Despite their cynicism about politicians, most people actually believe that mineral resources, including oil, are doomed to disappear. It’s obvious: Start with a given stock of provisions in the cupboard, subtract consumption and eventually the cupboard will be bare.
But what is obvious is often wrong. We never run out of minerals. At some point it just costs too much to produce them profitably. In the 19th century the big energy scare was in Europe. Most thought Europe was running out of coal. That doomsday scenario never materialized. Thanks to a plethora of substitutes, the prices that European coal could fetch today are far below its development and extraction costs. Consequently, Europe sits on top of billions of tons of worthless coal.
Once economics enters the picture, the notion of fixed reserves becomes meaningless. Reserves are not fixed. Proven oil reserves, for example, represent a warehouse inventory of the expected cumulative profitable output, not a fixed stock of oil thought to be in the ground.
When thinking about oil reserves, we must also acknowledge another economic reality: Oil is sold in a world market in which every barrel, regardless of its source, competes with every other barrel. Think globally, not locally. When we do, the dwindling reserves dogma becomes nonsense. In 1971 the world’s proven oil reserves were 612 billion barrels. Since then the world has produced 767 billion barrels. We should have run out of reserves five years ago, but we didn’t. In fact, today’s proven reserves are 1,028 billion barrels, or 416 billion barrels more than in 1971.
How could this be? Thanks to improved exploration and development techniques, costs have declined, investments have been made and reserves have been created. The sky is not falling.
If oil reserves aren’t the problem, what is? The real problem is our oil policies. We inadvertently give aid and succor to OPEC, the world’s clumsy oil cartel. That has been especially true since Nov. 13, 2001, when President George W. Bush announced that the U.S. would fill the Strategic Petroleum Reserve to capacity. Mightn’t this plan have a little something to do with the rise in the price of oil, from $22 then to $40 now?
The economics of crude oil inventories provides the key to unlocking this mystery. The net cost of carrying inventories is equal to the interest rate, plus the cost of physical storage, minus the “convenience yield.” The convenience yield is driven by the precautionary demand for the storage. When the convenience yield is zero, a market is in “full carry,” future prices exceed spot prices and inventories are abundant. Alternatively, when the precautionary demand for oil is high, spot prices are strong and exceed future prices, and inventories are unusually low.
When the President ordered the reserve to be filled, the spot and future oil prices were in rough balance. Since then the spot prices shot up and have exceeded future prices (until recently) by a wide margin, indicating scarce private inventories. Indeed, private oil inventories fell to a 29-year low on Jan. 23, 2004.
The oil price run-up and scarcity of private inventories can be laid squarely at the White House’s door. Since Nov. 13, 2001 private companies have been forced to compete for inventories with the government. Fortunately, it appears that, barring “events,” the oil price surge has run its course. Spot and future prices are once again in rough balance, and private inventories are up by 14.9% over their January lows.
The pain of higher oil prices could have easily been avoided if George W. Bush had followed his father’s lead. On Jan. 16, 1991, the day the first Gulf war began, George H.W. Bush ordered a drawdown of the government’s reserve. The results were dramatic: The spot price of oil fell from $32.25 per barrel to $21.48 in one day. More important, the positive spread between spot and four-month future prices also fell, from $5.90 per barrel to $1.65, indicating a higher comfort level with the adequacy of private inventories.
The lesson is clear: We have an oil weapon, too. The strategic reserve should be used to bloody OPEC’s nose, not to prop up a cartel.