Why $140-a-barrel oil is no surprise

It took awhile, but the market finally realized there's only so much of that black gold to go around.

Published June 26, 2008 9:05PM (EDT)

A reader observed in an e-mail this morning that for him, and a lot of the people he has talked to recently, the sharp rise in the price of oil and gas over the past year seemed to have come out of nowhere, out of the blue. Why now, he wondered? What triggered this sudden upsetting of the apple cart?

It's a sentiment I encounter frequently in the HTWW comments section from people who are (usually angrily) reacting to my posts on energy issues. If the law of global supply and demand is the true determining factor in the cost of oil, then why has the price more than doubled in just the last year? What's changed?

It's not just the hoi polloi who are suspicious. Economist Arnold Kling, who believes speculation must be part of the explanation, posed a variation of this exact question to economist Paul Krugman, who is convinced speculation isn't the culprit. If "fundamentals" justify the current cost of oil, then why was the price so low last year? Global economic growth certainly didn't double in the same time frame. Quite the contrary: It slowed down.

Let me preface my attempt to take a stab at this by acknowledging that I really don't know how much speculation has to do with the current price of oil -- and judging by the vigor with which the question is currently being debated by economists and politicians, I don't think anybody knows. I also would not be surprised in the least if declining global demand for oil, brought on by high prices, results in a sudden dramatic plunge. I would argue that any such plunge would likely be temporary, but I wouldn't dream of suggesting that such a thing would be impossible.

The first point that I think needs stressing is that oil and gas prices have been on a sustained upward trajectory for years. A gallon of unleaded regular was $1.55 in November 2000, and has more or less risen steadily ever since -- people were making a big fuss about $2.00 a gallon oil in 2004! The price of oil in 2000 was about 25 bucks a barrel, and it too, obviously, has risen relentlessly. Remember, in 2000, $60 dollar a barrel an oil would have seemed sky-high! Now it seems cheap. So what we are currently experiencing isn't a sudden break from past trends, but the rapid acceleration of a trend already well in place.

And as mighty as that acceleration might be, and as much as I wince, like everyone else, each time I have to visit a filling station, deep down, oddly enough, I just don't find myself that shocked. It seems to me that oil should be expensive. Perhaps I feel this way because my ecological consciousness was formed as a kid in the 1970s, when the first serious discussion of resource constraints began to permeate society. The belief that we would ultimately be forced to reckon with the planet's limited stocks of oil latched hold of me and never let go. I was more startled when the price of oil dropped below $10 a barrel in 1986 than I am by its rise all the way up to $140. Oh sure, I understood the price mechanics of how it happened: how the oil shocks of 1970s encouraged the rapid development of new oil fields that weren't controlled by OPEC, with a consequent undercutting of the cartel's pricing power. But it always seemed bound to be a short-term solution. Oil wells eventually run dry. Oil -- the lifeblood of the global economy, of modern agriculture and industry and transportation -- was thus inherently precious.

Here's one way to think about what's currently happening. As has been well-documented, the historical response to high oil prices has been an increase in production.

Until now.

And by that I don't mean just with respect to the most recent price surge. Six months or a year is too short a time period to bring significant new sources of oil production online. I'm referring to the long-term run-up of demand and price over the last eight years. Broadly speaking, growth in supply has more or less plateaued even as demand has continued to rise.

Perhaps we're just stuck in a transitional period before a slew of new oil production comes online, in Saudi Arabia and elsewhere (even, eventually, in ANWR and off the coast of California and Florida). But as I noted in my last post it's getting harder and harder just to replace the declining oil production of aging oil fields, and the newer sources of oil are generally more expensive to develop than the older ones. So we're replacing cheap, abundant oil with expensive, harder-to-find oil. That's a recipe for a sustained price rise.

It's also the basic premise of "peak oil" -- a theory much mocked by right-wingers who trust in the market to provide, but now also attacked from the left by those who are convinced that the real villain isn't limited resources but greedy traders.

Try this thought experiment on for size. What do you think would happen to global oil markets if a critical mass of the people buying and selling oil became convinced that yes, whaddya know, there are fundamental constraints on how much cheap oil can be pumped out of the planet and burned?

Wouldn't that realization, in and of itself, contribute to a dramatic change in market psychology? I submit that a possible explanation for the dramatic events of the past year is that a tipping point has been reached. Enough people now believe that the era of cheap oil is over to ensure a significant, and ongoing, adjustment upward in the real price. Modern civilization as we know it is dependent on cheap oil, and cheap oil is becoming scarce. Voilà -- time to panic. And a bit of a self-fulfilling prophecy dynamic kicks in. The higher the price of oil goes without encouraging dramatic increases in production, the more worried the market gets.

This thesis is only strengthened by the reality of what's happening in the world's emerging economies. I wonder if some of the Americans currently furious at speculators understand deep down the significance of the economic growth occurring in China and India. The Associated Press reported today that China has added 44 million mobile phone accounts since the beginning of this year, bringing the total number of such accounts in China to well over half a billion. Almost twice as many Chinese have mobile phones as there are American citizens. India is experiencing a similarly torrid growth rate. Not every mobile phone user in China or India drives an SUV or runs the air conditioner full blast, of course, but symbolically, that dramatic expansion of state-of-the-art connectivity is enough to tell us exactly what is going on -- we are witnessing a vast, globally distributed increase in the number of people with access to the means to consume petroleum-based resources. When economies that are already the size of China and India continue to grow at rates of 9 or 10 percent a year, extrapolations into the very near future become daunting. We can't possibly pump enough oil to slake China's thirst if it continues to grow at its current rate. Something's got to give -- and the most obvious weak point is the price of oil.

From that perspective, what's surprising is not that oil costs $140 a barrel, but how long it took for us to get to that point.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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China Globalization How The World Works India Peak Oil