The Recession

Get Ready for Oil Prices to Soar

| by Cato Institute

By Richard W. Rahn, Cato Institute

The price of oil soon will soar again. The present price of a barrel
of oil, $50 or so, is below the price needed to meet current demand for
a sustained period of time, and it is well below the price needed to
meet global demand as the world economy rebounds.

In addition, with the U.S. Federal Reserve System greatly expanding
the money supply - which will continue because of the explosion in
government spending - the dollar is falling against other currencies;
and given that global oil is priced in dollars, the price of oil will
rise in dollar terms, just as it did two years ago.

About 65 percent of the demand for global oil can be supplied at a
price of $35 per barrel. Another 20 percent of demand can be supplied
at a price of $35 to $60 per barrel, but the remaining 15 percent will
only be supplied over the long run at prices of $60 to perhaps $130 per
barrel. Oil, like all commodities, is priced at the margin, which means
the price of all oil demanded by the market is equal to the price that
producers can get for the last barrel of oil they sell.

It takes considerable time to greatly increase oil production, and
it also takes time to reduce production. Despite the global recession,
oil production capacity is only slightly above demand, so that any
significant supply disruption - a war in an oil-producing area,
pipelines being blown up or tankers sunk, etc. - will almost
immediately create a supply shock, causing the oil price to soar again.

Because of the drop in oil prices during the last eight months,
high-cost production facilities are being shut down, including
low-output wells, some offshore production, Canadian oil sands, etc.
When the oil price shoots back up, it will take time to get these
production facilities back on line.

Oil prices will almost certainly be much higher in real terms
(inflation adjusted) during the next 15 years because world energy
demand is expected to increase at an average annual rate of 1.6 percent
between now and 2030. More than 80 percent of the increase in energy
demand during the next two decades is expected to come from China,
India and the Middle East.

Low-cost oil production is declining sharply, as the old
easy-to-produce fields are being rapidly depleted. There are still huge
potential oil supplies, but most of it will be in very expensive,
deep-sea areas, or in oil sands (Canada) or oil shale (Colorado,
Wyoming, Utah), all of which are much more costly to produce. Biofuels
are also expensive and compete with food for land on which to produce
them.

If suddenly it were announced that a miracle electric battery - one
that could power a full-sized automobile at high speed for more than
300 miles and could be quickly recharged - had been developed, what
impact do you think it would have on the price of gasoline next week?
The answer is probably none because it would take several years for the
manufacturers of automobiles to switch over completely to
battery-powered ones, and then another decade or so before most of the
existing stock of automobiles would be battery powered.

In the long run, improved battery technology will probably reduce
the demand for liquid fossil fuels, but even under the most optimistic
scenario, the dependence on oil will last a couple or more decades.

As vehicles eventually move from liquid fossil fuels to electricity,
the demand for liquid petroleum will drop, but the demand for
electricity will greatly increase. The environmentalists and many in
the political class like to talk about "renewables" meeting the demand.
A nice notion, but at best it is not going to happen for decades. As
the chart shows, wind, solar and geothermal are less than 3 percent of
total energy supply. They all still need to be heavily subsidized
because they are not economical and probably will not be for many years.

Hence, even at high-growth rates, they will only supply a small percentage of total energy needs in the next two decades.

When oil prices soared a couple of years ago, the Bush
administration moved to open up government lands and certain offshore
areas for more oil exploration and production. Officials in the new
Obama administration are now in the process of again locking up these
areas to prevent oil production.

If the Obama administration is right in its forecast that the
economy will be growing again by the end of this year - which is
probably even more true for the world economy - the demand for oil will
be rising rapidly again. Yet much production has been shut down because
of the recession, and potential future supply inside the U.S. is being
restricted by government action.

The result should be obvious - gasoline at the pump will be at least
$3, if not $4 or more. Americans will still be hurting as a result of
the recession, so many of them will be most unhappy to see the prices
soar again.

Given that many in the political class seem to think the long run is
the next five minutes, they do not see or want to see this tsunami
coming. Many politicos will try to blame the high prices on "greedy oil
companies" or laggard automobile executives rather than to look in the
mirror and see the shortsighted demagogues whose policies led to the
mess.

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