Behold the Price of Oil

Low and Behold the Price of Oil

by Edward L. Morse

Edward L. Morse is Managing Director of Louis Capital Markets. He was Deputy Assistant Secretary of State for International Energy Policy in 1979-81.

After dropping from close to $150 in the summer of 2008 to under $34 last winter, the price of oil had more than doubled by the spring and was hovering around $60 in July. The rapid fall and then rebound in oil prices over the past year surprised many people. But it was not unusual: commodities markets are cyclical by nature and have a history punctuated by sudden turning points. Although this generally makes it difficult to forecast prices, it is safe to say that commodities markets will remain lower over the next few years than they have been over the past five.

In the oil industry, the most important new factor that accounts for low prices is the return of surplus production capacity among the members of the Organization of the Petroleum Exporting Countries (OPEC) for the first time since 2002-3. The disappearance especially of spare Saudi production capacity was the most critical element in driving up prices from 2003 to 2008--and its reemergence should be the most critical element in keeping them lower over the next few years.

The high prices of the last decade have also spawned massive technological breakthroughs, including in some surprising places. The United States used to be considered a country that would eventually suffer a long-term natural gas deficit and be condemned to import supplies. But high gas prices have spurred phenomenal developments in technologies to drill for natural gas trapped in the United States.

There are also surprising developments on the demand side. Most analysts expect that once the world economy starts recovering, global oil demand will rebound to its former growth rate of 1.5-1.8 percent per year. But a return to prior growth rates is unlikely. Due to the higher oil prices in 2008, oil demand in the United States has reached a plateau, even as the output of U.S. crude has been rising.

A different story is unfolding in China and other emerging markets with growing energy appetites, but the moral is the same: demand growth will be lower than has commonly been assumed. Like India and other oil-importing countries, China is learning that subsidizing energy drains government budgets and hampers economic adjustment. When emerging markets are left to operate more freely, prices are indeed high, but they bring substantial macroeconomic reform. The result has been a drop in oil demand growth.

The prospect of more reasonable growth in energy demand and surplus capacities in OPEC create opportunities for the Obama administration: it is a chance to make energy markets less volatile and strike arrangements with producing countries that will better serve the United States' long-term interests.

In Russia, revenues from taxes on energy sales, domestic or foreign, are critical to the legitimacy of the state and to its hopes of pursuing assertive policies abroad. Low oil prices mean that now is a good time to change the credit policies of the United States and other OECD countries toward Moscow and foster changes in how Moscow runs its domestic oil and gas markets.

The drop in oil prices also creates opportunities for the United States to change its relations with Iran and Venezuela. The governments of both those countries have faced greater strains and internal pressures and need more capital to develop their oil industries. And if the West holds out the prospect of greater capital, it might see a softening in the foreign policies of Iran and Venezuela.

The more direct challenge for the United States will be to set the right policies for relations with Saudi Arabia. Saudi Arabia's objectives in the oil market naturally converge with those of the United States. Both countries want to keep prices moderate in order to spur global economic growth. Both prefer to see Iran with lower revenues than it has earned in recent years. Both hope to control the flow of petrodollars to terrorists. And both want to limit the volatility in prices created by wanton speculation. But Saudi Arabia has a very different view of the role of the state in managing energy.

The U.S.-Saudi energy dialogue, which Washington has neglected for years, needs to be reinvigorated. Now that Saudi Arabia has a huge spare production capacity and thus the tools to advance Washington's economic and political goals, it should be easier to establish between the two governments better and higher-level communications about the oil market and the global political economy.

The opportunities presented by lower oil prices should not detract from the important goals of reducing global greenhouse gas emissions, enhancing the United States' energy security, and building a new generation of energy-efficient nonhydrocarbon fuel sources. But they should not be overlooked; it would be dangerous to ignore oil and "old energy." Defanging those that use oil as a weapon, prolonging moderate prices, and anticipating supply disruptions require an activist and global approach to energy.