Economics of Petroleum Gets a Bit Slippery

What’s ahead for energy prices? Despite Wednesday’s leap in oil futures prices, they will stay low in the short term but get higher in the longer term--perhaps three Christmases from now. If you want to understand why, forget the Organization of Petroleum Exporting Countries and its unfathomable Middle Eastern politics. And concentrate instead on some surprising numbers.

For the short term, the important thing to keep in mind is that this year’s spectacular fall in the oil price did not lead to greatly increased usage of oil products. Through the first 11 months, U.S. consumption rose only 2.9% (gasoline was up 2.6%) despite a drop in price of roughly 50%. That means that oil, like just about every other commodity worldwide, is in oversupply and caught in the deflation of this decade. Lower prices do not lead to increased sales of oil, nor do they lead--at least not yet--to a decrease in the abundant supplies.

The same is true for natural gas, the fuel that means so much to homeowners for heating and air conditioning. Even though the price--at least to industrial customers--came down sharply this year, U.S. use of natural gas declined. There is a surplus of natural gas amounting to roughly 18% of annual consumption.

Supposedly Scarce Commodity

Why is this happening in energy, the supposedly scarce commodity that caused so many predictions of doom in the last decade? Is it that the warnings of shortage were effective and the world learned to conserve fuel?

Not really. Despite what you may think from all your fiddling with the thermostat and driving a four-cylinder car, the world did not reduce its energy usage dramatically because of rising oil prices. From 1973 to 1985, according to figures compiled by the Morgan Stanley investment firm, worldwide use of oil declined by only 3.7%. That’s right, 3.7%, despite a tenfold increase in price. What happened is that, yes, the developed countries--Europe, Japan, the United States and Canada--cut back. But the developing countries, where living standards were growing, increased usage more than 50%.

The really important reasons we have an abundance of low-priced energy today (gasoline at prices that, adjusted for inflation, are no higher than in 1978) is that high prices in the last decade led to vastly increased supplies, and slow growth in the world’s major economies is holding down demand at present. That is, new oil production between 1973 and 1985 in Alaska, Mexico, the British and Norwegian North Sea and elsewhere outside the OPEC countries increased supplies on world markets by almost 25%.

Mediocre Economic Growth

But with business not brisk enough to keep the factories working overtime, the world is not going to use more energy, no matter what its price. And you know things are slow when predictions of a mediocre 2% growth in the U.S. economy rank as the world’s most optimistic.

What does that mean for the outlook? Well, think about it. High prices did not really reduce demand so much as they increased supply. And while low prices could well increase demand if the world’s economies pick up speed, they are unlikely to increase supply. The virtually certain result: Supply and demand will again come into balance, the OPEC nations--which have the most abundant oil reserves and lowest cost of production--will regain power in the marketplace, and prices will go up again.

When will that happen? Most predictions say 1990 at the latest. In fact, the forces determining the long-term pattern are already in motion. Output from the North Sea and from Alaska has peaked, and low prices are unlikely to spur efforts to replace their production. In natural gas, the United States will use 16.8 trillion cubic feet this year, but it will drill and develop less than half that amount to replenish reserves.

A sure sign that it’s getting late in the day for U.S. domestic resources is that the American Petroleum Institute, a lobbying group, will talk about the national security implications of depending on energy imports at a Washington press conference next Tuesday. There will be suggestions that Congress spur domestic exploration by raising the oil price through a tax on imports. But a tax is unlikely.

What will happen instead? Oil drilling and development will pick up once the industry is convinced that the energy price has a bias toward going up, not down. That hasn’t really happened yet, but Earl Stolz, an analyst who studies the oil service industry for Howard Weil Financial Corp., looks out from New Orleans and sees at least a few more drilling rigs looking for natural gas in the shallow waters of the Gulf of Mexico. And a major oilman, Shell Oil Chairman John Bookout, was quoted in Forbes magazine recently as saying: “Now with everyone uncertain, it’s time to take risks.”

The upshot? Higher prices will bring more drilling, which will find more oil, and we’ll go through the whole cycle again. Happy holiday.