Notes From the Oil Production Downslope: Smoke Signals

The price of oil on the NYMEX commodity exchange closed yesterday at $66.75 a barrel, less than half of its high point in early July at $146.65. Are happy days here again? Was all that peak oil catastrophe mongering so much short-sighted panic? No and no, sadly.

People pay a lot of attention to the price of oil for a couple of reasons. First, of course, it affects our lives. Gasoline and heating oil at $4 a gallon takes a whack out of our wallets. Second, and more to the point, we are taught that we can tell how plentiful or scarce a thing is by the price. Dirt cheap versus precious metals. The problem with this way of thinking about oil is a phenomenon I call “too many hands on the steering wheel.”

Over the long term, price does mean something. The fact that the NYMEX oil price broke the $100 mark this year when in 1998 it dipped as low as $11 is significant. It indicates that the supply of oil and the demand pressure for oil have become close. The recent price swings, however, are more about a complex system under pressure.

I should distinguish between above ground factors and below ground factors. Below ground factors are straightforward, yet mysterious. There is some amount of oil in the ground. This oil is distributed in reserves that are easier or more difficult to get to, easier or more difficult to pump out, and of varying quality. Overall, the quantity is declining by about 86 million barrels a day, the quality is declining, it is getting more difficult to pump out, and the more accessible reserves are playing out. This is all happening in a consistent and stately fashion, punctuated by periodic discoveries of a new oil field or a new section of an old oil field. Yearly world consumption has been exceeding yearly new discoveries since about 1982, and the two lines on the graph haven’t been anywhere near each other for years. Not much dramatic here. The mystery resides in the fact that the major oil producing countries are secretive about their reserves and also less than truthful about their production capabilities. All of the major OPEC producers magically experienced sudden doublings in their stated reserves at some point in the last twenty years. Jeremy Gilbert, former chief petroleum geologist at British Petroleum, politely called these “technically unsubstantiated reserve increases.” We call ‘em “lies.”

Above ground, we get into the “too many hands on the steering wheel” problem. Country by country, consumption rates are mostly going up, but when the U.S. consumption of gasoline drops by 4% (as it has), that is a big deal. The amount of oil and oil products in storage varies around the world week by week. Iran talks tough and the price goes up. Iran says something conciliatory and the price goes down. Trillions of dollars slosh back and forth between commodities (such as oil), the stock market, U.S. Treasury bills, money market funds, and back to commodities. Oil prices surge, oil traders worry about the effect of those prices on the economy, and there is downward price pressure. The MEND rebels in Nigeria blow up a pipeline and take over an oil platform, shutting in 300,000 barrels a day of production, and prices are pushed up. A new pipeline opens up somewhere else, China’s economic growth slows, and the price is pushed down.

Meanwhile, OPEC oil ministers are talking about trying to maintain oil prices between $70 and $90 by cutting production. This gives them lots of profit without major demand destruction or pushing anybody into structural changes in their energy use. They are confronted with all the problems listed above, plus the fact that some OPEC members cheat and exceed their production quotas.

Add to this the hysteresis of emotion among commodity traders. They are looking at all these factors and betting large sums of money on the possible price swings. They tend to jump onto trends and then try to gauge when the trend will stop. This adds a rubber band effect to the steering system: Spin the wheel hard one way, delay, tighten, and overshoot. Spin the wheel the other way, delay, slack, tighten, and overshoot.

In the present situation, where world oil production has been on a bumpy plateau since 2005, while demand has increased by a small percentage each year, small pressures have large effects. Our upcoming recession and, more importantly, fear and speculation about recession will fuel some dramatic volatility in oil prices. My advice is to ignore the week by week hysteria and look at the decade by decade movements in production and price. That message is clear: Flat and then dropping world supply, volatile and rising price. Pursue localization, conservation, efficiency, and renewable energy as if the recent drop hadn’t happened.