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Whither Oil Prices?

Oct 28, 2008
Michael Burt
Canadian Industrial Outlook
I’ll start out by stating that we at the Conference Board of Canada expect that oil prices will remain high relative to their historic average. However, the recent slide in oil prices, and the record peak that they reached in early July, bring to mind the previous record peak for oil prices following the revolution in Iran in 1979. What is striking is that after spiking to nearly $40 per barrel (or nearly $80 in inflation adjusted terms), by the summer of 1986 prices had dropped below $12 per barrel.

The consensus at the beginning of the 1980s was that oil prices would remain high. There were considerable political risks then, as now, such as the Iran-Iraq war, and global demand growth had been very strong since the end of the Second World War. Thus, forecasters got it wrong back then; could it happen again?

To answer this question, we need to understand what happened to drive prices down in the mid-1980s. There were two main causes to the drop in prices at the time. The first was ample supply. The price shocks of the 1970s led to new supplies coming on stream, for example, in the form of North Sea oil, and increased production in Canada and the United States. As well, although OPEC production dropped in the 1980s, it had ample spare capacity.

The second was a technology shift by users of energy. The efficiency of oil use in the large developed economies increased in the 1980s as people and businesses adjusted to higher oil prices. In fact, the amount of oil used per dollar of GDP in developed economies has dropped precipitously, thanks to a wide variety of technology changes and improvements. Everything from more fuel efficient cars to an increase in the use of nuclear power generation allowed economies to reduce their oil consumption.

Could this situation apply to the current high oil price environment? Well, one factor that was present back then is not present now. Global oil supplies are tight and much of the remaining unexploited supply that could be brought on stream in the future is either in politically unstable areas or controlled by regimes that are not willing to let Western oil companies gain access (with one notable exception being Canada’s oil sands). As a result, the possibility of increased oil supplies is largely controlled by OPEC nations or others with nationalized energy companies, who have an incentive to keep oil prices as high as possible.

However, technology is still a wild card. All one has to do is look at the crop of hybrid and electric cars that are slated to go on sale in the next couple of years to get an idea of how we could witness another upward shift in energy efficiency. Already people have begun to respond to higher prices by reducing consumption, with oil demand expected to fall this year in most developed economies. Even in developing countries where subsidies limit the price signals for consumers, the surging cost of supporting these subsidies is causing policymakers to consider how they can reduce demand in their own countries. Technology also has the potential to alter available supply, by changing what oil we consider recoverable in countries that are experiencing falling production.

Thus, if technology can change our supply and demand patterns sufficiently, it is possible that oil prices may have a lot further to fall. All it will take is time for these new technologies to be implemented. It wouldn’t be the first or the last time that technological change has proven forecasts wrong. Can anyone say Malthus?

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