The Cure for Low Oil Prices

Low Prices for Oil Tend to Lead to Much Higher Prices, Eventually

Gas Pump Prices for Fuel
Pump Prices at Gas Station. J. Pat Carter

The cure for low oil prices is low oil prices.  In fact, this axiom is true for just about every commodity; gold; base metals; wheat; coffee beans; corn.

Supply Countdown

After all, the world runs out of oil in 53 years and 169 days, according to an article in Zacks, so eventually, the demand for crude is destined to climb.  

When low demand, a glut of supply, or low prices start to impact production, most industries shift to adapt.

 For example, mines or rigs shut down or go idle, while exploration and development plans are put on hold.  

Many marginal oil wells are profitable at first, but not once the price of the underlying commodity falls. Then they are faced with two choices:

  • lose money each day they operate, or...
  • plug up the project until prices recover

Picture an oil well which has a cost of production of $40 for each barrel they bring to market.  When the price of the commodity falls to $30, they lose money, so they usually plug the well or temporarily go idle.

It has the effect of reducing total supplies being brought to market.  A couple of wells closing down, or even several dozens, will not make much difference, but with such depressed oil prices, there are major production curbs coming into play the whole world over.

You can even see the total oil rig count in America falling to 514, which is down 796 compared to this time last year.

 The International trend is quite similar.

As well, lower oil prices have other major effects, such as:

  • banks stop lending money for oil exploration and well development
  • many oil producers have to curtail their operations
  • some companies go bankrupt or completely close down

All of these impacts combine to reduce supplies.

 Meanwhile, with such low prices, you will also see the strategic petroleum reserves of many nations getting topped off, just like we recently saw with China.

There is also an effect on corporate efficiencies, whereby it is easier to use low-priced oil instead of high-priced coal/solar/geothermal, etc.  Why drop $100,000 on a new solar-powered rooftop setup, when you could buy more conventional fuel than you need, for a fraction of the price?

The key point here is that oil prices change much more quickly than the underlying supply and demand forces.  The cost of the commodity could drive 25% higher in a day, but it will take all idle rigs and oil producing nations months, if not years, to react and have any sort of impact.

Supply Constraint

It all leads to a supply constraint in the face of (eventual) higher prices.  People and countries are gobbling up oil, long before production and supply catch up.

In that window of time, demand outstrips supply to a major degree.  Oil prices get launched towards significantly higher levels.  As demand recovers, supply has typically been greatly reduced, creating a sudden stampede towards the limited commodity.  

That is why, when oil prices recover, it won't be a 5% or 15% increase in prices.

 More realistically, and also based on historical situations which were similar, you will will see the cost of a barrel at least double.  At very least.

Kind of like inflation, or a fire, or tumbling down a steep hill, once the move begins, it will be extreme and significant.  In other words, enjoy all the cheap gasoline now, because it is a temporary event.

As has played out many times in the past, the cure for low oil prices truly is low oil prices.  It may not seem like it right now, but you'll understand what we mean soon enough.