Why the World Oil Prices Should be High and Stable

After a decade of volatile prices, the past three years saw an unusual period of stability in the oil market, with a barrel of crude oil averaging $110 each year. However, forecasts for 2014 predict a decline to an average of $105, on the basis of expanding supply and a weaker-than-expected demand. A combination of geopolitical events in Syria, Libya and Nigeria have prevented oversupply despite the expanding entry of US shale oil into the market. The price has remained high thus far, but how long can prices stay above $100?

This coming price drop arrives at a time when the world’s largest consumer is nearing its long-held goal of energy self-sufficiency. The United States embarked on this quest in the aftermath of the 1973 oil crisis, and in recent years has seen the country develop a comprehensive nuclear program, develop biofuels and seek oil from ever-more-expensive sources: the tar sands of Canada, the depths of the Gulf of Mexico and even the wilds of Alaska. Further afield, it drew on oil from Brazil’s deep-water wells and West Africa’s low-sulfur oil deposits, all of which contributes to a reduced dependency on oil from the Middle East.

More recently, the development of unconventional sources of oil and gas back in the United States has led to a revolution in energy flows and policies, as the country stands on the verge of becoming a gas exporter. The rapid development of shale oil and gas fields has seemed miraculous at times, but like many of the conventional sources the US relies upon the production is more expensive (costing $60-80 per barrel) and more risky, as output and depletion rates seem less predictable than conventional sources. As a result US domestic and regional supply is quite vulnerable to price fluctuations, as witnessed when work at the tar sands of Canada came to a standstill in 2008 following a price drop.

Analysts have claimed that the age of “easy oil” is over, and we are entering a period of expensive extraction and capital-intensive processing. With the shale oil and gas sector currently requiring $1.5 in capital investment for $1 of revenue, several major oil companies have turned their backs on shale in favor of expanding their operations in the “easy” oil fields of the Middle East. Despite the risks involved, Iraqi oil pumped up at $20 a barrel seems like an attractive prospect, as do sources in Libya and Iran when politics and security permit. Still, will dumping more “easy” oil on the market lower prices to the point where shale oil production grinds to a halt?

Given the slow world economic recovery and unexpectedly low growth rates in India and China, lower oil prices would seem a certainty. With growth in demand lagging behind expanding supplies, can the U.S. petroleum industry weather the resulting price fluctuations as it becomes increasingly dependent on high prices to stay profitable?

Despite the low cost of Middle East oil production, only a few of the region’s smaller states could cope with an extended price drop below $100. Most need an oil price of $90 or greater to cover current government spending, with the IMF forecasting fiscal deficits in nearly all of the region’s oil-exporters by 2015 in the event of a major price drop. Even at $100 per barrel, public spending is expected to slow down in the region. These countries have grown dependent on their high oil rents, spending huge sums on unrealistic energy subsidies to domestic consumers and failing to invest in future generations.

Even Iraq, despite experiencing the region’s largest spike in domestic production, is running up an ever-mounting deficit as government spending outstrips expanded revenues. Last year’s budget reached $119 billion, a whopping six-fold increase on 2004 spending levels, while the government is expected to spend upwards of $150 billion this year. While oil production in Iraq is at its highest level in decades (3.5 million barrels a day in February, with some 2.8 million destined for export ), increased revenues are entirely dependent on high oil prices. Any drop in prices means that Iraq’s deficit – perpetually hovering at around 17% would spiral out of control. Worse, operating costs for Iraq’s oil industry are rising faster than its oil income, leaving fewer and fewer funds for capital investment, desperately needed for true economic development. 

A sharp drop in prices threatens political stability in much of the Middle East while potentially undercutting the growing petroleum industry in the United States. Yet higher prices are also a threat to world economic stability. In 10 out of the 11 US recessions since World War II, according to a study by economist James Hamilton, economic downturns were preceded by oil price hikes. Above all, excessive price fluctuations interfere with consumer’s spending plans and producer’s business strategies alike.

Currently, OPEC is attempting serve its economic interests by regulating the market with its combined 30 million barrels per day in production, with Saudi Arabia taking on the role of swing producer. The question is how long the Kingdom can sustain this role when faced with increasing demand at home and potential budget deficits. While Iraq has the potential to be a swing producer of the future, for the time being it seems the best course of action would be for both the major producers and consumers to come together to regulate supply and price.

To protect themselves from fluctuating prices, members of the International Energy Agency and many other non-OPEC producers have been stockpiling energy reserves. Given the increased volatility in price witnessed between 2000 and 2010 and the subsequent turmoil in Middle Eastern geopolitics, it seems sensible to call for market intervention with the goal of price stability. Working in concert, OPEC, the most powerful oil producers’ association, and the IEA, the largest energy consumers’ organization, could achieve this. In June 2011, for example, the IEA released 60 million barrels of energy reserves in response to the disruption of oil supplies from Libya. However, greater cooperation is needed between the two organizations – together. Together, IEA and the OPEC have the capacity to devise a suitable intervention model in the common interest of price stability.

Price stability would benefit the oil-dependent economies of OPEC and major African producers, stabilizing national incomes, supporting current government spending plans, and allowing states to plan for the future via the creation and expansion of wealth funds. International oil companies would be able to take a more secure view of their investments, supporting longer-term projects in infrastructure development and energy production. It would remove speculation from the market.

A stable price of $100 per barrel would give certainty to the market and to world energy policies. Prices at this level would also have positive side-effects for the global energy regime: they would encourage the development of alternative energy sources such as wind and solar power, promote increased energy efficiency, and encourage major oil companies to invest in more efficient technologies and remoter locations.

Contrary to popular wisdom, a lower oil price would only damage the economic prosperity of the U.S. and the major oil-producing nations, most of whom are developing nations acutely vulnerable to the damaging aspects of oil price volatility, which slowed their economic development to date. Critics might argue that such a high, stable price would slow down economic growth and recovery but in the long run it would do much to moderate the boom and bust aspects of the economic cycle, and reducing the risk to future, necessary capital investment. Building economic recovery on unrealistically cheap energy sets the system up for even greater failure when inevitable price shocks occur. What the global economy needs are stable, sustainable prices that can provide the basis for effective planning.