Economy

Falling Oil Prices are a Warning

By Ryan McGreal
Published August 06, 2008

A recent article in Fortune warns against celebrating falling oil prices. After pointing out the obvious immediate benefits to consumers, the piece points out:

[F]alling oil prices also suggest that the recession the U.S. has so far avoided is well on its way, as consumers pull back from the spending spree that drove economic growth earlier this decade. A weakening economy will mean more layoffs, further pressuring already reduced spending.

The article also manages to connect falling oil prices with falling North American demand:

Perhaps the biggest factor behind the recent 18% drop in the price of a barrel of crude is sinking North American demand. Federal Highway Administration data show the number of miles driven in the U.S. dropped from year-ago levels for the seventh straight month in May.

Aside from debunking the exceptionalist fantasy that North Americans drive because it's in our blood rather than because it's cheap and convenient, this suggests that the drop in oil prices is largely illusory: if we need a recession to make driving affordable, there's something wrong with the underlying transportation model.

Automakers in Jeopardy

At the same time, the Big Three automakers continue to struggle with herculean quarterly losses as consumer demand for bloated SUVs collapses, to the extent that the prospect of bankruptcy can no longer be dismissed.

Credit rating firm Standard & Poor's cut GM and Ford deeper into junk bond status last week, leaving their debt just barely above the level normally associated with firms at significant risk of near-term default.

The automakers are struggling to reposition themselves, with smaller, more efficient vehicles and more competitive cost structures, but these strategies will take years to play out.

In the meantime, the overall energy situation will continue to tighten. The Big Three may well discover that by the time they adjust their products for $100 oil, they're stuck trying to sell in a market with $200 oil.

Lower Prices Still High

Despite the recent drop, energy prices are still very high in real terms. It's bittersweet at best to observe relief over an oil price - around $120 a barrel - that would have produced howls of pain just a year ago.

An alarming NY Times article from yesterday suggests that home energy prices this coming winter will "far exceed those of last year."

Even after a precipitous decline from its peak in early July, the price of natural gas is still 11 percent above where it was last winter.

Heating oil is 36 percent higher, with the government projecting that the costs of both fuels will stay high. Electricity prices are also up moderately.

Prices have become so volatile that energy retailers are now reluctant to offer price protection plans, meaning that consumers will be on the hook, month to month, for unpredictable heating bills.

Load that on top of the existing pile-on of flat wages, increasing layoffs, higher transportation costs, falling property values, ongoing foreclosures, tightening credit markets, and rising inflation rates.

Today's Suburbs, Tomorrow's Slums?

If all this is starting to feel a bit cataclysmic, think of people living in ghostly, half-finished subdivisions that were started at the tail-end of the housing bubble.

The WSJ article reads:

In the past year, roughly 15% to 20% of residential developers have gone out of business, suspended operations or changed their line of work, according to an estimate by the National Association of Home Builders.

Canada mostly escaped the real estate mania, and so far it has mostly escaped the real estate collapse as well. However, the premise on which most of our new residential developments over the past several decades have been planned is still highly vulnerable to the forces shaping the global economy.

Many of today's suburbs may will turn out to be tomorrow's slums when it becomes too expensive to drive everywhere. The worst thing we can do in response to falling oil prices is ease back into our old habits of single use zoning and car-centric transportation.

Instead, we should snatch the opportunity to invest in more sustainable land use while we still have the wealth to do it.

Ryan McGreal, the editor of Raise the Hammer, lives in Hamilton with his family and works as a programmer, writer and consultant. Ryan volunteers with Hamilton Light Rail, a citizen group dedicated to bringing light rail transit to Hamilton. Ryan writes a city affairs column in Hamilton Magazine, and several of his articles have been published in the Hamilton Spectator. He also maintains a personal website and has been known to post passing thoughts on Twitter @RyanMcGreal. Recently, he took the plunge and finally joined Facebook.

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By Capitalist (anonymous) | Posted August 06, 2008 at 13:31:00

Could you please set a target date for when you think that oil prices will hit $200/barrel or some other ridiculous price? That way if you are right then you will garner some respect. But if you keep going on with these rants without being able to stick your neck out with a hard prediction, that you can be held accountable for, then the people who read your stuff will know you are just blowing stuff out your a$$.

