The case for higher oil prices  

The SMH has part 3 of their series on peak oil and the oil price out - The case for higher oil prices.

In the first two instalments of this three-part series we considered peak oil theory, the importance of the marginal cost of production and the clear trend towards higher-cost oil discoveries. Using US Department of Energy figures, we also revealed that global oil demand exceeds current production rates.

It’s now time to consider what this tells us about future oil prices. In the short term, the answer is not much. Over the long term though, the price of oil should equal the marginal cost of production.

If the market price is lower than the price of producing an extra barrel of oil, producers will cut production to avoid losing money. But as the market price rises, new sources of oil with higher marginal costs will be developed. Marginal costs, therefore, are instrumental in determining future oil prices.

Having considered what economists call ‘‘the supply side’’, what of demand?

Whereas oil producers can adjust their output based on their marginal cost of production, consumers have less flexibility. Oil is embedded in our lives in a way that is hard to overstate.

Consider the mundane act of eating a home-cooked meal: from the fertiliser used to grow the produce, to the fuel in the semi-trailer that delivers it to the retailer; from the bag you use to carry your shopping home, to the heat you use to cook it and the knife and fork you use to eat, oil is essential.

And, while oil demand in the developed world may remain stable, or even fall thanks to lower population growth and the higher representation of services in the economies of richer countries, the industrialisation and affluence of the developing world is adding hugely to the demand for oil-based products.

Developing nations want the cars and consumables that we’ve enjoyed in the West for decades. So it’s hard to see how the demand for oil won’t rise with these aspirations.

Is there a flaw in this thesis? Perhaps. The greatest risk to higher oil prices lies in the substitution effect where, as oil gets more expensive, consumers start to change their behaviour, as occurred last year when oil hit $US147 a barrel.