Why Oil Prices Will Drop

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With energy supplies expanding and the demand for oil showing signs of faltering, it won't be very long before economic fundamentals reassert themselves. If oil were a normal commodity, competition would eventually drive the price down to a level close to the current cost of production, which at the margin is probably somewhere between $20 and $30 a barrel.

Of course, the oil market is hardly a textbook case of open competition: The OPEC cartel controls 40 percent of the supply, and geopolitics is an ever-present factor, as is speculation. The recent surge toward $100 a barrel was a dramatic demonstration of how traders can cause prices to become unmoored from costs for a lengthy period. But that also means that once market sentiment turns, the fall in prices could be just as dramatic.

Nobody in the oil market—not Wall Street, not Exxon Mobil, not even OPEC—can sustain prohibitively high prices for very long, a point that Sheik Yamani, the Saudi oil minister during the oil price shocks of the '70s and '80s, recognized. "If we force Western governments to invest heavily in finding alternative sources of energy, they will," he said in 1981, shortly after OPEC production cuts caused the price of crude to hit a record of $39.50 a barrel—roughly $100 a barrel in 2007 dollars. "This will take them no more than seven to 10 years and will result in their reduced dependence on oil as a source of energy to a point which will jeopardize Saudi Arabia's interests."

Most people ignored Yamani's warning, but he was right. Between 1979 and 1983, oil consumption in the non-Communist world fell by 6 billion barrels a day, or more than 10 percent. Motorists bought smaller cars. Homeowners threw out their oil furnaces. Power stations switched to coal, nuclear fuel, and natural gas. And this all happened at a time when new oil fields in Alaska, Mexico, and the North Sea were coming onstream in a big way. The result was an excess supply of crude and a huge drop in prices. In 1986, the cost of a barrel of crude fell to as low as $11.

The oil industry entered a prolonged slump, devastating Texas and other producing areas. For most of the '90s, the cost of a barrel of crude stayed below $20. At the end of 1988 and the start of 1989, it fell below $10, and you could get change out of a dollar for a gallon of gas.

I'm not saying that the oil price will slink all the way back to $10 a barrel. But a reckoning is inevitable. Serious divisions are emerging within OPEC about 2008 production levels. Presidential candidates in the U.S. are calling for tougher fuel-economy standards. Many Western countries, the U.S. and Britain included, have been making plans for a new generation of nuclear power plants. In the oil market, the laws of supply and demand sometimes appear to have been suspended. Ultimately, however, they do work.

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