The Paradox of Oil: The Cheaper it Is, the More it Costs

I’ve just published a new Simplicity Institute Report, ‘The Paradox of Oil: The Cheaper it Is, the More it Costs’. I’ve posted the introduction below and the full paper is available here.

There will be oil, but at what price? – Chris Nelder and Gregor Macdonald


1. Introduction

It would be fair to say that the timing of the sudden drop in the price of oil since June 2014 took energy and financial analysts by surprise. After averaging around US$110 per barrel since 2011 (IEA, 2013: 6), suggesting a ‘new normal’, the last six months have seen the price of oil fall to around US$50 per barrel (as of February 2015). But although the timing of this price drop was not forecast by analysts with any precision, there are economic, geological, and geopolitical dynamics at play in light of which the price volatility we are seeing is not actually that surprising.

In my article ‘The New Economics of Oil’ (Alexander, 2014) – published a few months prior to the fall in price – I explained why expensive oil has a stagnating effect on oil-dependent economies, which I argued could lead to a drop in oil demand and thus a sharp fall in price. I also explained why expensive oil can incentivise greater investment in production while dis-incentivising consumption, a dynamic that can increase oil production faster than demand and thereby generate short-term oil gluts that can also lead to price volatility, only via a different route. Both of these dynamics go a long way to explaining the current state of oil markets. While the exact timing of the current fall in prices may have come as a surprise to everyone, including me, the phenomenon itself is quite comprehensible when one recognises the intimate connection between energy (especially oil) and economics. As we will see, the ever-present influence of geopolitics is shaping oil markets too.

What is so frustrating about the state of much oil commentary today is the tendency for analysts to focus on the immediate or short-term situation, often from a purely financial/economic perspective, neglecting the larger social, political, and environmental contexts in which oil markets unfold. When those larger contexts are given due attention, it becomes clear that oil is a commodity that defies reductive analysis and which cannot be understood unless one looks through a multi-dimensional, interdisciplinary lens.

In this article I outline and analyse various explanations for why the price of oil has fallen so dramatically in recent months and present some considered but tentative hypotheses about what we can expect from the oil markets in coming years. I also hope to challenge the naive conclusion – drawn all-too-hastily in the mainstream media – that the drop in price somehow debunks the analytical framework of the ‘peak oil’ school (see, e.g., Sakya, 2015). Although it may sound counter-intuitive, cheap oil is actually a complicated function or symptom of peak oil dynamics, and far from solving oil problems, the drop in price is merely creating new problems of equal or greater weight, in ways that will be explained. Those who claim that the effects of cheap oil are ‘clearly positive’ are at best being simplistic and are at worst just plain wrong (see, e.g., The Economist, 2014a).

The main conclusion defended below is that so-called ‘cheap oil’ (at ~$50 per barrel) is just as problematic as expensive oil (at $100+ per barrel), but for very different social, political, economic, and environmental reasons. Just as expensive oil suffocates industrial economies that are dependent on cheap energy inputs to function, cheap oil merely propagates and further entrenches the existing order of global capitalism that is in the process of growing itself to death (Turner, 2014). The fall in prices also undermines the oil industry by scaring off capital investment in an age when the costs of establishing and drilling new fields is relentlessly on the rise (Kopits, 2014), due to declining energy returns on investment (Murphy, 2014). Cheap oil therefore is likely to retard mid-to-long term production, setting the scene for a foreseeable mid-range supply crunch that will soon enough push prices back up (see Kent and Faucon, 2015; Mushalik, 2015a).

Accordingly, we should not be fooled by this current period of depressed prices. As the world continues to replace the easy ‘conventional’ oil with ever-more marginal ‘unconventional’ oils (e.g. deepwater, shale oil, tar sands, etc.) and alternative ‘biofuels’, the laws of physics will forever be putting upward pressure on production costs. So despite currently depressed prices, it remains true to say that we live in an age of expensive oil, a position that might seem contradictory if interpreted superficially but which is actually accurate when interpreted in geological context: the low-hanging fruit is gone. The only way oil will remain cheap over the long term is if our economies are doing so poorly from a conventional growth perspective that we cannot afford for oil to be any more expensive, making oil demand weak and keeping prices deflated (see Meijer, 2014a).

Looking at the current situation from a different angle, cheap oil also makes renewable energy alternatives less ‘cost competitive’, which will have disastrous ramifications on climate change mitigation by dis-incentivising the necessary transition beyond fossil fuels at a critical time. This ecological issue is typically overlooked by those oil analysts who are blinded by the apparent, short-term economic benefits of cheaper oil. Herein lies the paradox of oil: the cheaper it is (economically), the more it costs (environmentally).

For these types of reasons I will argue that there is no ‘optimal’ price for oil in much the same way as there is no ‘optimal’ price for heroin. This analogy between oil and heroin may appear like a polemical exaggeration, but I hope to show that it is, in fact, worryingly apt. When heroin is expensive, addicts cannot afford what they desperately need, or feel they need, and suffer accordingly. Expenditure on more worthwhile things is cut back in order to fund the increasingly expensive and debilitating addiction. But when heroin is cheap and readily available, the negative effects of addiction become even more pronounced through overconsumption, and the addiction only deepens as hopes of rehabilitation fade. Oil acts as industrial civilisation’s own form of heroin, and whether it is cheap or expensive, addicts today are in as much trouble as ever.

The full paper is available here.

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