Price Of Oil - Drawing The Line

The $40 Mystery

Last summer, when the price of oil was bouncing off the rev limiter and a gallon of regular was putting $4-plus holes in our wallets, we wondered if it would continue, and what we would do if it did. The slide in oil prices has been the best news that consumers have gotten all year. But will low fuel prices continue?

Just a few months after the near-$150 high, the price of a barrel of crude oil plummeted 70 percent, to about $40. It turns out that this upside has more than a little downside, and it may mean bad news in the future. Last summer's high prices were a result of a complex series of events-a "perfect storm" involving speculation in the oil markets, high demand for oil products, the peaking or near-peaking of production volumes, the incipient financial crisis, etc. But at least we now have a pretty good explanation for what went on in the price increase.

We don't have such a good explanation for why it's at its new low level, and seems to want to stay there. I've read dozens of articles about the situation, and it's a mystery to everyone. You can't explain it with the law of supply and demand, because demand is only down 5 or 10 percent. Supply is certainly not up at all, and is slowly being contracted.

The problem is that no oil producer is making money at $40 per barrel. I've heard estimates that the break-even point is now $60 to $80 per barrel, so producers are hurting. Why doesn't a producer simply stop producing if it loses money on every barrel? That question is answered when you realize that most of our oil now comes from national entities (Saudi Arabia, Venezuela, Iran, etc.) rather than companies like Exxon or Shell. These countries do indeed work with companies, but the basic decisions there are governmental. These governments are dependent on oil revenue for infrastructure, social programs, military spending and all the rest. For them, if revenue stops, the government stops.

The OPEC nations want the oil price to climb to at least $70 per barrel, and to help make that happen they've agreed to cut production by about 4.3 million barrels per day. Total world production is now about 85 million barrels per day, so the OPEC cuts represent about 5 percent of the total. The result should be a boost in oil prices, but it hasn't worked-at least not yet. Part of the problem is that while the nations may agree, they may not cut as much as promised to avoid a drop in revenue.

More drastic cuts in production might do the trick, but no one knows the "tipping point" at which a large reduction in supply might lead to a rapid price increase like last summer, and those kinds of prices might hurt everyone by making the worldwide recession worse.

The $40-per-barrel price is hurting oil companies and oil nations around the world. You heard the mantra "drill, drill, drill" last summer, but something like $100 billion in new oil-industry projects have been cancelled since the fall in prices, and oil rigs, infrastructure and equipment are idle or not being maintained. Alternative energy projects have also taken a hit, as their worth is compared to the price of oil, and if oil is cheap, why seek alternatives?

Some of the most negative voices are coming from old hands in the oil patch, and it's not just because of the current price. The industry's infrastructure is made predominantly of steel, and many of the rigs, platforms, pipelines and refineries that were new 40 or 50 years ago are rusting and not being renewed. The industry also has depended on a generation of workers who are not only aging, but are too often not being replaced.

If demand for oil increases once again as economic recovery begins, where will the necessary increase in supply come from? Are we, as many analysts believe, at or beyond the all-time peak of production? Oil at $40 per barrel-and the financial crisis-has left us a weaker oil industry. And, ironically, a weaker alternative-energy industry, at a time when we need both to stabilize future energy resources. If we see serious shortages, prices will spike. Let's hope it's not the making of another perfect storm.