Wednesday, February 4, 2015

Oil prices will continue on their wild swings for years to come

"Oil prices drop by half in just a few months". A headline from early 2015? No from 2008, as this article attests. Prices had been up in the $140's before that, and between 2008 and mid 2014 they went back up again well above $100.

So in fact, we are currently in the midst of a series of wild multi-year swings in the price of oil. This pattern of wild swings in the price of an important resource as it was being depleted was also experienced in the 1800's in the price of whale oil.

It's really pretty simple: High prices encourage investment in improved extraction (in the case of whales, better boats, better hunting techniques, longer voyages). After an important time lag these investments pay off in terms of increasing supplies; for a while the investment keeps pouring in because there are high prices and lots of product to sell. The resource producers do well, those dependent on the resource suffer from the high prices. 

But then a glut takes hold. Too much resource. In 2008 it was exacerbated by a recession that dropped demand, but whether or not there is a recession, the hyper-investment in supply will cause a glut, even in a dwindling resource. The temporary glut causes prices to start to fall, fast. It takes time to turn off the investment, there is still plenty of supply for a while, pushing the price way down. Some suppliers (with lowest production costs) are not to bothered by the situation as they know it will push other suppliers (with high production costs) out. It works. Suppliers shut down, Investment stalls. OPEC is right now pushing Russia and US out.

Then supply slows just as demand is soaring due to people loving the low prices. Smash ... the price soars again. But for some time there are fewer suppliers, so the price overshoots at the top end. Even now OPEC is predicting $200 oil in the not-too-distant future. There will be a lot fewer US wells producing by then, so OPEC will make a lot more money than they would have if this crash in prices had not happened. The price swoon in fact might jeopardize the dreams of the US being independent of OPEC supplies.

The last thing businesses and the modern economy need is price swings. Business can't plan; investments are too uncertain. But laissez-fair economics will guarantee swings of this nature. That is, unless a new disruptive technology takes hold. In the 1800 crude oil took over from whale oil, whose price eventually dropped off as it was no longer needed.

So there are two possible futures:

  1. Solar + nuclear + fusion + other technologies eventually save the day.
  2. We will be stuck with swinging oil prices. 

My guess, for the next few years is the latter. $200 oil in late 2016 or 2017? Another crash to $50 in the early 2020's; back unto $250 oil shortly afterwards?

Investors who can play long-term markets and can wait out these swings could make fortunes. But most futures plays are only for the short to medium term.

Theoretically governments could intervene in the market to smooth out prices. For example taxes on gasoline and other petroleum prices could be much, much higher when the crude price is low, with funds going into a trust to be saved for the next peak and to support investment in continued supply. When prices peak again, the taxes would drop, supporting a slow and steady rise in real prices paid by consumers and business. Unfortunately conservative thinkers currently in power would never stomach this.

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