Lower oil prices make me nervous

I try to avoid making hard predictions on this blog, but regular readers know that I’ve recently made two high profile picks. I’ve argued more than once that political-economic fundamentals suggest that Barack Obama will win the Presidential Election in November handily. Admittedly, that’s looking a bit dicey at the moment, but I’ll still be astonished if Mr. Obama somehow manages to snatch defeat from the jaws of victory in the most favorable electoral climate in almost three decades. I will also petition that the Democratic Party disband and its leaders seek gainful employment in a completely different line of work. Further, I’ve argued that the new baseline for oil prices will be $100/barrel. In recent days, however, oil has crossed the Rubicon and is currently trading around $96. Does that mean I’m wrong?

It’s too early to say definitively, though I don’t think so. But there’s a larger problem: it could very well be a bad thing if oil prices continue to slip.

It is a fact that the global economy runs on oil. It is also true that right now there exists no substitute that could completely replace oil. Therefore, if the global economy continues to grow, which most people agree is a good thing, it also means that oil consumption will continue to grow, which most people agree is a bad thing. But without a substitute, the world will need more oil. 37.5 million extra barrels a day, to be exact, according to the International Energy Agency. That’s on top of about 85 million barrels consumed each day currently.

Without a substitute or sustained economic recession, that oil needs to come from somewhere. The problem, as I’ve mentioned, is that most of the ‘easy’ oil is already being pumped. In a fascinating article today, RI notes that most of the oil majors are pricing new investment projects at a cost of about $70/barrel, which they would like to sell at market for $100/barrel. Simply put, if the price of oil continues to fall, it is likely that they will delay these new investment projects, which could lead to a major supply gap in the future. Rather than a gradual rise in oil prices, we might see a disruptive spike.

Conversely, it is clear that in the face of accelerating climate change and higher energy prices, the world needs to develop renewable energy sources. Say what you will about Tom Friedman, he’s an ideas man and his new book looks like it highlights what will be one of the major political economy challenges of the coming era (n.b. I haven’t yet read it). However, as I’ve also mentioned, declining oil prices likely reduce the impetus for investment in alternative energies.

Understandably, oil companies want to keep selling oil for as long as possible. It’s what they know, it’s what they’re good at, and it’s extremely profitable. In Congressional testimony last week, the President of M.I.T. noted that oil companies invest less than 0.25% of their revenue in R&D, compared with 18% for pharmaceutical companies and 16% for semiconductor firms.

But this is ultimately unsustainable. Anyone interested in developing an energy substitute in a timely fashion must first acknowledge that the era of cheap oil is over. In my opinion, any prolonged forays below $100/barrel are just delaying the inevitable hangover, and very likely making it worse.

(Incredible picture by nzdave)