Lower oil prices ain't gonna happen... and that's not all bad

The price of oil soared this spring and earlier this summer. Remember that? Investors, journalists, and politicians were all sounding the doomsday whistle, and not a day went by without hearing some previous unthinkable news: Goldman Sachs says $200 oil is possible. For the first time ever, investors bet that oil would reach $300 by December. On July 11th, the price reached the dizzying heights of $147.25 per barrel. Then it suddenly lost steam and began to fall faster than it had risen. The price has settled for the time being in the $110-$120 range.

People who tend to believe that the spike in oil prices was the fault of speculative traders could be forgiven for thinking that the markets will continue to correct themselves and that prices will settle at even lower equilibrium, perhaps under $100. Unfortunately for consumers, this just isn't going to happen. You've heard it before, but it's true: the era of cheap oil is over. Markets, and especially long-term market pricing, are driven by supply/demand fundamentals, which don't look good for oil (unless you happen to work for Exxon, and if so can you please get me a job???) Supply capacity is strained, and demand is surging thanks to economic development in the non-Western world. We all know this part of the story.

Perhaps less obvious, bringing significant new amounts of oil to market is challenging. You can't think of oil reserves as an absolute number: you have to consider which sources of oil are 'economically recoverable'. This basically means whether or not the profit you make selling the oil is higher than your operating costs of pumping it. The really easy sources of oil to pump (say, the desert sands of Saudi Arabia) are going at near full capacity. The moderately-difficult sources of oil to get are also mostly tapped, and you increasingly have a scenario where you're looking at pumping oil in very inhosipitable places. Think oil sands in Alberta and deep offshore drilling. This kind of production ain't cheap, and the higher costs are built into the price consumers pay. According to CNN (although I can't independently verify this), the head of exploration for Conoco Phillips says that they need a long-term base price of about $100/barrel to make future investments profitable. Because of these higher production costs and the supply/demand fundamentals, I'm quite skeptical that we'll ever see oil again at less than $100/barrel for any extended period of time.

It's also important to remember that oil markets are probably more volatile than they've ever been, so large price swings in a very wide band are likely to be the norm. And for what it's worth, a number of analysts I trust think oil prices are currently sitting near the low end of that band. Don't be surprised if the markets resemble a roller coaster for the foreseeable future.

But there is an upside to high oil prices. It is the only way that large industrialized countries will ever seriously invest in alternative fuel technologies and actually sustain that investment. Necessity in the mother of all invention. Plus, oil prices closely track expectations about the economy: the main reason they collapsed in the last month was that markets perceived that the prices would be too high for struggling economies such as the US to afford. If prices continue to retreat right now, a large reason for that is weakened demand, which suggest the economy is struggling even more. At best, lower oil prices would be bittersweet.