Historically, there has usually been a fairly strong consensus about long-term oil price trends, and the consensus has tended to be wrong.  In the mid-1970s, after the first oil price shock, most thought prices would decline by a third, then remain stable.  Instead, they tripled again, and the consensus became that they would continue rising.

As a novice to energy economics at the time, when the computer model I worked on, developed by Nazli Choucri at M.I.T. predicted weak prices in the early 1980s, I didn’t question the results.  However, when Prof. Choucri presented the forecast at a 1980 Stanford conference on oil market modeling, it was the outlier: 8 of 10 predicted rising prices, one stable prices, and we were the only ones showing lower prices and falling OPEC output.  But, I protested later, it was normal for commodity prices to retrench after booming.  She explained that the others argued that “oil was different.”

Our price forecast proved to be seriously in error–after 1985, when we saw prices recovering, and they instead collapsed.  It usually gets a laugh from the audience when I point out that I’m able to brag about “only” missing the price forecast by 100%.  It is also instructive that all but a handful of, mostly academic, experts correctly interpreted the 1970s oil price increases as largely temporary, not the “new paradigm.

Many sectors are subject to price bubbles, including real estate and agriculture, and it is probably just human nature that some analysts will always insist that the sector has entered a new phase, and prices will not revert–even though that’s what always happens.  There’s the “new paradigm” of the Internet or, in the 19th century, railroads, where the industry is said to be so different that its pricing should not be expected to follow previous standards, that is, trust me it’s not overpriced.

Resources follow a different path, the “supply is finite, but demand isn’t, so surely prices must rise.”  Will Rogers once advised, buy land, they aren’t making any more of it, and even today, analysts promote agricultural stocks on the basis of the simple theory, people gotta eat.  And any number of supposedly knowledgeable people have said to me, “Don’t you agree oil is finite?”

Actually it’s not, but the rate of renewal is very slow, so it might as well be.  But whether or not it’s finite is irrelevant.  The question is, at what rate are we using it up?  The atomic fuel of the Sun is finite, but we have at least several hundred million years before it matters, so I wouldn’t build a shelter just yet.

The argument for high long term oil prices ($100 or more) include: rising demand in China; low discovery rates; high oil field decline rates; and rising costs.

Some note that the “easy” oil is gone, but this is meaningless.  Oil has always been hard, as has everything.  Tried farming lately?  Or read Dickens’ Hard Times, where he notes: “Surely there was never such china-ware as that of which the millers of Coketown were made….They were ruined, when they were required to send labouring children to school; they were ruined when inspectors were appointed to look into their works; they were ruined when such inspectors considered it doubtful whether they were quite justified in chopping up people in their machinery; they were utterly undone, when it was hinted that perhaps they need not always make quite so much smoke.”

And demand growth certainly matters, but remember that the highest demand growth was in the 1950s and 1960s, when oil prices were falling.  Then, growth was 5-7% per year, while since 1990, growth has been only 1.4%.  And while Chinese demand is booming (this year is an exception), it was in 2004 when it unexpectedly rose by 17%, which was in large part due to shortages of coal; from 2000, Chinese demand has averaged 6.5% per year.

Discovery rates are down, but especially in a semantic sense.  Estimated discovery sizes are very conservative when first announced, and they are revised upwards over time, so the most recent years’ discovery rates are always understated.  Generally speaking, upward revisions to existing fields account for most of “reserve” additions in any given year, so that, even though discoveries are said to be replacing only one out of every three, four or five barrels produced, global reserves remain stable and even growing.

Many have also argued that high depletion rates have caused the industry to fail to grow production, referring to this as the “Red Queen’s challenge,” or running faster and faster just to stay in place.  This primarily reflects the ignorance of many novices who are surprised to discover that the industry has to place declining production, and actually spends more on that than increasing production in a net sense.  This is not something new, as the industry has long had to replace 4-5 million barrels a day of capacity each year, and indeed, Jimmy Carter remarked on the need to replace a Saudi Arabia equivalent every three years.

Finally there’s the very real problem of rising costs.  It is generally accepted that upstream costs have roughly tripled in the past decade, and some analysts argue that this will prevent prices from dropping below $100.  Total’s chief de Margerie actually stated that marginal costs are $100 a barrel, and anything below that would so depress investment as to bring prices back up.

But cost increases are primarily cyclical in nature, reflecting the high activity levels in the past decade, which have pressured personnel and equipment markets the most since the early 1980s.  A drop in prices will mean lower costs overall, as well as the abandonment of the few extremely expensive projects–where significant capital is not yet sunk.

Many insist that this scenario is not possible, but few seem to remember that the same arguments were made in the early 1980s: demand recovery was inevitable, costs were too high to support lower prices, and so forth.  The result was that few companies or governments were prepared for the 1986 oil price collapse, which increased the pain of adjustment.  The oil industry has often heard the adage, “Grant me one more boom, and I won’t screw it up,” but I’m not convinced the lesson has been learned.