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By adam2 (anonymous) | Posted August 06, 2008 at 14:09:09

Here is $/barrel over the past 5 years:

5 yrs ago - $25 / barrel
4 yrs ago - $40 / barrel
3 yrs ago - $60 / barrel
2 yrs ago - $75 / barrel
1 yr ago - $75 / barrel
today - $120 / barrel

As you can see, oil prices went up 500% in the past 5 years. In the past year, they went up 200%

According to this exponential growth model, we should reach $200/barrel sometime next year. I'll be conservative and set my own personal estimate in 2010.

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By adam2 (anonymous) | Posted August 06, 2008 at 14:17:20

According to the stats, average growth rate for oil ($/barrel) over the past 5 years is 40%

If this average growth rate remains the same, we'll have $235/barrel in 2010. I'll put my "neck out" and say this is inevitable unless something drastic happens -- like a major recession.

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By Capitalist (anonymous) | Posted August 06, 2008 at 14:24:53

adam2,

According to the figures you provided, oil prices have increased by 380% not 500% in the past five years. This is the formula for calculating a percentage:

((120-25)/(25))*100 = 380%

In the past year, oil prices increased by (again according to your figures) 60% not 200%:

((120-75)/(75))*100 = 60%

Secondly, data on oil prices exists as far back as 1890. To use the last five years of data and fit an exponential growth model to forecast future prices is completely nonsensical.

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By Ryan (registered) - website | Posted August 06, 2008 at 14:56:26

Capitalist wrote:

Could you please set a target date for when you think that oil prices will hit $200/barrel or some other ridiculous price?

In general, I think our track record at calling the energy situation is pretty good, compared to the mainstream pundits who scoffed at the possibility of $100/barrel oil.

(See, for example, this August 7, 2007 CNN article titled "Why oil won't hit $100":

http://money.cnn.com/2007/08/07/news/economy/cheap_oil/index.htm )

Everyone thought it was ridiculous in 2005 when we "stuck our necks out" and posted articles predicting that oil would hit $80 or $100 per barrel (see below).

We also posted articles about people in oil-dependent industries scratching their heads and saying, "No one could have predicted" the rise in oil prices.

The peak oil hypothesis predicts exactly what we have observed over the past few years, in which demand tries to grow against a flat supply and prices rise as a result:

  1. The oil production rate is stalled at around 84-85 million barrels per day.
  2. Demand keeps growing.
  3. Oil prices go up to bring demand and supply in balance.
  4. Sharply rising oil prices cause inflation and economic slowdown.
  5. Eventually, the economy goes into recession and demand stops growing.
  6. When demand falls, the price of oil starts to fall as well.
  7. Once the price falls low enough, it will spur new economic activity and growth in demand, which starts the cycle all over again.

That's the "bumpy plateau" that peak oil analysts have described and that I've tried to explain. We're at step 6 in the cycle right now. How oil prices move over the next year or so depends on how hard the economy shrinks before rebounding.

That, in turn, depends on a number of factors, including how central banks manage interest rates and what governments do to spur consumer spending. If the emphasis is on getting people to start buying new cars and suburban houses again, the next oil price spike could come relatively quickly and be steeper than the $145 spike we just passed: say, $200/barrel by 2010.

If the economic recovery is slower and/or governments direct investment into infill development, transit infrastructure, higher fuel efficiency, higher fuel/carbon taxes, etc., demand will rebound more slowly and fuel price increases will be less volatile.

In that scenario, the oil price could rise to $200/barrel more slowly - say, by 2012.

A big unknown is the outcome of the 2008 US federal election. I don't particularly trust either the Democrats or the Republicans to have an especially sensible energy policy, but the noises coming out of the Obama campaign at least sound fairly pragmatic, whereas McCain's solution seems to consist of cutting gas taxes as approving offshore drilling.

The former will simply transfer more money from transit systems to the oil companies, and the latter won't significantly increase the overall rate of oil production for several years, if ever.


