Generation, Natural Gas, Renewable Energy

When Will Oil Prices Recover? Three Economic Theories Provide Different Answers

Issue 1 and Volume 94.

by Tanya Bodell, Energyzt

Crude oil prices have continued their dramatic slide and the industry is searching for signs of recovery. Timing impacts both supply and demand for electricity. On the supply side, the price of oil impacts deployment of rigs and drilling activity which also yields natural gas. On the demand side, high oil prices combined with low natural gas prices could create opportunities for petrochemical production and liquefied natural gas (LNG) exports, both of which would increase demand for electricity. Three different economic theories about oil prices predict different price recovery trajectories and portend different impacts on the power sector.

The Invisible Hand

Under basic economic theory, a glut of oil supply combined with declining demand equals lower prices. Continued production by The Organization of the Petroleum Exporting Countries (OPEC), combined with growing levels of oil production by non-OPEC countries such as the U.S. and Russia, nearly topped off storage tanks last year. To make matters worse, China’s economic growth has slowed, along with that of other economies, decreasing global demand for oil. Although rig counts dropped precipitously, lag in supply response as production from existing wells slows down has resulted in large price swings as the market adjusts. Under a traditional economic approach, the glut should work itself out naturally, perhaps by the end of the year, and return to the long-run marginal cost of production. If a world-wide recession ensues, prices will take longer to recover.

Predatory Pricing

Economics generally consider predatory pricing an irrational practice that is mitigated by market forces. However, OPEC countries have been accused of purposefully overproducing, sacrificing short-term gains for long-term strategic objectives in order to maintain market share. As a result of low oil prices, more than 40 independent exploration and production companies in the U.S. have declared bankruptcy totaling tens of billions of dollars in claims according to industry reports. Purposefully setting prices at artificially low levels to drive competition out of business usually would be considered illegal and is not sustainable according to economists. However, calls by Saudi Arabia for non-OPEC countries such as Russia to reduce output implies that perhaps OPEC alone can no longer control prices due to increasing competition from non-OPEC countries who will simply increase market share at higher prices. Regardless, prices will continue to stubbornly bounce in the $20 to $30 per barrel levels or lower until sufficient economic stress causes enough pain to motivate collective reduction in output.

Game Theory

Another explanation of low prices ties to cooperative behavior under game theory and a foreseeable end to oil’s dominance as a fuel source. The ability of a block of producers, such as OPEC, to control prices depends on cooperative behavior that can be maintained during repeating interactions, but quickly breaks down near the end of the game as individual firms increasingly engage in individual behavior. If Saudi Arabia believes that alternatives to oil such as renewable energy and natural gas are inevitably positioned to win substantial market share, it would have the incentive to produce as much oil as possible now vs. saving it in the ground for higher prices in the future. OPEC’s price-setting power would break apart as all members produce to maximize revenues today. If the case, the end of high oil prices is nigh.

Implications for the Power Sector

Although less than 1 percent of power generation is fueled by oil, oil prices impact the electricity sector in other ways. When oil prices stayed high, natural gas production continued to rise despite falling commodity prices. A near-term recovery in oil could realize increased demand for electricity and natural gas for feedstock, but increase supply of natural gas, thereby lowering prices. Sustainably low oil prices over the mid- to long-term could eventually raise natural gas prices, but remove potential demand growth from the petrochemical industry and LNG export facilities. Embedded in all of this are lag effects and dissension in the Middle East that result in substantial price volatility. When will oil prices recover? Which economic theory do you believe?

Tanya Bodell is the Executive Director of Energyzt, a global collaboration of energy experts who create value for investors in energy through actionable insights. Visit www.energyzt.com. She can be reached at: [email protected] or 617-416-0651.

“I reject the peak oil theory insofar as it refers to technological limits on human ingenuity.” –Robert P. Murphy, Economist with the Institute for Energy Research