WHY, BUT NOT WHEN, OIL PRICES MAY FALL. BUT FIRST A POLEMIC AND THE OBLIGATORY HARD LESSONS

Today is the 232nd Anniversary of American Independence. Independence is a word that is frequently bandied about in the context of “energy independence”. It is a canard, a glittering generality that is trotted out to deflect attention from real remedies to gluttonous and profligate American energy consumption.

“Energy Independence” contains scents of American Exceptionalism, Nativism and “good old” American Know-How and Yankee Ingenuity. The two former are delusional, the later two traits perhaps not enough.

GOT A LIGHT?

The world still lives by the campfire. Most of the energy produced is the result of the combustion of carbon. For hundreds of thousands of years the source of combustion was sticks and logs. Trees, the most available resource, were burned for warmth and later the smelting of metals and other productive uses.

But while humans were chopping wood above ground, a neater trick was going on below ground. Hundreds of millions of year’s worth of trees, plants and carcasses were being condensed and processed into coal, natural gas and oil.

Humans began using these sources in earnest when the Industrial Revolution began in the 1830s. First coal. Later, around the beginning of the 20th century, oil. In massive quantities with a slakeless thirst.

SO MUCH ENERGY. SO LITTLE TIME.

How much longer will the campfire keep burning? Oil? Another 30 years? Another 50 years? Another 100 maybe?

When will coal run out? Are 100 years left? 200? 500?

Half a billion years, perhaps more, went into the production of coal, natural gas and oil. 500,000,000 years. How many years have and will go into the extraction and depletion of these resources? 200? 300? 500? Maybe a 1000?

And how many human generations feasted upon the extraction and depletion of these resources. Six? 10? 20?

In .000002% of the time it took to accumulate this energy to be consumed, it will be depleted.

NOW, A LITTLE GOOD (?) NEWS…

Oil is a commodity and responds to the basic laws of economics and commodity pricing. So what will the laws provide?

An article on Yahoo Finance from June entitled “Why the Oil Boom will Eventually Bust” may promise temporary relief, but no long-term remedy, to increasing oil prices.

The price paid for commodities is generally the cost of the “last bushel” harvested or the “last barrel” out of the well. As the article states:

In a normal oil market, the cost of producing the last, most expensive barrel of oil needed to satisfy worldwide demand sets the price for every barrel the world over. Other auction commodity markets work much the same way.

So even if Saudi Arabia produces at $4 a barrel, if the final, multi-millionth barrel required to heat houses and run cars costs $50, and is produced, for argument's sake, at a flagging field in West Texas, the world price is $50. That's what economists call the equilibrium price: It's where the price that customers are willing to pay meets the production cost, including a cushion, naturally, for profit or "the cost of capital."

So what is going “wrong”?

A big swath of the market isn't really paying that $125 [AUTHOR’S NOTE: Currently $140]a barrel number you hear about seemingly every hour. In China, India and the Middle East, governments are heavily subsidizing oil for their consumers and corporations, leading to rampant over-consumption - and driving up prices even more.

And as a side note, the US currently “subsidizes”, in a functional sense, the price of oil by not subjecting it to the taxes that most Western nations impose to curtail consumption and cross-subsidize other transportation modes.

SUPPLY LAGS, BUT IT TAGS ALONG.

Almost exactly the same thing happened in the housing market. And both housing and oil supply react to a surge in demand with a long lag. In housing, the lag is caused by restrictive zoning and development laws, especially in coastal markets like California and Florida.

So when the economy roared back in 2002 and 2003, builders couldn't turn out homes fast enough for buyers armed with those cheap mortgages. As a result, prices spiked. They no longer bore any relation to the actual cost of buying and improving land, or constructing and marketing a new house (at some reasonable profit margin). Instead, frenzied buyers were setting the price.

Because builders were reaping huge windfall profits, they rushed to buy and develop land. And sure enough, those new houses were ready just as buyers were retreating to the sidelines because they could no longer afford to buy a home. That vast overhang of unsold homes is what's driving down prices today.

AND WHILE SUPPLY LAGS, DEMAND SAGS.

Historically, the oil market has under-anticipated the amount of conservation brought on by high prices," says [Stephen] Brown [an economist with the Dallas Federal Reserve]. Sales of big cars are collapsing; Americans are cutting down on driving. The airlines are scaling back flights.

We've learned another important lesson from the housing market: The longer prices stay stratospheric, the worse the eventual crash - simply because the higher the prices and bigger the profit margins, the bigger the incentive to over-produce.

It's even possible that, a few years hence, we could see a sustained period of plentiful oil supplies and low prices, meaning $50 or below.

A similar scenario occurred following the price explosion in the 1970s and early 1980s. The price spike caused the world to cut back sharply on oil consumption. By the mid-80s, oil prices had fallen from almost $40 to around $15. They remained extremely low for two decades.

It's impossible to predict how the adjustment this time will take shape, just as it was in housing. There the surge in supply came in places the experts swore there was "no supply," and wouldn't be any. Builders found a way to extend vast tracts of homes into California's Inland Empire and Central Valley, and even build "in-fill" projects near the densely-populated coasts.

WILL AMERICA BE A DEPLETING SHRINE TO PROFLIGACY OR AN ADVANCING MODEL OF ENERGY CONSERVATION AND EFFICIENCY?

In the 1970s the United States had an opportunity to remake itself into a post-hydrocarbon economy. It could have developed, through incentives and subsidies, alternative energy sources and efficient and available public transportation. But it did not.

America has the opportunity again. The lesson will likely again go unlearned.

TALKING, AND MORE FREQUENTLY, WALKING IN THE DESERT OF THE REAL!