 5 miles below the surface: it will probably never make sense to exploit it.
It must also be noted that the relationship between price and shortfall or surplus of a commodity is not linear; that is, a 5% shortfall does not lead to a 5% increase in price, rather it may lead to a 50 or 100% increase in price. By the same token, a small surplus may lead to a sharp reduction in price. In classic supply and demand theory price is a function of cost of production plus profit. When a shortfall occurs it leads to an immediate price rise which then encourages entrepreneurs to get involved in increasing production until balance is achieved.
The theory breaks down when you are dealing with a limited resource like oil or gold or copper, etc., since you are really not producing it, only extracting it. Since the world economy is expanding rapidly within a limited resource base and world economic philosophy is based on ‘gluttony is good’ we are headed for a time in which, in the long view, the only way prices can go is up.
The second major factor in the rise in oil prices is speculation. As ranted over several times in past commentaries, the world is awash in super-rich dollars; that is, while the masses have been treading water economically over the past few decades, the wealthy have become fabulously wealthy. Income disparity in the US is now the highest level it’s been since 1929. This did not happen by accident, rather it’s a direct result of trickle down economic policy. The theory being that if you throw lots of money at the wealthy, they will build lots of factories employing lots of peons and everybody makes out in the end.
The problem is that there is (exactly because there is so much money floating around to invest in things) now a glut of productive capacity in the world. This is partly because there are so many people in the world making things which they themselves could never possibly afford: workers who make $100 Nikes often earn only $50 month. At any rate, if you have a billion dollars hanging around to deal with you don’t stick it under your mattress even assuming you had a bed big enough. So why not buy something you think will increase in value? And what better commodity than oil which is absolutely crucial to modern life?
I’ve seen estimates that crude oil would be going for about $30 less per barrel if not for speculation. Essentially, you and I are paying more for everything because the wealthy have too much money to play with. The obvious solution then would be to remove some of that discretion by making them pay their fair share of taxes and prices would go down… well, at least temporarily.
Finally, a large factor in the rising price of oil is the falling value of the dollar. Furthermore, the US government is doing everything it can to drive the dollar lower. Of course that isn’t their stated goal, but it might as well be.
Here’s a good analogy. You are driving towards a cliff at breakneck speed; barring a death wish, you slam on the brakes and try to swerve out of the way of the chasm. If you are an American policy maker – Fed, Congress, President, you floor it to get your last little thrill before the end.
If you are deeply in debt while the value of your assets in declining, do you borrow more? No, you cut back, tighten your belt, start to bring your accounts into balance. If not now, when? When crude oil is $200 per barrel?
American obsession with growth at all costs has led the Fed to lower interest rates and Congress to increase the deficit for a worthless economic stimulus package. Both will increase downward pressure on the dollar. Both will further drag the US economy into the mire. It will not be a pretty sight.