Conventional wisdom can be dangerous. As humans, we are constantly seeking explanations to changes in our environment. But the fact that everybody “knows” something is occasionally simply indicative of the fact that a more plausible explanation was too complex or too opaque, and that a more convenient—but less accurate—explanation was easier to accept.

So it is interesting to note the intensity with which it has become conventional wisdom among energy industry observers and policy analysts alike that the world is currently staring down the barrel of high and rising oil prices well into the future. As the argument goes (and we have often made it here), the most recent price spike (2003-2007) was the result of a confluence of persistent factors that are endemic in today’s global petroleum market. The most widely accepted factor is increasing demand for energy, especially in emerging markets. No doubt, this is an empirically provable fact. Since 1990, demand for oil in China has more than tripled, from 2.3 million barrels per day to 7.5 million barrels per day (mb/d)—essentially adding two more Germanys to world demand. The story is roughly similar throughout emerging markets, which the International Energy Agency (IEA) now expects to account for roughly 100 percent of the 20 mb/d increase in world liquid fuel demand through 2030.

The second factor arguing in favor of future high prices is constrained supply growth. The global financial crisis has severely impacted the ability of many oil companies to access capital markets and invest in new production. The recession has also brought low oil prices, which weakens the incentive for international oil companies to invest in high-cost projects like Canadian oil sands. And within OPEC and other places where governments run oil companies (Mexico and Russia, for example), decisions about investment in new production capacity are often distorted by social spending.

Add geopolitical volatility to these market fundamentals, and the case for a long-term price uptrend seems pretty straightforward. Tight supply, increasing demand, and the occasional terrorist attack on a pipeline should mean oil prices trend upward over the long-term, right?

Maybe, maybe not.

Two historical reference points tell a different story. The first is anecdotal, the second is more empirical.

Think about the tone of discussion on oil prices heading into the summer of 2008. Analysts at major Wall Street investment banks were forecasting $200 oil. The CEO of Gazprom was reported to have said $250 oil would be here in 2009. This hysteria contributed to a feedback loop in which dire predictions led traders to believe that future market fundamentals supported ever-higher prices today. What so many observers conveniently (and somewhat ironically) forgot, however, is that markets are dynamic systems in search of equilibria. When a system gets knocked off of its equilibrium and heads toward a new resting place, we often call that a ‘tipping point.’ A $147 barrel of oil was a tipping point of nearly epic proportions—it was the price at which demand growth ceased to exist in practical terms and instead began to plummet, taking prices along for the ride.

The lesson is that high oil prices are never a fait accompli. If for no other reason, this is because high prices sow the seeds of their own destruction by reducing demand.

Next, take a look at the graph below, which was inspired by this entry from the folks at Newsweek’s Wealth of Nations blog. The graph charts historical crude oil prices and world population growth. For now, let’s look only at the price data (left axis). As the Wealth of Nations entry points out, real oil prices have historically been volatile, but it’s hard to argue that they have ever exhibited any specific long-term trend. In general, there are two reasons for this. First, commodities have unique characteristics as goods. For example, each individual commodity is typically interchangeable regardless of its origin of production (think copper), which makes price competition fluid. Second, society often finds a way to replace commodities or use them more efficiently when prices rise. Either that, or new commodities come along to supplant existing ones (for example, in the 19^th century, whale oil was replaced by coal gas, which was replaced by kerosene for home lighting). This technological change factor effectively limits the extent to which prices can rise over long periods of time.

Source: BP plc., Statistical Review of World Energy 2008; UN Development Program 

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