Oil prices are headed down, and I mean down at least $20 a barrel. The key reason is that prices have been high. It's not a paradox, but a result of the long time lags in oil production.
Oil prices were fairly stable from 1986 through 2001, averaging just $20 per barrel. Then prices started rising, spiking to $134 just as the recession began. The price of oil has been above $80 for the past two and a half years. With rising prices has come a dramatic increase in exploration activity. During the era of low prices, the number of drilling rigs in operation around the world was 1,900 on average; now we are at nearly double that pace, and we have been for nearly three years.
Drilling activity results in oil production, lasting for many years after the drilling is over. Take a look at the accompanying chart of drilling rigs and total production. Drilling jumped up after the oil price hikes of 1973 and 1979. By 1986, increased oil production brought prices crashing down. Oil exploration quickly followed suit.
Production, however, continued to grow long after new drilling declined. When drilling was high, much of the activity was exploratory—trying to find the oil. When prices fell, the riskiest drilling made no sense. What was left was in-fill. The oil field had been identified, and further wells were needed to best utilize the resource. These wells are fairly low risk, with high rewards compared to the cost of the drilling rig. As a result, even low levels of drilling activity led to substantial increases in global production.
Today we've had moderately strong drilling activity for several years. New fields have been identified and delineated. Now we'll see fairly mild drilling activity but continually increasing production.
In the past year production has been soft, barely growing, but that's a reflection of weak demand. In the short run, production can be dialed back to save more oil for the future. In the long run, though, production capacity rules the roost.
What of demand? Demand should grow a little slower than the global economy. Unless the world starts to boom—an unlikely scenario, given problems in Europe and the United States—production capacity will grow faster than demand, pulling prices down.
What of peak oil worries? The concept is often sound when looking at one well—but even a single well will sometimes be re-worked to increase its output. For the world as a whole, the peak oil theory fails to consider that higher prices lead to greater exploration for new oil fields, greater in-fill drilling of established fields, better care of older wells, and development of new technology for all of these functions. The world's oil production will peak when the cost of finding new oil rises and the development of alternative energy makes the value of oil decline.
Over the coming few years, look for oil prices to decline at least below $80 a barrel and quite possibly more.