After reaching record levels at around $150 and barrel earlier this year, oil has plunged to less than half that in only a matter of months. Just as the price spike was unprecedented, with companies like Goldman Sachs predicting it would continue climbing through $200, so its retreat has no precedent. Goldman Sachs is now saying it could fall below $50.
So what’s going on?
Today’s lower oil prices have little to do with supply. They are a sign of global financial chaos, and its surprisingly rapid translation into the destruction of demand for oil.
The credit crunch does two main things. It drops demand for oil through job losses, bankruptcies, stalled projects, and reduced global trade. Secondly, the money supply shrinks in relation to the amount of available oil. The $US has entered a deflationary cycle (albeit one which threatens to violently reverse direction). Both factors lead to lower oil prices in $US dollar terms while in practice, access to oil and its derivatives become ever more difficult. Meanwhile, desperate hedge funds liquidate their oil futures in attempts to stay afloat, putting another temporary downward pressure on the price of oil.
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How serious has the demand destruction been? There’s one very good measure. The Baltic Dry Index — the benchmark for dry raw materials shipping costs, such as wheat, copper and coal, went into freefall about a month before oil, dropping over 90% since May. As a measure of raw materials trade it’s a dire warning about a subsequent drop in global manufacturing, and even food availability for many.
While financial chaos can cause dislocations and hardships, it is available energy–– the lifeblood of industrial societies – which in a very fundamental sense defines the heights an economy can reach. The Financial Times this week leaked the results of the International Energy Agency’s much-anticipated study of the depletion profiles of the world’s 400 largest oilfields. The study’s stunning conclusion is that “Without extra investment to raise production, the natural annual rate of output decline is 9.1 per cent.”
The oil industry has been running on a treadmill since 2005 with production staying essentially flat. Capital for oil infrastructure investments which might have seen new production continue to offset declines for a few more years yet has withered with the financial collapse. Lower oil prices are both contributing to, and masking this new reality — that global oil production has almost certainly peaked.
When the economy attempts a recovery in several years time, global oil production will be well into its decline curve, and no amount of investment may be able to increase oil production to its previous heights again. Resurgent demand will hit falling production and the world’s economies will experience ever more volatile oil prices and resultant financial cycles as we begin a rocky descent of the energy curve.