Oil: Does Supply and Demand Still Apply?

Includes: DBO, OIL, USO
by: Saj Karsan

We consistently hear from oil bulls that we've reached peak oil as production can no longer keep up with demand. We discussed the demand situation here, but what about the supply? Have we reached a point where we just don't have enough oil to supply demand? In the short term we're close, but in the long term, with prices at these levels, productive capacity will grow. There are many articles that discuss how supply and demand work, but here let's take a look at past data for the oil industry to see this in action.

Below is a chart showing both the price of oil along with the number of exploratory wells drilled for the last 30 years:

Notice how high oil prices in the early 80s resulted in a strong incentive to drill for oil. As a consequence, supply increases, resulting in lower prices. Clearly, with the price of oil being so low from the mid 1980s to the early 2000s, there was little incentive to explore for oil, as profits were too low. This has resulted in the situation we are in today, with little excess supply. Since 2005, however, incentives appear to again exist for further exploration, and we an increase in drilling occurring.

At first glance, however, it appears that the number of wells drilled is still far below where it was during the 1980s. Could this be that we've run out of places to look? Not so. Digging a bit further reveals that as technology has improved, well exploration success rates have increased, as follows:

Throwing substitutes for oil into the mix (e.g. alternative energy), suggests a future for oil similar to the one we've seen in the past: high oil prices result in exploration that increases supply, and increases use of alternatives, as we've seen here. As such, the long term price of oil will decrease as supplies increase and demand declines.

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