Why Oil Costs So Much

Perhaps you have seen the circus in the U.S. Congress recently, where they have proposed "windfall" profit taxes on the five largest oil companies. And, where one Senator pleaded with a CEO in a strained voice, asking "Don't you see what you're doing to your country?"

Or, in another fit of irrationality, Congress' newly proposed legislation to undo the Carter reform of pricing oil in a commodities market. They have proposed this to thwart the greedy Wall Street speculators.

Surely, there must be evil lurking somewhere. There must be some scapegoat to pay the price.

But, it isn't to be. I did a little research on my own a few days ago, and convinced myself of what BP has provided in its own Statistical Review of Global Energy 2008.

In their report, they point out that oil production FELL by .2% in 2007, despite through the roof prices. In fact, I found on Wikipedia that oil production has been roughly flat since the beginning of 2005.

What does this mean? Normally, when demand falls, the price drops, and then the supply falls. The reason that supply falls is that each oil well has a price per barrel where it makes economic sense to remove it from the ground. In other words, if it took $100 per barrel to pump the stuff out of the ground, why do it if the price is only $90 per barrel on the open market? You'd be losing $10 per barrel that you sold, and you wouldn't last long in the oil business.

Up to 2005, this relationship is solidly in place. You can put the price chart next to the supply chart, and see them moving together. But starting in 2005, the production stops going up; it's as if it hits a limit. The price keeps rising, because the world economy is growing, and it needs more oil to function. Those prices should have caused more expensive barrels in the ground to be pumped up - but they haven't.

Why? My thinking at the moment is that high prices are stimulating exploration and production - the problem is that old production is falling away, as old fields decline. It may be that technology will bail us out of this (new ways of pumping previously unreachable oil), or that new production projects that can meet the world's demand have long lead times. But, at 3.5 years of elevated prices (and counting), my hope there is starting to run thin.

Basically, this is supply and demand. Not greedy speculators and not evil oil companies. This is the result of billions of people around the world emerging from poverty and improving their material life style.