The Oil Price Enigma

Oil is the single most important commodity purchased today, and its price influences the fortunes of every nation on the planet in significant ways. Yet nobody can tell you with honesty that they know where the price is headed.

Thirty years ago (and much younger then), I imagined that I could construct a model to calculate the future price of oil -- and even persuaded some others to accept this idea.  Needless to say, the price never really performed as my model had predicted, except in very general terms; it did go higher.  The experience left me with a deep appreciation of the importance of assumptions in models -- in this case, extraneous political parameters  Usefully also, I acquired a certain skepticism towards models generally.

The situation then was relatively simple: There was just an OPEC monopolist and the 'rest-of-the-world' producers.  Today, the situation is much more complicated and I'm not sure I know how to predict a future price for crude oil.

In 1982, the world price was controlled by an OPEC core, mainly Saudi Arabia, which had excess production capacity and could also afford to cut their production in order to maintain a price.  In fact, in the early 1980's, Saudi Arabia cut its production from 10 million barrels per day (MBD) down to almost 2 MBD in order to sustain a high world price.  Ultimately, they failed -- probably because they needed the revenue (i.e., total number of barrels sold times the world price).  The other world producers, including the rest of OPEC, were simply "price-takers," selling as much as they could produce at whatever the world price happened to be.

Under those circumstances, the scenario was fairly simple.  One assumed that the OPEC core acted rationally, which means they would try to maximize their 'discounted profit stream' by adjusting their production from year to year (or perhaps month to month) to obtain the optimum price path over time: not too low a price to cut profit per barrel -- and not too high to cut the number of barrels sold. 

This kind of problem can be solved with the help of 'optimal control theory,' as used by engineers and physicists.  (Economists refer to it as the Pontryagin problem.)  Mathematically, it means finding the integrand that will maximize the value of the integral. 

In this case, the integral would be the summation over future years of (profit per bbl)x(number of barrels sold by the 'core'), all discounted to the present with a certain discount rate. 

This problem, as originally posed by MIT Prof Robert Pindyck, can be solved by brute-force methods, using high-speed computers that try progressively different integrands until a maximum of the integral is reached.  It turns out, however, that after some minor simplifying assumptions the problem can be solved analytically.  The complete solution, though elegant, looks rather forbidding and is discussed in Appendix 2 of my monograph "The Price of World Oil" [Ann. Rev. Energy 1983].  But by applying recursive calculations, one obtains a price vs. time curve that will maximize the discounted profit stream to the OPEC core.

The solution of the problem demonstrates some interesting facts.  The most important parameter for the OPEC core to consider is the discount rate -- as seen by Saudi Arabia.  For example, fear that the Kingdom might lose control of the oil implies a high value of discount rate (that devalues future profits heavily) and calls for selling as much oil as possible within a short time frame.  On the other hand, if there are no such fears about security, then the discount rate will be more normal, of the order of 2-3% per year.  The solutions generally show an increasing price as the cost of production rises when wells are depleted.

Yale economist William Nordhaus has pointed out that there will be a backstop technology that sets an upper limit to the future price of oil.  He assumed that this will be liquefied natural gas (LNG)-which seemed reasonable at the time, with crude oil selling for about $12 a barrel and LNG up to $100 for the energy equivalent.

That was in 1982.  Today the situation is much different - and actually reversed.  With a world price between $90-100 per barrel, many oil resources around the world have become profitable.  In Canada, tar sands production is increasing year by year.  In the US, advances in 'fracking' and horizontal drilling now permit oil extraction from shale deposits, although kerogen in tight shale rocks is still beyond reach.

[As an aside, I still remember the National Petroleum Council, the industry energy experts who advised  the Department of Interior, telling us around 1970 that "if the price of crude oil ever reaches $3 (yes, three dollars) a barrel, shale oil will become economic."]

It appears to me that the present price of oil, between $90-100 a barrel, is unstable -- as production increases around the world without a corresponding increase in demand.  The major demand is still for transportation, on the ground and in the air.  But the price of natural gas has fallen so much that the price-energy ratio is now around 6.  LNG can be sold on the world market at around $15 (per oil-equivalent barrel) and provides a fairly effective backstop to the world price of crude.

However, things are not as simple.  While natural gas is very cheap in the United States and indeed in many other parts of the world, the situation can change drastically because of political decisions that have to do with environmental factors.  For example, because of efforts to reduce emissions of CO2, natural gas is rapidly displacing cheap coal as the major boiler fuel for electrical generation.  Many utilities have already made the switch or plan to go in that direction -- which would vastly increase the demand for natural gas. The use of LNG as a more economic fuel for large trucks is also becoming popular and can displace up to 3 MBD of US oil demand -- and therefore about one-third of oil imports.

Finally, we have the possibility of converting natural gas directly to gasoline or diesel fuel.  Shell Oil has already built such a plant in Qatar and is planning the construction of a much larger plant in the United States.  So even with natural gas production rising throughout the world, demand may rise even faster and raise the price of natural gas in relation to crude oil.  It is difficult to predict where the balance will occur and how it will change over time -- with LNG becoming a world fuel, much like crude oil, as transportation costs become a small fraction of the total cost.  Even tiny Israel may join the club of LNG exporters on the basis of their discoveries of huge gas fields in the Eastern Mediterranean.

But political developments can change this benign scenario almost overnight.  Without the Keystone pipeline, high transportation costs would discourage the full development of Canadian tar sands.  If environmental zealots succeed in curtailing drilling and fracking, gas prices will surely rise and affect oil prices.  On the world market, all price predictions are off if the Middle East blows up.  In all of these scenarios, which vitally affect global economic growth, the White House plays a crucial role.  Dare we hope that as a 'lame duck' Obama will be less likely to follow Green zealots?

Ultimately, we have technological imponderables.  If methane hydrates from the ocean floor should become commercial, then we can access a truly spectacular resource of natural gas -- and all bets are off.

S. Fred Singer is professor emeritus at the University of Virginia and director of the Science & Environmental Policy Project.  He is a Senior Fellow of the Heartland Institute and of the Independent Institute.  Though a physicist, he has taught economics to engineers and written a monograph on the world price of oil.  He has also held several government positions and served as an adviser on energy policy to Treasury Secretary Wm. Simon.

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