Editore"s Note
Tilting at Windmills

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April 13, 2005
By: Kevin Drum

$50/BARREL OIL....Yesterday Matt Yglesias mused out loud about high oil prices:

I understand clearly why individual purchasers are displeased to see their gas bills high (and don't get me started about the heating oil this past winter) but in broader economic terms it's hard to see the looming crisis here....Are these high prices really something that should be an independent source of economic concern? I don't see it.

This is worth a bit of countermusing, I think. The problem here is not high oil prices per se, it's the reason behind the high oil prices.

In a nutshell, global demand for oil is about 82 million barrels/day. Total global capacity to pump oil is about 84 mbd. Since demand has historically increased pretty steadily at the rate of 2 mbd per year, that means we're now close to maxing out global capacity.

Of course, there are alternatives. There's biomass and oil sands and oil from coal. There's ANWR and the South China Sea. And it's true that these are all things that have the potential to increase our supply of oil. Unfortunately, all of them take time to develop anywhere from a few years to a few decades and in the near and medium term we know what fields are available, what technology is available, and what infrastructure is available. And the answer is: enough to pump about 84 mbd, with only a small upside.

This has a couple of effects. First, since a lot of people still don't really believe this, it means a sudden spike in prices is pretty likely once the reality finally sets in and people begin to panic. A price increase from $50/barrel to $100/barrel over the course of three or four years isn't a big deal. That same increase over the course of three or four months is a recipe for global recession.

Second, and perhaps more important, it makes the oil market enormously volatile. Any kind of sustained interruption would have grave consequences.

For example, OPEC has the capacity to supply about 30 mbd. Question: what incentive do they have to continue pumping this amount? Economically, they have very little. If they cut production by 20% (6 mbd), that would reduce global supply to 78 mbd. Prices would immediately double to around $100/barrel, maybe even higher, since there would be no other source to make up the shortfall. As a result, OPEC's revenues would skyrocket not all at once, since most oil is delivered under futures contracts, but soon enough. In addition, most Middle Eastern fields are being overproduced right now, so cutting production would have beneficial long-term effects as well.

So why not do it? In the past, it was partly because Saudi Arabia kept the rest of the cartel in line by threatening to increase its pumping capacity to make up any shortfall. But Saudi Arabia no longer has much spare capacity left, and the Iranians and Venezuelans might decide someday that they don't care all that much about a global recession in the west. They'd rather have the money.

But even if OPEC decides not to take the risk of cutting production, perhaps out of fear of an American military response, it might happen anyway. A serious terrorist attack on a large field could have the same effect. Or political unrest in an oil rich but unstable country. Or something we haven't thought about yet. Take your pick.

Bottom line: the oil shocks of 1973 and 1979 were artificial and could be overcome fairly quickly. Even at that, though, they had serious effects. Conversely, an oil shock today would be based on hard production limits. The minimum result for the United States would be a further ballooning of the trade deficit, a sharp increase in interest rates, and a serious recession. The maximum result would be war.

So yes, it's true that oil at $50/barrel is not itself a big problem. At the same time, it's a symptom of a very big problem indeed. It's worth keeping your eyes on.

Kevin Drum 5:48 PM Permalink | Trackbacks

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