To Drill or not To Drill. What's up with the price of oil?

I want to put to rest the idea that producing more oil in the US won’t lower the price of oil. Increasing the amount of oil produced WILL result in a price of oil lower than it would have been without the additional production. To argue otherwise is just economically ignorant. It is also true that other market forces might cause the price of oil to increase despite an increase in production.

I think it’s disingenuous to argue that drilling and producing more oil won’t decrease the price without also admitting that the price would be even higher without the additional production.

Elementary Economics Alert!

There is a “Law of Supply” and a “Law of Demand”. They are two separate things.

The law of supply says that (all other things being equal) as the price of a good increases, the quantity of that good offered by suppliers increases. (The “all other things being equal” part is important.)

The law of demand says that (all other things being equal) as the price of a good increases, demand for that good decreases. (Again, the “all other things being equal” part is important.)

These two laws affect each other, creating self correcting feedback loops. As the price of “A” increases more “A” is produced, but at the same time demand for “A” decreases. When demand for “A” decreases, the price of “A” drops, which causes a decrease in supply. As the price of “A” drops, demand increases again, causing the price to go up and an increase in the supply of “A”. And it goes on in a never ending, very confusing cycle.

Now, lets look at oil.

The price of oil has increased. According to the law of supply we should see suppliers increasing output. According to the law of demand consumers should be using less oil. We HAVE seen consumers decreasing their demand for oil. People are driving less and buying more fuel efficient cars. Also, oil production has increased worldwide by a few percent.

So why is the price of oil still going up?

Here’s where that part about all other things being equal comes in.

One thing that isn’t equal is the value of the Dollar. According to the Federal Reserve, the US Dollar has lost 30% of it’s value in the last six years. The price of oil in Dollars would have increased just because the Dollar is worth less than it used to be.

There’s also a lot of money chasing oil futures.  In fact, what we are seeing is an oil price bubble similar to the housing bubble and the .com bubble.  The oil bubble will pop and oil prices will fall.  

Current estimates of the post bubble oil price are around $50 – $70 per barrel.  Just like the 70’s and the 80’s, the current high oil prices will drop and the press will be whining about the oil glut just like they did then.    The more insane oil prices get, the sooner the bubble will burst.  

Imagine you run an oil company.  You know all the economic facts and you know what your production capacities are.  You know the current prices are an aberration and in a short time the price will fall.  

Do you want to spend a lot of money opening up new oil fields so they’ll come on line just in time for an oil glut?

Neither would I.

That said, I think the laws that restrict oil production in places like ANWR and off the coasts of Florida and California are stupid.  The time to develop oil fields isn’t at the peak of a bubble, but during a glut before the next oil shock.  The environmental fears are groundless and the fact is that someday those fields WILL be developed for oil production.  It’s just a matter of time.

Cross Posted at Alan C. Andrews