Why You Should Plan on Gas Prices Staying High

One of my favorite email “forwards” regards the huge amount of oil in the Bakken Formation, a Mountain range in Western United States.  The email implies that there is a conspiracy among powerful environmentalists that keep this coveted resource from getting used. It goes on to say that tapping into this oil source would dramatically drop the price of gas at the pump and save our economy.  I love the image of powerful environmentalists controlling the world, but alas, I am quite certain that is far from the truth.

The general public seems to believe that the high prices for oil today and in 2008 are temporary price peaks.  However, I contend that the price of oil dropping after 2008 was out of the ordinary and due to the entire world economy collapsing.  As the economy slowed down, factories that use oil stopped operating, construction slowed, and general demand for oil decreased temporarily as millions of businesses and households slowed production.

In the 1950’s, a man named M. King Hubbert published a paper that predicted that the United States would peak in oil production between the years of 1965 and 1970.  At the time, the United States was responsible for more than half of the world’s oil production.  He predicted this peak in production based on the rate that oil was removed from the ground.

Well, Hubbert’s theory was correct, and the United States peaked in oil production in 1970.  By applying this same model to the rest of the world, scientists calculate various estimated years that oil production will peak, many of those estimates falling into the range of 2010 and 2020.  This is much more complicated to estimate though, since many countries under-report the amount of oil that they have.  One reason for doing this is that it makes it easier for them to borrow money to improve infrastructure if lenders assume a large amount of oil assets.

Oil is traded in a global market, sold by producers and bought by consumers.  The number of consumers continues to increase each year, especially as rapidly growing China and India increase their dependence on oil.  Currently, the world continues to produce more oil each year to keep up with this demand.  However, when oil production does begin to slow, the price for oil will drastically increase since there is a thirst for more oil than can be met.  Open markets settle this through higher prices, and some folks that can’t afford it will not be able to get the oil they need.  Fortunately, though, this raise in price will lead to increases in energy efficiency and conservation.

Here is the key to why oil prices will stay high.  The world currently demands more oil each day than we can gather from places that are inexpensive.  Oil from Kuwait costs as little as $2 per barrel to extract from the ground, while using a complicated drilling technique to reach oil in the Gulf of Mexico is much more expensive. However, since all oil is basically the same when it is sold, the price will be sold at the highest rate that demand will pay; this is true for almost all commodities.

I do not think we have already reached the point of peak oil supply, or we would be paying much higher prices.  However, as we demand more oil than can be produced through cheap sources like Kuwait, it makes it more economically viable to take oil from expensive sources, like the Bakken Formation.  For example, if it costs $105 per barrel of oil to convert from the Bakken Formation, no company in their right mind would do this if oil sells for $90 per barrel elsewhere.  They would have to be losing $15 for every barrel of oil they produced (or receiving a tax subsidy from the government).

As oil prices increase, and we pay more than $4 per gallon of gasoline, it will become more economically viable to get oil from difficult places.  This supply increase will not drop the cost, otherwise companies would not be able to sell the oil and make money.  Unfortunately for many, this means our gas prices will continue to rise, no matter what source we’re tapping into.

And just as environmentalists are not evil manipulators controlling the world’s energy supply, oil companies are not there just to make the world a better place.  So plan your business (and life) around a world that has gas prices staying high whether we hit peak oil or not.


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