Another Oil Price Shock Is Brewing

Photo: Philadelphia Inquirer

Fun news: another oil price shock is coming.

How can I tell? Simple. The price at the pump is already back above $4/gal. There was a debate last December (on The Oil Drum) about 2012 barrel price projections. But, as Voltaire noted, Les hommes discutent, la nature agit--we can quibble about our projections, but the ultimate arbiter is what actually comes up out of the ground and who gets it.

This is something the U.S. is losing. Oil production began to plateau in 2002; in 2005 China and India became major buyers Hoovering up all the world's excess crude. In 2005 the U.S. ceased to be the world's crude sink.

2005 was peak oil for America. It was the peak of availability, note, not of absolute production. That has not yet indisputably happened. But since 2005 India and (especially) China have been the buyers of choice, those who get first crack at oil, while the developed world has had to make due with decreasing local supplies. This has, unsurprisingly, led to slow but sure increases in U.S. gas prices.

In 2006-7 wanton speculation in the oil futures market (an early reaction to a local collapse of the housing market that actually began in 2006) led to a steep rise in the price of gas, leading to the first price shock, which in turn catalyzed the more general collapse, particularly in the housing market, we saw through 2007-8. With that collapse, the price of gas dropped to unsustainable lows, and has since been increasing in lockstep with the economy's inchworm improvements.

But the final straw that brought about this collapse was the fact that the price of gas became too high to bear. $4/gal seems to be the critical threshold, beyond which non-automotive transportation options, whatever their limitations, become mighty appealing. And we find ourselves back at this threshold early this year, before the spring or summer traveling seasons have even begun.

A key issue is the long-term ramifications of the Arab Spring and the Iranian oil sanctions, both of which have essentially taken Mideast oil supplies off the map. Continuing political tensions there will continue to effect oil prices.

But this is key--unlike with the last price shock, there is no clear evidence that speculation was driving an unsustainable bubble. In fact, it seems the opposite is true. The price of oil is up because (a) production is as flat as it has been for a decade (this is in accordance with realizations of Hubbert peak theory) and (b) China and India have fast become "thirsty" countries. In fact, I posit the supply of oil in China and India will be inversely proportional with the supply in the developed world (the U.S., Canada, Western Europe, Japan, and Australia). In the long run, these two demand blocs will just about evenly split the balance of the world's oil demand, but this is not going to happen without severe economic adjustments in the West.

But--$4/gal is the critical mass beyond which Americans will begin en masse to seek alternative transportation options; we can expect $4.50 or even $5/gal gas over the summer. And, to repeat: this will be the second oil price shock.

Particularly late last year, when the oil price inexplicably dropped (Libyan reserves coming back online?) oblivious or in-denial Americans began to revert to their gas-guzzling ways. This came while at the same time the younger generation, when they could afford it, showed a clear preference for urban living.

The economic reaction to this shock is very much up in the air. America is stronger right now; Europe is knee-deep in the Euro crisis (another debt crisis). But the dominant economic structure right now is deleveraging--each debt crisis is catalyzing another one, and will continue to, until debt burdens are enormously shrunk, if not outright eliminated.

It is very likely the U.S. will have a reaction to this shock the same way the Europeans had the first one--no need to panic, this is just like 2007, only this time we don't need to choose between our house and our car (we made that choice five years ago). To them, though, this could be the one missing brick that brings down the tottering structure that is the Eurozone--or, obversely--be the foundation block that cements a unified Europe...