Here are a few relevant RTH posts going back to early 2005:

Super-Spike Published April 4, 2005 "Goldman-Sachs Global Investment Research have just released a report predicting that the oil market is entering a 'super spike' period of price instability that could see oil top $100 a barrel." http://raisethehammer.org/blog/046/

Reaching the Peak Published April 27, 2005 "[T]he April 13, 2005 CIBC World Markets Occasional Report #53 predicts that oil prices will almost double over the next five years." http://raisethehammer.org/blog/065/

$4/l Gas in Hamilton's Future? Published August 23, 2005 Gilbert argues that there's a better than 50% chance that gas prices will reach $4/l by 2018. http://raisethehammer.org/blog/112/

Oil to hit $80 a barrel Published February 6, 2006 "[The oil price] will break through in the second quarter and just keep on going up through the year. We expect the average to be $80 US a barrel" http://raisethehammer.org/blog/181/

CIBC: $100/Barrel Oil by End of 2008 Published July 19, 2007 "A new report by Jeff Rubin and Peter Buchanan at CIBC World Markets predicts that oil will hit $100 per barrel by the end of 2008." (a conservative prediction in retrospect) http://raisethehammer.org/blog/707/

Don't Say We Didn't Warn you Published October 16, 2007 "The Hamilton Spectator website's breaking news section carries an AP report that oil just hit $88 per barrel." http://raisethehammer.org/blog/802/

Oil Flirts With $90/Barrel Published October 19, 2007 "Oil futures just flirted with $90 per barrel before settling at around $89." http://raisethehammer.org/blog/807/

Peak Oil Watch: $100/barrel Oil is Coming Soon Published October 31, 2007 "Reuters reported yesterday that oil futures hit $93.80 per barrel before settling at $93.53." http://raisethehammer.org/blog/821/

Oil: 'Do or die to reach $100' Published November 21, 2007 "[A]gainst tight supplies, shrinking oil reserves and a falling US dollar, oil futures jumped yesterday to $99.29 per barrel before settling at $98.39." http://raisethehammer.org/blog/850/

Oil Passes $100/Barrel Published January 2, 2008 "Just missing predictions that it would happen before the end of the year, oil futures prices passed $100 per barrel today before falling back to around $99.15." http://raisethehammer.org/blog/886/

Oil Passes $126 a Barrel Published May 9, 2008 "Reuters reports that oil has gained 11 percent since the start of the month, passing $126 per barrel." http://raisethehammer.org/blog/1000/

Oil Passes $135 per Barrel Published May 22, 2008 "It has almost become tedious to keep reporting new records in oil prices, as the price of a barrel of oil passed $135 today." http://raisethehammer.org/blog/1009/

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By highwater (registered) | Posted August 06, 2008 at 14:57:30

I can see why someone named 'Capitalist' would be dubious about a bunch of rants in pinko rags like Fortune, NYT, and WSJ.

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By Running Dog (anonymous) | Posted August 06, 2008 at 15:06:40

Oh, oh, don't forget the agitprop streaming from Goldman Sachs.

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By adam2 (anonymous) | Posted August 06, 2008 at 15:41:47

Price of oil today is 480% the price of oil 5 years ago. There, did I get the wording right that time?

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By Capitalist (anonymous) | Posted August 06, 2008 at 15:49:23

adam2

Using your figures: Oil price today = $120
Oil price 5 years ago = $25
That is a 380% increase not 480%. Please see the formula I provided earlier.

Sorry to keep pressing this point, but I find it incredible that you are unable to do a simple percentage change calculation.

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By adam2 (anonymous) | Posted August 06, 2008 at 15:49:40

Price of oil today is 480% the price of oil 5 years ago. There, did I get the wording right that time?

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By adam2 (anonymous) | Posted August 06, 2008 at 16:08:46

We are saying the same thing in different words: oil today is 480% of the price 5 years ago or as you put it, a 380% increase.

Now to answer your original question, I expect based on extrapolation that oil will reach $235 / barrel in 2010. Can you provide reasons why you believe the trend will not continue?

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By Ryan (registered) - website | Posted August 06, 2008 at 16:18:30

adam2 wrote:

Can you provide reasons why you believe the trend will not continue?

