This short paper was written in August 2016
The Emerging Free Market in Oil – August 2016
What happens to a market when prices are held above the long run inflation adjusted cost for extended period of time? You get surpluses. What happens when you get surpluses? Prices decline. What happens when you get price declines? Inefficient companies (and in this case countries) go bankrupt. This is all economics 101.
Oil prices are not low, they are within on standard deviation of the long run inflation adjusted prices per barrel. The 2006-2011 prices were historically high on an inflation adjusted basis.
The long run mean inflation adjusted price of a barrel of oil from 1946 (Post war period) in 2015 dollars is $41/barrel, since 1980 it is $51. The price is barely below the mean of the last 36 years and above the mean for the past 70 years. This mean is also biased to the upside due to cartel behavior. A free market, like the one that is developing would have had a lower inflation adjusted price.
Oil has been a managed market since the early 1900s. First it was a monopoly with production regulated by the Texas Railroad Commission followed by an oligopoly with price management by OPEC.
In a free market the quantity produced would be Qc and price Pc and in an oligopoly the price would be Po and quantity Qo. If the price is managed perfectly and set the right amount above the marginal cost curve the economic profit derived to the oligopoly is small enough that it deters new entrants, but should demand expand too quickly and prices rise fast enough there is an incentive for new entrants to enter the market.
This is what happened between the years of 2000 and 2011. Demand from emerging markets expanded faster than the oligopoly could increase production, leading to prices rising far enough above the marginal cost of production. This created enough economic profit to entice new entrants to the market.
The oligopoly believed that peak oil was imminent and that the price increase and subsequent increase in economic profit would not be enough to entice new entrants and new technology due to the limited undeveloped global crude oil reserves. As prices were held above the marginal cost of production, due to the cartel effect, and the belief in the inelasticity of supply, the non-OPEC producers were able to free ride and be inefficient. This situation of oligopoly and inefficiency is essentially no different than what the US automakers had to adjust to when the Japanese entered the US market and began to gain market share in the 1980s. But to claim costs are low is incorrect and to forecast dire straits to infinity bears the semblance of the predictions of the end of the US automakers in 1980.
The natural gas market is localized and is more of a free market than the global oil market. This difference spurred technological innovation and the risk taking and the quicker adoption of technology. This technology adoption was transferred to the oil sector and converted resources into reserves.
The energy business has historically been slow to adopt new technology and methods. Directional drilling was first used in the 1930s but only adopted in the 2000s and wells have been fracked since the 1940s (the American Association of Petroleum Geologists released a paper in the 1950s discussing the first 10 years of this practice). It took 70 years to combine the two. No other industry would survive adopting technology and change this slow.
The reason is due to 100 years of oligopoly (Texas Railroad Commission followed by OPEC). In response to the technological change, the oligopoly flooded the market to attempt to eliminate the high cost producers. However, by doing this the dominant oligopoly producer had to act as a monopoly producer and destroyed the cartel partners. While this was going on the new entrants and the free riders from the oligopoly produced market began to reduce costs, due to the adoption of new technology and this threatens the monopoly producer’s ability to return to a managed market. What is happening is the emergence of a free market in oil. In a few years costs will be lower for those that survive and those that cannot reduce costs they will disappear.