Many people look upon the increase in the price of oil during the past few years as a sign that oil has run out - A sign that the oil reservoirs are running out and that very soon there would be no oil. While it has created the much needed visibility for alternate energy technologies like solar energy, the economics of oil – the supply and demand equation is far more complex than the simple notion that oil has run out.
Large oil reserves have not been tapped into or have been producing far below their potential for various reasons -
o Environmental concerns – reserves in the arctic and potentially in deep sea waters
o Geopolitical circumstances – Iran, Iraq, Nigeria etc
o Cost of extraction – the large super oilfields which are capable of producing in large quantities cheaply (using current technology) are starting to decline in their outputs.
o Slow rate of emergence of new technology – Technology has not kept pace with the rate of increase of the demand. New technologies which dramatically decrease the cost of production from oil reservoirs which were hitherto expensive to produce from, have not come on stream quickly enough. Thus the average cost of production increases. The rate of increase in production is not fast enough.
While the above factors are responsible for oil production being below the potential of the proven reservoirs there are two other factors which are also responsible for the increase in prices.
Underinvestment: One of the reasons for the slow rate of emergence of new technologies has been underinvestment from oil companies. This is primary due to the nature of the business cycle. The oil industry has always been through boom and bust cycles. This has led to a chronic underinvestment in lean times. This under investment leads to shortage during the upswing in prices during the boom. The shortage is created because the time lag / gestation period for a new oilfield to move from exploration to start producing to its full potential can range from 5-10 years. The underinvestment in R&D leads to new technology coming online slower than expected and also a shortage of equipment such as rigs, drill ships which restricts capacities. This creates the spike in prices by which time it is too late to increase investments.
Demand Growth: The growth of demand for oil has been at a furious pace as more developing countries start to increase the penetration of cars. Thus while oil may not be 'running out' per se, a complex bunch of factors coupled with speculation in the crude markets, ensures that oil prices remain high.
The Future Prediction:
While no one really knows the way forward, I will go forth and make a prediction just to give myself half a chance of saying ' I told you so' a few years from now. Perhaps I will become famous for the prophetic prediction some day – as did that non-descript analyst who predicted the spike in oil price.
The current trend of decreasing prices will continue over the next few months to drop to around $ 50 per barrel in around 1-2 years time. The price will continue to hover at these levels for about 3-4 years before slowly starting to increase beyond 2010 – perhaps then the prices would touch 200-300$ per barrel by 2015-2020. By then electric vehicles and solar energy will start to have a significant impact on oil demand. And before that boom and bust cycle comes to and end with a drop in prices by 2020 alternate sources of energy will take over and the price of oil will no longer make national headlines.
