Why Oil Prices Could Fall to Below $50 a Barrel

June 27, 2012 RSS Feed Print

Michael Lynch is the president and director of global petroleum service at Strategic Energy & Economic Research.

Recently, while speaking to a seminar of oil industry executives, I remarked that high oil prices appeared to be suppressing demand beyond the level that would absorb soaring supplies (watch the panel discussion at the 5th OPEC Seminar). A lower price seemed likely in the next few years, I posited, possibly as low as $50. While the audience didn't gasp, one reporter suggested I was joking (but recognized that I wasn't) and an oil company CEO politely disagreed—but made it clear that he thought the suggestion ridiculous.

His rationale: His costs were $100 a barrel (that was the hurdle rate for new projects) and anything lower would reduce investment and supply, sending prices right back up. Although this sounded logical, it is overly simplistic in a number of ways, and smacks more of the sort of wishful thinking that has hurt, for example, Chesapeake Energy, whose CEO warned natural gas prices were too low as they kept declining from $8 to $2/Mcf, his opinion notwithstanding.

Certainly, lower prices would reduce upstream investment which could, ultimately, take prices back to their earlier levels, but this is relatively unlikely. First, a significant portion of lower prices would be absorbed by governments, whose tax take fluctuates with prices. Second, upstream costs would decline with lower investment, as the overheated market for drilling services would cool off. But finally, most new supplies (and none of the existing production) cost well below $100 to produce.

[See a collection of political cartoons on gas prices.]

Historical ignorance is display, as so often is the case with energy. There have been repeated periods when industry figures argued that prices were too low to cover costs, most famously in late 1985, when prices were $30 but then collapsed to $18 the next year. This despite the fact that there was near-unanimous expectation of continued higher, not lower, prices.

Similarly, some argue that revenue needs of oil exporting countries like Iran and Saudi Arabia will determine prices, based on the oil price necessary to cover their fiscal needs. Which is certainly interesting, but hardly determining of the ultimate price, since while they can influence the price, they cannot set it. From 1986-2005, roughly, few OPEC members met their fiscal needs from oil revenues, yet that didn't result in higher prices.

In the short run, as Keynes said, it is the opinions of traders that determine asset prices, while in the long run, the balance between supply and demand are the primary factors (along with taxes, politics, and so forth). But the wishes of producers, whether companies or countries, are only marginally relevant to where they will go.