The big uncertainty about the future of the world economy is the price of oil. Opinions differ about what will happen next. The truth is that no one knows.

Looking at the fundamentals of any good and deciding what the price should be is impossible. The Soviet Union proved this to be true. They analysed the fundamentals for goods and decided what the price should be, but they always got it wrong. They set the price of bread to low, so there were always shortages and people had to queue. Other prices were set too high, producing a glut of goods that nobody wanted.

No person or organisation has sufficient knowledge to determine what the price of any good should be. The benefit of markets is that prices go up and down to ensure that supply matches demand.

There are several factors that make the price of oil particularly hard to forecast. Some are negative and others are positive. An economic model that can accurately assess and weigh all these factors together to determine the future price of oil does not exist.

The Bad News about Oil

  1. Oil production has slowed over the past few years. It is not clear if we are at peak oil, but there is no doubt that the easy oil has already been pumped.

  2. The North Sea fields operated by Norway and the UK are being depleted quickly.

  3. The Saudi Arabians do not allow any outsider to monitor their production or authenticate their reserves, so these may be much smaller than they claim. When the truth emerges, the world might be shocked.

  4. Nigeria has become an important oil producer, but the political situation in the oil producing regions is increasingly unstable. Oil workers have been kidnapped and oil pipelines have been destroyed.

  5. Iran is an important oil and gas producer. Any military action against Iran would disrupt Iranian oil production. Iran might retaliate by closing the Straits of Hormuz through which half of OPEC oil must pass. This would blow out the price of oil.

  6. Russia has immense reserves of oil in Siberia, but may not have the technical capability to extract and deliver this oil to market.

  7. Central Asia has large reserves of oil and gas, but transport is difficult and the political environment is unsettled.

  8. The United States has already pumped all of its cheap oil. Even if the law is changed to allow off-shore drilling, the new oil will be costly to extract.

  9. In the long term, demand for oil from China and India will be huge.

  10. The American suburban lifestyle cannot function without cheap gasoline. Americans may not be able to change their lifestyles sufficiently to bring about a permanent reduction in their dependence on oil. Whenever gasoline prices drop a little, they hit the hammer again.

  11. We cannot assume that the new energy technologies will arrive just when they are needed. There may be a lag before they are available.

The Good Oil News

  1. The United States is less dependent on oil than it was during the first Oil Shock in 1973, because much of the oil intensive manufacturing has moved to China.

  2. New pumping and drilling technologies allow more oil to be extracted more dead oil wells.

  3. Huge reserves of oil have been discovered in sand and shale deposits. Technologies to extract this oil have been developed and are becoming economic.

  4. Alternative fuels are being brought to the market.

  5. Technological advance means that existing supplies of oil are now used more efficiently.

Slow Change

The usual pattern for most goods and services is that prices rise and fall to clear the market. If demand increases, the prices rise and supply increases to meet the new demand. If demand declines, the price will fall slightly, causing the supply to fall.

If either the supply or demand for a good does respond quickly to small changes in price, big price changes may be needed to clear the market. This is the situation with oil. (Economists describe this as inelasticity with respect to price, but you can forget that if you are not an economist).

The main reason for sharp fluctuations in the price of oil is that production does not respond quickly to changes in price. Prospecting for oil is a hit and miss affair that takes time. Bringing a new oil field into production takes several years. When there is no spare capacity, an increase in price does not lead to increased supply, because producers cannot bring new fields into production.

The other reason is that most of the large oil fields in the world are owned by government authorities. Politicians often cannot reduce their spending, because they depend on handouts paid for by oil money to stay in power. When prices fall, state controlled oil companies do not cut production, because the politicians do not want to reduce their spending. The politicians do not respond to price signals, because they have a short-term focus that makes them unwilling to think further ahead than the next election, or the next coup.

The complexity of the production process and the complicity of the political process prevents oil supply from responding quickly to changes in price. This means that changes in demand can produce sharp fluctuations in price.

Speculation

Many commentators blame speculators for manipulating the price of oil, but his is not as easy as they think. There are three ways that speculators came make money from a commodity like oil.

  1. Speculators can buy shares in the companies that produce the commodity. This has happened with oil companies, but a change in share prices does not directly change the price of oil. The effect is more the other way.

  2. Speculators can invest in commodity futures, but future prices do not feed directly into current prices. Unless they close out the contract before the settlement date, the parties to a contract must settle on that date. If the market price has diverged from the contract price, one of the parties will make a loss. This means that the market price eventually dominates the futures price. Speculators may push the future price of oil up and down, but if they diverge to far from the price required to clear the market, they will eventually take a bath.

  3. The only way to speculate in a commodity with certainty is to buy and store it. This reduces supply while leaving demand unchanged, which should cause the current price to move up. Buying and storing is quite easy for many commodities. Gold coins can be purchased and stored in a vault or under the bed. Wheat can be purchased and stored in a silo. The problem with purchasing oil for speculation is that it is not that easy to store. Storing oil in a tank or a tanker, which is costly, so holding large volumes of oil for speculative purposes is not easy.

Be Prepared

In the longer term, the pressures on oil prices are mostly upwards. How fast and how far they will go up will depend on how quickly new supplies can be discovered and pumped and how quickly the world can reduce dependence on oil.

The West has developed a lifestyle, society and culture based on the automobile and cheap fuel. If oil prices were to rise dramatically, that lifestyle might become unviable, until new technologies emerge.

Christians should be thinking about this risk. How serious is it? What mitigations can we put in place? We should not bury our heads in the sand, but should be aware of the direction that the wind is blowing.

Christians have made the same commitment to an automobile-driven, suburban lifestyle. Much of our church life depends on automobile travel. We should be thinking about the risk for our church life and and make mitigation where possible.