What is to be made of the dramatic, 18-month run-up of oil prices? Despite the political Sturm und Drang, the oil price spiral is not that hard to understand.
After hitting a modern low of $10 a barrel in 1998, demand started back up again as Asia recovered from its financial crisis and the European economy staggered forward. Supply was further constrained in March 1999, when OPEC production cutbacks were announced as a matter of economic survival. The "Big Three" non-OPEC producers — Mexico, Norway, and Russia — jettisoned their long-standing policy of maximizing production at OPEC's expense and made a non-aggression pact with their competitors in the cartel.
Oil companies were in no position to increase production, because — after hemorrhaging billions during the glut — exploration, development, and production budgets had been slashed. It takes time to reverse course, and when prices began to climb again, oil companies feared that the price recovery was only temporary. Only now are companies taking prices seriously and putting money back into production. But with inventories low and refinery capacity stretched to the limit, there won't be any break in price soon without significant change in OPEC policy.
That's the story. Now, let's dispel some fears.
First, the belief that the oil fields are running dry is nonsense. Proven reserves (that is, oil that can tapped and marketed today at a profit) are 15 times larger today than they were in 1948. Moreover, given present consumption levels, the Energy Information Administration reports that oil fields could last another 230 years before running dry and that unconventional petroleum sources (tar sands, shale, and the like) could meet present demands for an additional 580 years.
The key, however, is price. When prices are low, a lot of that oil will remain in the ground. With prices at today's level, that oil becomes highly profitable to bring to market. It takes time, but once the industry is convinced that high prices aren't some sort of mirage, that oil will flood the market.
Are these prices a mirage? Well, they're real enough, but they don't reflect underlying realities about the availability of oil. Although the Saudis are producing 8 million barrels a day at a cost of $1.50 a barrel, they were churning out 10 million barrels a day during the Gulf War and have the capacity to go as high as 16 million barrels a day if they wished, at no increase in marginal cost. While it's true that the rest of OPEC is producing at near capacity, OPEC is less a cartel than it is one dominant market leader — Saudi Arabia--and a collection of moderately influential followers.
Non-OPEC producers thus face a difficult dilemma. The Saudis are clearly capable of flooding the market at a moment's notice, driving prices back down and making investments today unprofitable tomorrow. To invest or not to invest is really to bet on Saudi production behavior. Up until now, most non-OPEC producers believed that the Saudis were simply engaged in the economic equivalent of a drive-by shooting of oil consumers, an undertaking made easier by the exogenous developments in the global economy over the last few years.
The same dilemma is faced by consumers. As most any environmental activist will tell you, we have a tremendous cupboard of energy-efficient technologies and alternative-energy sources that have been gathering dust because, with energy cheaper than water, it made little sense to invest in them. If prices remain high, America can, over the long run, shift away from oil consumption far more quickly — and far more dramatically — than it could in the 1970s. While demand for oil is inelastic in the short run, every energy economist knows that it's quite elastic in the long run.
All this means that the Saudis — and therefore OPEC — can't maintain these prices forever. Too much slack capacity exists in the system. The trick for the Saudis is to extract what economic rents they can without inducing major increases in non-OPEC supply or long-term investments in energy efficiency. Either the Saudis will break the price bubble, or non-OPEC suppliers will do it for them — as was the case in the great price collapse of 1986.
In the meantime, don't worry about another oil-induced recession. Adjusting for inflation, oil prices in 1973 stood at $90 a barrel. So we've got a long ways to go before prices approach those of the 1970s in real terms. Moreover, the economy is far less vulnerable to oil-price shocks today. Whereas 9 percent of the GDP was spent on oil in the 1970s, only 3 percent is so spent today. Oil prices are simply unable to wreak the amount of havoc in today's economy that they could in the economy of 20 years ago.
In the final analysis, there's nothing that government can do about the underlying realities of the world oil market. Subsidies to domestic producers are incapable of significantly diminishing Saudi Arabia's market power, no matter what you hear from oil-state politicians. As long as oil costs $1.50 to produce in the Persian Gulf and $7 to produce elsewhere, OPEC's going to have plenty of short-term market power to periodically hold up consumers if that's their wish. Moreover, no amount of "get tough" rhetoric or "pretty please" diplomacy has ever affected OPEC production decisions, despite what American politicians would have you believe. Finally, "energy independence" is no answer: Even if the U.S. imported zero oil from the Gulf, domestic crude would rise to the international market price because oil is a global commodity.
If government must do something, it could open up the otherwise useless Strategic Petroleum Reserve for domestic consumption. Energy economist Phil Verleger argues that using our "rainy day" oil fund to combat periodic OPEC price-gouging operations is the only sensible use of the SPR, and he's right. Tapping the SPR could bring prices down $10 a barrel or more almost overnight. If the Saudis are intent on using their short-term market power to periodically hold up American consumers (a power that God gave them by putting those dirt-cheap reserves under their sand), then using the reserve to buy oil when it's cheap and sell oil when it's high makes eminent sense. Moreover, it will discourage future price-gouging episodes by taking some of the profit out of them.
Otherwise, politicians should stay out of the market's way.