Answer: There is neither anything unusual in these things, nor are these price movements unique to oil. Here are some brief answers, with links to longer discussions.
- Oil prices rose along with commodity prices during the boom
- The price of commodities varies with global economic activity
- In recessions the price of oil drops below the marginal cost of production
- Effects of the recession on peak oil
1. Oil prices rose along with commodity prices during the boom
The prices of most industrial commodities have increased since 2003. When a wide range of industrial commodities rise in price (especially vs. gold) we can examine each individual commodity to determine specific reasons for the rise. That is probably pointless, as there is likely a common cause. In this case, all have strong price elasticity to rising global GDP. This is easily understandable, as demand increases far faster than existing mines can be expanded or new mines (or oil fields) developed.
In the most recent cycle (roughly since 2003) copper increased slightly more than Brent oil. (The sensitivity of copper prices to economic growth has earned it the nickname of Dr. Copper.) Small changes in demand for commodities produce large swings in price because their production can quickly be changed only by small amounts. When production from existing sources is at its maximum, as happened during this long boom, the only responses to increased demand are …
- a price increase that “destroys” the excess demand, or
- price increases sufficient to justify opening new mines.
During the past few years of record global growth we saw both happen to a wide range of industrial commodities. Now we see that this process works equally well in reverse. Small declines in demand produce large changes in price. So it has even been with commodities, and will be so for the foreseeable future.
(An excerpt from this post, November 2007)
2. The price of commodities varies with global economic activity
My guess is that the global downturn will be long and deep. Perhaps a drop in world GDP of 1% or even 2% sometime during 2009 or 2010. Much depends on the economies of the emerging nations, esp China. If China’s GDP crashes from the low-teens to zero (or negative!), then the global recession probably will be long and hard. Nobody — probably not even China’s government — knows what will happen. We are “off the map” of the post-WWII era, with few precedents to help forecast events — and no clear precedents.
Global GDP has not gone negative since 1970 (there is not good global data before that). During the major slowdowns – 1975, 1982, 1991, and 2001 — it never dropped below 1%. Growth was unusually rapid during the recent expansion (an extraordinary rate of almost 5%/year for 4 years; see the IMF data mapper for details), and the downturn might be equally large.
That is what the crash in commodity prices suggests. Oil from almost $150 to the $50’s. The crash in scrap steel prices (roughly from $600 lbt to $200). Likewise copper and the other industrial minerals, most of which now trade at prices below their marginal cost of production. Miners that had great profits are now have low profits. High cost producers are losing money.
3. In recessions the price of oil drops below the marginal cost of production
Almost every industrial commodity is now trading like at or below marginal cost of production. Mines are closing, expansion plans cancelled. For oil:
- Deepwater, oil sands, and alternative energy require oil prices above $80 or $90/barrel. (see this for more information)
- Polar oil, heavy oil, and sour oil require prices above $50.
This is typical during recessions, and is one reason inflation declines during recession. General price levels can go negative (deflation) during deep recessions (and depressions).
From another perspective, this is why mines have high cost of capital. They must make really good money during booms, because they lose money (or even go bust) during downturns.
Unique to this cycle is the combination of pressure from both low oil prices AND greens. I suspect the resulting crash of investments will surprise both sides, and the finger-pointing after oil prices skyrocket will be deserve both laughter and tears (yes, the world will eventually recover, and with it oil demand).
- “Alternative Energy Suddenly Faces Headwinds“, New York Times, 21 October 2008
- “Suncor Cuts 2009 Budget, Delays Oil-Sands Project“, Bloomberg, 23 October 2008
- “Fort Hills latest oil-sands casualty“, The Star, 18 November 2008
- “Green groups ramp up attacks on oil sands“, Financial Post, 19 November 2008
4. Effects of the recession on peak oil
The collapse in oil prices affects the timeline to peak oil.
- It pushes the date of peaking back. Consumption falls, so supplies last longer.
- It makes a supply shortage (not the same thing as peak oil) more likely during the recovery. Energy and capital investments will crash during the recession (this process has already started).
- It means that our preparation for peak oil (aka as “Mitigation”) might stagnate or even reverse, if investment in research and development of alternative energy sources crashes along with oil prices.
Result: If peaking occurs during the next 10 years we will be far less ready, and the consequences worse, than if oil prices has remained above $100.
For example, plans to expand bitumen mining (aka “oil sands”) production in Alberta are being canceled.
It need not be like this. The recession gives us more time to prepare for peak oil. If we use this time to force energy investments — using government funding and regulation to over-ride the price signal — than we might be well-prepared for peak oil (whenever it hits).
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Some posts about energy issues:
- Colonel Lang shows us why the 21st century might prove difficult – even painful – for America, 26 August 2008
- An urban legend to comfort America: our massive reserves of unconventional oil, 29 August 2008 The secret cause of high oil prices , 6 August 2008
- How does the long-term trend of peak oil affect us, in terms of short-term events?, 30 August 2008
- An urban legend to comfort America: crash programs will solve Peak Oil, 5 September 2008
- An urban legend to comfort America: oil is oil, even if it is not oil, 10 September 2008
- An urban legend to comfort America: alternative energy will save us, 16 September 2008
- Another example showing how energy research is just inspired guessing, since America prefers being blind, 23 September 2008
- The secret cause of high oil prices
- Oil is $63 a Barrel, Lindsey Williams Predicted $50
- Diddy for VP
Originally published at Fabius Maximus and reproduced here with the author’s permission.