Well, the obvious reason is that the high price of oil has stalled and reversed demand growth, which has at least temporarily reversed the trend of oil price increases. Because price signals are blunt and markets are panicky, the pendulum may swing pretty far the other way before falling oil prices trigger a new wave of demand growth.

That "bumpy plateau" of 85 million bpd production may last for a few years or for several, depending on:

  1. How steeply conventional oilfields go into decline. Judging from Saudi Arabia (8% a year), North Sea (10% a year), Cantarell (10% a year), this could get ugly pretty fast.

  2. How fast non-conventional oil comes online. Remember that falling oil prices will stall some of these developments.

  3. How aggressively oil-producing countries subsidize domestic oil consumption. If total oil production goes into decline but domestic consumption keeps growing (as it did in the US), exports will decline even faster than production to make up the shortfall.

Eventually, total global production will go into real decline. When that happens, each time demand bangs off the production ceiling, that ceiling will be lower, and I expect the downturn that follows will be steeper.

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By gullchasedship (registered) - website | Posted August 06, 2008 at 18:47:36

The other factor affecting price that you're not adding into the equation is new production. Even when demand remains high, increased production will lower prices.

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By Melville (anonymous) | Posted August 06, 2008 at 21:40:43

Yep, more stats to fit your own conclusions.. starting to be par the course around these parts.

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By Ryan (registered) - website | Posted August 07, 2008 at 08:09:49

gullchasedship wrote:

The other factor affecting price that you're not adding into the equation is new production. Even when demand remains high, increased production will lower prices.

That's exactly my point: despite years of strong demand growth and very high prices, production has not increased to meet that demand. Even now, prices are not falling because the rate of production has gone up (it has essentially been stalled at around 85 million barrels per day for over three years) but because the very high prices have pushed demand down.

http://raisethehammer.org/article/643

The reason for this, according to peak oil theory, is that the global rate of production simply cannot exceed a peak of around 85 million bpd.

The evidence in support of this theory is very broad and robust. Consider the following supergiant oilfields, all past peak and declining dramatically: Mexico's Cantarell, Saudi Arabia's Ghawar, North Sea, Russia's Samotlor, and Kuwait's Burgan. Oil discovery peaked in 1964 and has fallen ever since.

The OPEC countries all increased their reserve estimates overnight in the early 1980s when OPEC rules changed to restrict exports to a percentage of total reserves. Since many have nationalized oil companies, there's no empirical data to support their claims, but actual production rates are consistent with much lower actual reserves (as Kuwait quietly admitted a couple of years ago after a leaked report noted that actual reserves were only half the "official" total).

http://raisethehammer.org/article/234/

A memo leaked from Saudi Arabia two years ago admitted that its production was past peak and would decline by 8 percent the next year, even as spokespeople for Aramco announced they would increase production. A year later, total production was down 8 percent.

http://raisethehammer.org/blog/220/ http://raisethehammer.org/blog/520

The bottom line is that the price signals for increased production have been very strong and growing steadily for the past seven years. Money has poured into expensive new projects, like the Alberta Oilsands, that aren't even cost-effective when oil is less than $50/barrel.

Despite all this new production, the total production has been flat, which means these new non-conventional projects are barely covering declines in conventional production rather than adding to the net total.

This the single strongest sign that something's up: the fact that additional net production is simply absent despite the huge market demand for it.

Right now, inventories are rising slightly for the first time this year. This is not due to an increase in the production rate but in a decrease in demand. As a direct result, futures prices are falling - which suggests, ironically, that the speculative futures market is working exactly the way it's supposed to and actually smoothing out the spot price of a barrel of oil. Without the speculators, prices would be even more volatile.

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By another capitalist (anonymous) | Posted August 09, 2008 at 11:44:45

Let's start a contest.

I say by the end of next spring oil will hit $90/barrel, the Cdn dollar will be $.86 against the U.S. dollar

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By David (anonymous) | Posted October 03, 2008 at 02:57:12

Despite all the bright people writing on the Web about these and similar concerns, Ryan always encapsulates the story better than anybody.

Matt Simmons says $100 oil is cheap because of what he knows about supply and demand. Prices falling below that is an indicator of economic slowdown. And this one is "the big one", folks. The ship has hit the sand. Books on edible nuts and berries are a good investment right now.

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