Yep. You read it right.
Is this guy crazy – or what??
I mean – oil prices have been hitting records.
By this time next year, oil will have dropped well below $100 a barrel. Possibly as low as $80. In the following year it will likely sag even lower. Why? Because even though oil is a finite resource, the oil price escalation is a classic example of a speculative bubble – destined to burst. What’s more, the oil and energy fields – perhaps more than any other fields – have been characterized by boom and bust cycles for more than a century.
The potential impacts for responsible energy use and the environment are calamitous. Not only will people who predict $200-plus oil be viewed as kids who cry "Wolf!", a collapse in oil prices will also dramatically curtail research and development into alternatives much as happened in the 1980s.
So here’s the dope.
If the oil business has a history of speculative cycles and if the current oil price run-up has all the attributes of a speculative bubble, then what makes this event so very different from previous speculations in the oil business and speculation in general?
The Teapot Dome Scandal of the Harding administration in the 1920s is linked to one of the earliest warnings of oil running out. Fearing that the easy oil was running out just as the U.S. Navy was converting its ships from coal to oil, Congress created three huge Naval Oil Reserves in the 1910s. All of that oil proved irresistible to Harding administration officials who offered it to companies in no-bid contracts in return for private favors.
Image - Main Street, Kilgore, Texas - 1939
Public Domain, FSA/OWI Archives
All of that changed, of course, when "Dad" Joiner struck oil in East Texas in 1930 – the biggest oil find until Alaska. Massive overproduction of this field was not only wasteful, but also helped drive the price of oil down such that a barrel hit ten cents during the Great Depression.
Image - Abandoned Apartments, Jeffrey City, Wyoming
Dr. Phil Roberts, University of Wyoming
Out here in Wyoming there’s a saying about the "Boom and Bust" economy -
"Lord, just give me another boom and I promise not to piss it away."
You see, Wyoming has been through this more than once. In the late 1970s and early 1980s, there was a huge energy boom that was going to last forever. It didn’t. The modern-day ghost town of Jeffrey City is testament to the fact that the then-new paradigm wasn’t worth a pair of dimes.
Despite this roller coaster history in the energy field, many are talking about sky-high prices that will only go higher. Yes, oil is a finite resource. Yes, carbon emissions are a serious problem. And, yes, Americans are extremely wasteful when it comes to energy. But the facts suggest that rather than $200 oil, the price of oil is poised for a dramatic collapse, perhaps not as devastating as the 1980s collapse, but substantial nonetheless.
Here are three points to consider. First, on paper, the dizzying rise in oil prices looks like every other speculative bubble in the history of the markets. The obligation lies with those who say that oil prices are not speculative to show, convincingly, why this is different. Second, having witnessed two huge speculative bubbles in the past decade – the dot.com boom and the housing bubble – it seems likely that the current economic climate is speculation friendly. And third, the unique economics of energy markets tend to magnify short-term shortages while producing two delayed responses that intersect at the peak of prices – capital-intensive increased production and conservation or more efficient energy usage.
First, here’s a graph of the recent rise in oil prices –
Crude Oil Prices 1998 to 2008
And here’s a graph of the most famous speculative boom in American history,
The Great Bull Market of the 1920s – Dow Jones Index -
Dow Jones Index - 1920s
In the case of the 1920s stock run, the Dow Jones Index doubled between January 1923 and January 1928, then almost doubled again by late 1929. Also, after stalling in mid 1929, the stock market made a final surge to its peak. From mid 2003 to early 2007 oil prices doubled from $30 to $60 a barrel, then have more than doubled to $140 in mid 2008. There was also a dip in early 2007 followed by the current escalation.
So then, the oil price curve certainly looks like a bubble.
Oil may hit $150. Then again, it may not.
Second, although the jury may be out on whether oil prices are part of a speculative run-up, the American economy has been held captive to two major speculative bubbles in the past decade - the dot.com boom and the housing mortgage fiasco.
Here is a textbook picture of a speculative peak and collapse – Sun Microsystems.
Sun Microsystems - Stock Price for the Past Ten Years
Source - Scottrade.com
The price of Sun’s stock went from $13 to $260 and back to $13 between early 1997 and early 2003 – a twenty-fold increase and collapse. Note also, the last-gasp surge to the peak – characteristic of so many speculative patterns. Most people over thirty will remember the surreal numbers connected with dot.com initial public offerings (IPOs). Dot.coms like Pets.com lasted less than a year after their IPOs – burning through millions of dollars. And through it all were refrains that the tech boom was bringing an end to the business cycle. Right.
Just for fun, let's cut the graph off right at the top.
Just before the dot.com collapse.
