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Oil Price Decline
Dampens Alternative-Energy Fervor

Jim Prevor’s Perishable Pundit, October 17, 2008

The world has become so complex that it is hard to figure out what is good and what is bad.

With the news being that Oil Falls Near $70 a Barrel, 16-Month Low, Alarming OPEC — meaning that oil is down over 50% from its $145.29 high in July — one would think we have cause for celebration.

After all it was just back in June that James P. Hoffa of the International Brotherhood of Teamsters told us that Obscene Gas Prices Hurt Consumers, and we were told it was urgent to get oil prices down with the Center for American Progress pushing Eight Reasons to Release Oil from the Strategic Petroleum Reserve.

Certainly lower oil prices mean some people who make a lot of trouble will have less money to make trouble with and may even have trouble keeping control of their own people. The Miami Herald ran a piece entitled, Falling Oil Prices a Bad Omen for Chàvez:

…Venezuela relies on oil for 94 percent of its foreign income, and oil prices have plummeted from their record $146 a barrel in July to about $75 a barrel on Wednesday.

If the world recession is here to stay for awhile, as most economists predict, rich countries will buy less oil.

The Goldman Sachs bank projected this week that crude prices will be at $70 a barrel at the end of the year, and may drop further to $50 a barrel in the case of a deeper-than-expected world recession. Others estimate oil prices will be at $65 a barrel.

With these prices, Chàvez will have trouble maintaining his domestic social programs, which could lead to growing social tensions. And his grandiose economic aid promises abroad will be very hard to meet.

PFC Energy, a Washington D.C.-based consulting firm, says Venezuela would need oil prices at $97 a barrel to balance its external accounts in 2009 — way beyond current oil prices.

Rose Anne Franco, one of the authors of the PFC report, told me that this estimate does not include foreign aid promises that Chàvez makes almost daily around the world, but that have not yet been included in Venezuela’s budget. That would push the threshold even higher.

Threats Watch,a non-profit organization that monitors and disseminates information about national security threats, writes of Iran’s Fear of Low Prices:

…there seems to be real fiscal concerns at hand for the Islamic Republic. Mohsin Khan, Director of Middle East and Central Asia at the International Monetary Fund, argues,

Iran’s break-even price is $90 a barrel, and that is a big issue in Iran right now. If prices dip below $90 a barrel,…then they would have to tighten their public expenditure policy, and probably cut subsidies, which would be an issue for the government there — the public would not be content.

For other oil producing nations, Khan believes break-even threshold is much lower. “The UAE will have a fiscal balance at an oil price of $23, if it goes below they would run a deficit. For Qatar, the break-even price is $24 a barrel.” Saudi Arabia’s standard of $49 a barrel is the highest amongst the Gulf Cooperation Council countries on account of its high spending “on a lot of projects right now, and oil money is used to fund these projects.”

Iran’s struggling economy might not be able to sustain a prolonged period of low oil prices. The economy is the primary issue in the upcoming presidential elections and the political factions are fractured over how to fix it. Seeing the strain that subsidies have put on his inflated budget, President Ahmadinejad is considering abolishing many of them — a move that could cause inflation to spike if not done slowly and cautiously (the official inflation number is already at 26%).

If there is a positive to take from the credit crisis fallout, this just might be it.

So there are many good things that come from lower oil prices, but there are three big problems:

First is that the reason oil prices are going down is that lower levels of economic activity are reducing demand for oil. Lower levels of economic activity mean fewer employed and less prosperity.

Second, that great sucking sound you hear is sustainability going out the window. As the economy got softer, retailers started redefining sustainability to only focus on those initiatives that clearly generated a positive financial return — as opposed to those efforts pursued for environmental or social reasons. With oil prices down 50%, a lot of this so-called “low hanging fruit” is now hanging higher. So meaningful sustainability initiatives have become much rarer. Many are now just “greenwashing”.

Third, the other sound you hear is that of brakes screeching all over the world as alternative energy projects no longer make sense and consumer sacrifices for conservation — say smaller cars — become less appealing. Whether for reasons related to environmentalism, nationalism or other motivations, many believe we need to move to a post-oil world. If this is true, then declines in oil prices will likely postpone that move.

As the economists would say, with an assumption of ceteris paribus or “all things being equal,” it is obviously better to pay less for something we buy than to pay more. The problem is that advocates of renewable energy, non-carbon-emitting energy sources, energy conservation and promoters of energy independence are not simply saying that one day we may run out of oil; they are making claims that there are externalities to our use of oil that the market price doesn’t capture because these costs have been socialized.

In other words, if we have to maintain a large Navy to sustain a big flow of oil, there is a cost to the use of imported oil that is not included in the price of oil. If our use of oil is going to cause sea levels to rise so we have to build expensive dikes and relocate populations, that is a cost of using oil not included in the price of oil.

Once oil is discovered, the cost of producing the oil is only somewhere between $4 and $9 per barrel. This means that oil production does not stop simply because oil prices fall.

This makes investors hesitant to spend money on windmills, solar power, tar sands, shale, nuclear, hydrogen cars and other technologies. All these investments will take many years to pay off but because oil is so inexpensive to produce there is no assurance that oil prices will remain high enough to allow these investments to achieve a reasonable return.

Indeed, as those in produce well know, even small changes in the supply or demand for a commodity can cause large swings in price. The current crash in oil prices — an over-50% drop — can be understood in relationship to US gasoline consumption. Over the four weeks ending October 10, consumption was down 5.2% from the previous year. Though that one statistic is not the whole story, it illustrates how quickly prices can decline.

This makes investments in alternative energy sources even more problematic. If electric cars or hydrogen fuel-cell vehicles capture, say 5% of the market, a very real consequence may be a collapse in oil prices making the fuel cell or electric vehicles uneconomical. Same thing with efforts to use the tar sands or windmills. If any of these ventures are successful enough to be significant, they can easily lead to a decline in oil prices making the alternatives uneconomic.

Perhaps the most significant public policy question before us today is this: Are the externalities involved in the use of petroleum (or carbon-emitting fuels) such that we ought to establish a minimum price (or a tax regime to achieve the same goal) so that investments can be made more confidently in conservation and alternative energy? This type of initiative would not guarantee a profit — if the windmills don’t work, if the technology is bad or the company is incompetently run, one could still lose money. One would not, however, have a market risk below a set price.

It is not exactly free enterprise, but if one sticks to eliminating externalities, even a robust free marketer could go along, and, besides, in the current environment, defending ideological purity is difficult. We suppose we could make the case that we need alternative energy more than we need Bear Stearns.

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