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I have never had much use for peak oil believers. Their arguments are generally not worth the time it takes to read them. But my arrogant dismissal of peak oil has been shaken by Stuart Staniford. Unlike most peak oilers, Mr. Staniford really gives you something to think about.

While I was reading Mr. Staniford’s latest post, it struck me that he was one of the few people who have truly shaken up my view of the world in recent years. When I was a teenager this would not have been so noteworthy. But as I get older, it seems like I have seen every argument a million times already. In that context, Mr. Staniford is like a breath of fresh air.

I may have already said as much in some past post. I am too tired to take the time to check my archives. My point in bringing it up again (if that is what I am doing) is twofold. First, I want to encourage people to read Mr. Staniford’s latest post. Second, I want to raise an issue that runs contrary to everything that Mr. Staniford has been discussing.

I believe that even if everything that Mr. Staniford says is true, oil prices could drop like a rock in real terms in the near future. I can imagine most of the oil producing countries falling on hard economic times. I can imagine people wondering why they ever thought oil scarcity was going to be a problem

Given that oil prices are fast closing in on 100 dollars a barrel, this seems like a pretty wild statement. After all, even Mr. Rapier thinks that oil producers are going to do very well in the decades to come and he is the most intelligent critic that Mr. Staniford has. How can oil producers possibly suffer in the world of declining oil production that Mr. Staniford predicts?

The answer is simple. If demand falls by more than production, oil prices will crater even if production is off its peak. Most peak oilers do not foresee this happening because they know more about the history of oil production than they do economics. They assume that oil producers will always have the whip hand.

But let us say that a severe global economic downturn causes oil demand to drop like a rock. If it drops faster than production is “naturally” dropping off due to “peak oil,” then producers will have to cut back on production just to keep the price of oil from falling. But even if they do that, the oil producers will still be pulling in less money than they were before because they will be selling less barrels of oil for the same price per barrel. This ought to be self evident, but for some people it is not.

Some peak oil believers seem to think that oil producers could just cut way back on production and cause oil prices to stay high enough that oil producers will still make the same amount of money as before the drop in demand.

But this is false. Such a course of action would only cause demand to drop still further and the oil producers would be right back where they started. There is no way that oil producers can escape from the fact that falling demand (relative to supply) equals falling income.

What most people forget is that the thing that has been keeping oil prices high is not the fact that supply has been leveling off, but the fact that demand has stayed strong. If demand fell in line with supply we would not have seen the price run ups. But it has not, so prices have had to rise high enough to price people out of the market.

If you can understand how the income for oil producers will go down if demand falls faster than supply, even if you buy the peak oil view of potential supply, you should be able to understand how this situation would lead to lower oil prices.

Let us say that you are a country like Iran or Venezuela. Both of these countries are spending everything they’ve got right now even though oil prices are high. If their oil income falls, their economies are going to fall right along with it. They have no cushion.

If you were in these countries’ shoes, would you cut production when demand dropped? Especially if much of the benefit to keeping prices high went to the bigger producers? No, you would produce every last drop that you could in an effort to keep your oil income from falling. Let the big guys make the production cuts.

Historically, this is what has broken OPEC pricing power in the past. And I don’t see any reason why it can’t happen again.

I only bring this up because more and more people seem to be investing their life’s savings around the idea that oil will always go up. That is not a bet I would want to make even if the peak oilers are right.

One Response to “Even if peak oilers are right, oil prices can still fall.”

  1. on 05 Nov 2007 at 11:40 pmProf. Goose

    you’re exactly right. I fully expect the price signal to break $100/bbl, hang out there through the winter, then break down to at least $80/bbl…if not further. Demand will be destroyed at some point…who knows when?

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