Sun Microsystems - Stock Price Increase thru Autumn 2000
Source - Scottrade.com
And the Housing Bubble
The dot.com bubble was followed by the housing bubble. Were they linked? In important ways – since the Bush administration used absurdly low interest rates to mask the recessionary impact of the dot.com bust. The housing bubble was two-fold. As current owners refinanced at lower interest rates, many chose to upgrade their housing which heated up the housing market and escalated housing prices. Since realtors and the lending industry used monthly payments as the primary measuring tool, buyers found themselves being to buy far more house – at least initially – since prices rose accordingly.
U.S. Housing Prices - Nominal and Inflation Adjusted
But the other side of the coin was that the real estate and lending sectors had to keep bring in new buyers to keep the boom going after traditional buyers had already availed themselves of financial opportunities that low interest rates and refinancing offered. Thus the move to subprime and adjustable rate mortages (ARMs) for less qualified buyers.
So then, the oil price run-up has taken place within an overall economy characterized by massive speculation.
And third, rapid rises in energy prices produce a dual response. First, higher price tend to bring more energy into the market according to classic economic theory. However, most new energy production is not instantaneous. A few capped, unprofitable wells may be brought into production quickly, but tertiary recovery and nontraditional sources take a few years to enter the market. So there is a lag in response time.
The second response to higher price is reduced usage. This is twofold. On the one hand, businesses and individuals can simply drive less and turn the thermostat down. Such has taken place - with U.S. gasoline consumption dropping at least 3% in the past year. On the other hand, users can also switch to more energy efficient vehicles, equipment, and appliances. Again, this takes a number of years.
U.S. Gasoline Demand - 2007 and 2008 Comparison
And there's the rub.
Energy demand is relatively inelastic. A small shortfall can create the very real condition of not having heat for one's house or gas for the car. But if there is too much, there is, similarly, little market for the excess. The classic example is the construction of the Columbia Dams in the 1930s and 1940s. All of a sudden, Bonneville Power had more electricity than it knew what to do with. Not surprisingly, electric rates were rock-bottom and the aluminum smelting industry (which requires massive energy inputs) located in the Pacific Northwest.
Bonneville Dam on the Columbia River
U.S. Army Corps of Engineers Photo
The problem in the early 1980s was that the energy price run-up promoted increased production while it simultaneously led to reduced consumption. The two intersected in the early 1980s to produce a long-term collapse in prices. And while Saudi Arabia may have had the luxury of capping wells, smaller producer nations had become politically and economically reliant upon the higher revenues; thus, OPEC found it impossible to staunch the glut.
Similarly, the new production modes that had just come on line had massive capital costs to defray - again, creating unsustainable production pressures. Unfortunately, the 1980s energy collapse took with it most of the early research into solar, wind, and geothermal alternatives.
The 1980s Oil Spike
In addition, energy consumers had adopted long-term energy saving responses such as greater insulation of factories and homes, as well as more efficient machinery and appliances. Thus, energy consumption had been dramatically altered with no possibility of returning to the former consumption pattern. This took place on top of the overall reduction in economic activity resulted from sky-high energy prices.
So, is it happening again?
It sure looks likely. Oil prices are staggering at the $145 level. There may be one more spurt up to $150, maybe $160. But the high oil prices have produced a decided inflationary spike that has the potential to turn into a worldwide recession which would dramatically lower oil demand. Already, energy demand is declining.
And although conventional oil resources may have passed peak production, nonconventional sources such as the Athabasca Oil Sands are just coming into production. A case in point - production from the Athabasca Oil Sands now exceeds the production from the Cantarell Field, Mexico's largest oil field. It is indicative of the transformation in oil production that Canada now is in second place behind Saudia Arabia in provable oil reserves.
Although oil production from oil sands has a far great environmatnal and carbon footprint, it is profitable at anything about $40 a barrel. Is there anyone who would suggest that development of oil sands will not continue given the billions in corporate profits, millions in tax revenues, and thousands of jobs that will accrue? Not to mention the gasoline for Canadian and American drivers.
Thus, there are many reasons why this boom and bust cycle of oil prices is harmful to any long-term and rational approach to energy policy. Here are just a few likely results of $80 oil. First and most importantly, a dramatic decline in the price of oil will call into question most of the policy solutions advocated by those who forecast ever-increasing oil prices. It will lock in the fossil-fuel powers for the next generation. Second, in addition to the ideological shift, the drop in oil prices will devastate alternative energy production. Since all forms of energy production have high front end capital demands, the newer alternatives will be bankrupted and cast aside - much as they were in the early 1980s. And third, like the proverbial frog in the cooking pot, Americans will be delighted to have $2.85 a gallon gasoline. Many will quickly forget the fundamental questions of unsustainable energy consumption in the world.
Thus, this diary is far more than a warning about futures and/or options trading in oil. It is about moving the future of sustainable energy policy away from extreme fluctuations in oil prices - whether they are caused by speculation, structural bottlenecks, or classical economics. A sane energy policy cannot be based on $200 oil, because if oil fails to reach $200 we will revert to the insanity that has dominated our energy policy for the past half-century.