30 January 2016

What if the Real Question is not Why Are Oil Prices Falling? but instead, Why Did They Start Rising in 2003?

It's an open question as to why oil prices have fallen so much so quickly. In June of 2014, oil prices were $111. They are now about $30.

Some of the explanations for the fall sound conspiratorial. Countries like Russia and Iran that the West has reason to weaken, are hurt by low oil prices. It might be that Western countries are engineering oil price manipulations to weaken Putin but of course this glosses over the fact that Western countries have trouble even managing their own currencies, much less the global price of oil.

Another, very interesting theory, is that solar and alternative energy sources are becoming cheaper. Some people believe that solar panels may follow the path of computer chips, becoming cheaper and more effective at a rate that mirrors chips doubling in capability every 18 months. Couple that with continued advances in fusion power and it may be that oil prices would have to drop to stay competitive with alternative energy. If oil producers believe this might happen, it would make sense that oil producers would work to sell off inventory before it becomes obsolete, driving down prices now before the great collapse in oil prices later. In this scenario, oil producers are like FAX salesmen scrambling to sell machines before email marginalizes their product.

It's also true that more incremental advances have brought down oil prices. Fracking, shale oil, and new methods of extracting oil from previously unattainable places has increased the global supply of oil and driven down prices.

But maybe the question, "Why are oil prices falling," is the wrong question. Perhaps a better question is, "Why did oil prices jump?" Because while oil prices are as low as they have been since the end of 2003, they aren't much different than what they were before 2003.

From 1987 to about May of 2003, oil prices averaged just under $20. From May of 2003 through the middle of 2014, oil prices averaged $79, 4X higher than what they'd been before 2003. So far this year, oil prices have averaged a little over $30, closer to the pre-May 2003 period than after.

What happened in 2003? The US invaded Iraq. And it didn't take the market long to realize that rather than stabilize the Middle East, ensuring a steady supply of oil, this was likely to destabilize markets by threatening oil supplies. When retreating Iraqi forces set fire to 40-some oil fields, it made for fairly spectacular footage. 

When the US invaded Iraq, oil prices were about $23 to $34. After that, they began to steadily rise until peaking at nearly $140 in June of 2008, when the Great Recession had begun. (Everyone points to mortgage markets as cause of the Great Recession, and for good reason. Oddly, no one points to incredibly high oil prices in spite of the fact that high oil prices have started recessions before.) From the month the US invaded Iraq to June of 2008, oil prices rose $115.

It might be that oil prices that range from $20 to $40 is not the exception but instead, oil prices that ranged from $100 to $140 were the exception. As the market realizes that even radicals as ideological as ISIS are willing to sell oil, perhaps the market is now seeing less risk to oil supplies and thus, is pricing oil at less of a premium.

Oil prices peaked at nearly $140 in June of 2008, about $115 higher than they had been when the US invaded Iraq in 2003.
The question is not, Why are oil prices falling. The question is, Why did oil prices rise? The answer to that question may well be complex and debatable. It might also be that the answer is as simple as this was just one more price paid for bad US foreign policy. It was a policy based on the simplistic notion that the bright shining light created by this invasion would radiate from democracy in the Middle East rather than burning oil fields.

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