Why Oil Prices Can’t Bounce Very High; Expect Deflation Instead

Economists have given us a model of how prices and quantities of goods are supposed to interact.

Figure 1. From Wikipedia: The price P of a product is determined by a balance between production at each price (supply S) and the desires of those with purchasing power at each price (demand D). The diagram shows a positive shift in demand from D1 to D2, resulting in an increase in price (P) and quantity sold (Q) of the product.

Unfortunately, this model is woefully inadequate. It sort of works, until it doesn’t. If there is too little of a product, higher prices and substitutions are supposed to fix the problem. If there is too much, prices are supposed to fall, causing the higher-priced producers to drop out of the system.

This model doesn’t work with oil. If prices drop, as they have done since mid-2014, businesses don’t drop out. They often try to pump more. The plan is to try to make up for inadequate prices by increasing the volume of extraction. Of course, this doesn’t fix the problem. The hidden assumption is, of course, that eventually oil prices will again rise. When this happens, the expectation is that oil businesses will be able to make adequate profits. It is hoped that the system can again continue as in the past, perhaps at a lower volume of oil extraction, but with higher oil prices.

I doubt that this is what really will happen. Let me explain some of the issues involved.

[1] The economy is really a much more interlinked system than Figure 1 makes it appear.

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Why “supply and demand” doesn’t work for oil

The traditional understanding of supply and demand works in some limited cases–will a manufacturer make red dresses or blue dresses? The manufacturer’s choice doesn’t make much difference to the economic system as a whole, except perhaps in the amount of red and blue dye sold, so it is easy to accommodate.

Figure 1. From Wikipedia: The price P of a product is determined by a balance between production at each price (supply S) and the desires of those with purchasing power at each price (demand D). The diagram shows a positive shift in demand from D1 to D2, resulting in an increase in price (P) and quantity sold (Q) of the product.

Figure 1. From Wikipedia: The price P of a product is determined by a balance between production at each price (supply S) and the desires of those with purchasing power at each price (demand D). The diagram shows a positive shift in demand from D1 to D2, resulting in an increase in price (P) and quantity sold (Q) of the product.

A gradual switch in consumer preferences from beef to chicken is also fairly easy to accommodate within the system, as more chicken producers are added and the number of beef producers is reduced. The transition is generally helped by the fact that it takes fewer resources to produce a pound of chicken meat than a pound of beef, so that the spendable income of consumers tends to go farther. Thus, while supply and demand are not independent in this example, a rising percentage of chicken consumption tends to be helpful in increasing the “quantity demanded,” because chicken is more affordable than beef. The lack of independence between supply and demand is in the “helpful” direction. It would be different if chicken were a lot more expensive to produce than beef. Then the quantity demanded would tend to decrease as the shift was increasingly made, putting a fairly quick end to the transition to the higher-priced substitute.

A gradual switch to higher-cost energy products, in a sense, works in the opposite direction to a switch from beef to chicken. Instead of taking fewer resources, it takes more resources, because we extracted the cheapest-to-extract energy products first. It takes more and more humans working in these industries to produce a given number of barrels of oil equivalent, or Btus of energy. The workers are becoming less efficient, but not because of any fault of their own. It is really the processes that are being used that are becoming less efficient–deeper wells, locations in the Arctic and other inhospitable climates, use of new procedures like hydraulic fracturing, use of chemicals for extraction that wouldn’t have been used in the past. The workers may be becoming more efficient at drilling one foot of pipe used for extraction; the problem is that so many more feet need to be drilled for extraction to take place. In addition, so many other steps need to take place that the overall process is becoming less efficient. The return on any kind of investment (human labor, US dollars of investment, steel invested, energy invested) is falling. Continue reading

Why US natural gas prices are so low – Are changes needed?

US natural gas prices are at record lows–about where they were in 1976, and at the low points in the 1990s, in today’s dollars (Figure 1).

Figure 1. US wellhead natural gas prices based on EIA data, adjusted to January 2012 price levels using US CPI All Urban Price data.

There are several reasons why US natural gas prices are so low:

  • Our pricing system is based on short-term supply and demand, and storage facilities are limited. It is very easy for supply to overwhelm the system, and prices to drop very low in response, if there is a mismatch.
  • US demand for natural gas has been fairly flat for the last 10 years, regardless of price. Of the four major uses for natural gas ((1)residential heating, hot water, and cooking;  (2)commercial heating, hot water, and cooking; (3) industrial demand; and (4) electricity), only electrical use has been growing.
  • Supply does not drop very quickly, even if prices fall, because producers need to continue to extract natural gas in order to repay loans and to comply with use-it-or-lose-it lease terms.

Besides variability, there are a number of other problems with depending on short-term supply and demand for pricing:

  • Today’s prices appear to be far below the cost of production for some providers, leading to the likelihood of a shakeout.
  • Unless price levels are higher and more stable, it is not clear that natural gas supply will grow over the next 10 or 20 years, making long-term investment in new uses (for example, vehicular use, gas-to-liquids, and pipelines to underserved areas) questionable.
  • Natural gas prices in the US are much lower than prices elsewhere in the world (Figure 2, below). This means that there is likely to be strong demand for US exports of natural gas, most likely as Liquefied Natural Gas (LNG), competing with internal US uses.

Figure 2. Natural gas prices in the United States, Europe, and Japan, based on World Bank Commodity Price Data (pink sheet)

Ramping up natural gas production is now very much of interest, even if new sources of demand are not available, because

  • Oil prices are high and some believe that natural gas can act as a substitute, and
  • Natural gas seems to produce less CO2 than coal or oil.

It is not clear that the current natural gas pricing approach is up to handling this mismatch between supply and demand.  In many ways, natural gas is a drill-it-as-you-need-it product, and our current market free-for-all does not recognize this.

Perhaps we should be considering a different method of regulating natural gas, since in many ways natural gas is essential. It is needed for balancing wind and solar PV, and for allowing us to continue to continue to heat our homes and businesses with natural gas. In the early days of gas, gas was regulated to produce a reasonable rate of return for providers. Perhaps something closer to this approach needs to be used again today.

If price is regulated, the amount to be drilled would need to be regulated as well, probably on a month-to-month basis. Higher prices would probably be needed under the new system to provide funds for more storage and for maintenance of pipelines, and to assure that US needs could compete with demand for LNG from overseas markets. I am doubtful that such a method of regulation would be feasible or would be politically acceptable, however.

In this post, I will explain these issues further.
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