Friday, October 26, 2007

Could Oil Prices Collapse?

With oil over $90/barrel and seemingly headed for $100/barrel, let's ask a contrarian question: Could Oil Prices Collapse?

Peak oil--the slow but unavoidable decline in global oil production--is a reality. Some very credible folks believe we have already experienced the upper plateau of global oil production, and it's all downhill from here.

Other equally credible folks believe the final descent is still a few years away. (I have posted numerous excellent links below to aid your own conclusions.)

When we drop over the cliff of Peak Oil depends not just on supply, but on demand. Commentators almost unanimously foresee growing global demand for oil as China, India and other less-developed nations hurry through a vast industrialization.

But what if they're all wrong, and demand falls even faster than supply? The world would yet again be awash in cheap oil. Can't happen, right? Don't bet the farm.

Let's start with a long-term chart courtesy of frequent contributor Harun I.

For an in-depth analysis of oil price fluctuations, I suggest Oil Price History and Analysis.

What are the obvious take-aways? Mideast crises spark price spikes, and global recessions knock prices down. In other words: let's say global oil supply drops 5% from 84 million barrels a day (MBD) to 80 MBD as a result of a Mideast crisis (is that a redundancy?). If demand is 84 MBD, then the price could spike up 50% or even 90%, as it did in 1990.

But what happens if a global recession drops demand by 5%? Then prices can fall in half or even more, as they did in 1999. Note that the Asian Contagion recession was limited in global terms; the world's largest economies, the U.S. and Europe, were growing robustly even as southeast Asian economies suffered currency and credit contractions.

Even this limited downturn caused oil to drop from over $35/barrel to under $15/barrel. That begs the question: what would happen to oil prices if the major global economies actually shrink rather than grow?

I know, I know, recessions have been officially banned by the Federal Reserve and the other central banks. Uh, right. But let's say the Fed can't stop the U.S. sliding into recession, and the rest of the world declines behind it.

Even if interest rates drop to 1%, if the consumer is under water and overleveraged already he/she can't borrow any more money. And risk-wary lenders will no longer be willing to give money to people who are mere months away from declaring bankruptcy.

Now who would benefit from a collapse in oil prices? Hmm. Let's say various agencies in the U.S. government and other governments accept that a global recession was now inevitable. I don't mean the worthless shills in the Fed and the Treasury Department--I mean the Real Players in the Pentagon, Intelligence community and Executive branch.

Let's say various goverments have an interest in either crippling or replacing the ruling regimes in Iran, Russia and Venezuela. What is the weapon of choice? A barrage of W-88 nuclear warheads? That would certainly kill many innocent people and destroy infrastructure, but these weapons wouldn't hit the intended targets: the political powers-that-be.

Let's connect the dots. The absolute best way to cripple or overthrow the regimes of these oil-dependent economies is to drop oil prices back to $20 or lower. Such a plunge would engineer the same death-spiral that nearly bankrupted oil-exporters in 1999.

As their primary (or only) revenues dry up like a puddle of water in the desert, these regimes--totally dependent on oil revenues for their lavish social spending and subsidies--have no choice but to pump even more oil to offset their staggering losses of income. This exacerbates the oversupply and the continuing drop in global oil prices.

Can't happen? Recall that prices are set on the margin. History shows again and again that a 5% decline in oil supply does not result in a 5% decline in price; a 5% increase or decrease can eventually lead to price swings of 50% or more.

Who else would like to see Iran removed as a regional challenger? Saudi Arabia has spent much treasure and effort to become the central player in the Mideast. Its citizenry are mostly Sunni. Iran is Shi'ite. Which nation is vulnerable to a collapse in oil prices? The Saudis would certainly have to cut spending as revenues declined; perhaps they might even have to tap their immense reserves of capital for a few years.

But Iran is already teetering on insolvency, even with oil prices as record highs. Both Venezuela and Iran subsidize their citizen's gasoline to absurd degrees, and as a result (of course) gasoline is squandered. As a result, the Iranian authorities imposed quotas for gasoline purchases, causing widespread unrest and even rioting.

How will they manage if oil falls to $20 a barrel again? How angry will the mobs be when bread, gasoline and other staples are no longer subsidized because their government is flat broke? Russia too is riding high atthe moment based almost solely on ballooning oila nd gas revenues. Were those revenues to fall by 2/3, what would be the consequences?

Suppose that, without much fanfare, the Saudis continued pumping huge quantities of oil into global supplies, further depressing prices, even as OPEC officially calls for reduced production.

Recall that the U.S. alone consumes 25% of global oil. A deep, prolonged recession in the U.S. is enough in and of itself to drop global demand by more than enough to trigger a price decline. And as the fast-growing economies of China and Asia slow down behind the U.S., then demand falls further. As the dominoes fall, global demand weakens until a price collapse occurs.

Yes, we will face Peak Oil at some point. But if global recession cuts demand by 10-20%, then oversupply will quickly rear up and the consequences to oil-revenue-dependent states will not be positive or brief.

Readers sent in a number of excellent links on Peak Oil and other petroleum-related stories:

From Fabius Maximus:

The Shape of Oil to Come (
Peak Oil (Federal Reserve Bank of Cleveland)

From U. Doran:

Peak Oil (
Oil Bull Market Analysis (
Oil Market Analysis by Dorsch (
Oil Market Analysis by Simmons (
Oil Business Update (
Global Oil Update (
Russian Natural Gas Treatise (

From Cheryl A.:
presentation by Kenneth Deffeyes (video of the author)
Energy Watch Group (Germany) (video)

Thank you, readers, for the excellent recommendations.

Thank you, John U., ($44.44) for your generous and numerologically-attuned-to-the-economy donation to this humble site. I am greatly honored by your support and readership. All contributors are listed below in acknowledgement of my gratitude.

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