The price of crude oil has fallen more than 50% since summer and drivers are responding exactly as economists would predict. Americans are driving more, the market for SUVs is roaring again and the average fuel economy of new cars sold is declining after years of increases.
Many oil analysts predict that oil prices won’t stay this low, and the futures markets agree. The price for oil delivered in March 2019 is 40% higher than the price for oil delivered in March 2015. Regardless of whether oil prices regain some of their 2014 losses in the next few years, the latest petro-roller coaster illustrates the monumental challenge that still lies ahead for attempts to reduce greenhouse gas emissions by switching to EVs or biofuels.
To see why, start by recognizing that the oil crash of 2014 resulted from a collection of unforeseen changes to supply and demand. Economies in Europe and Asia saw slower demand growth than was forecast. The U.S. supply expansion (mainly from fracking in North Dakota and Texas) continued at a more robust pace than anticipated, while U.S. demand is dampened by years of improving fuel economy. Libya’s oil production rebounded as warring factions reached enough accord to get oil onto tankers. And OPEC did not offset these surprises as it has done in the past (mostly just Saudi Arabia) by taking a few million barrels per day off the market.
But the piece of this story that has gotten very little attention is how small the supply and demand surprises have been as a share of the 92 million barrel per day market. Given past trends, the news in the last year didn’t plausibly change the supply/demand balance by more than 5 million barrels per day, and it was probably a lot less. Yet, that was enough to drop the spot price of oil by more than 50% and push down long-run oil price expectations by more than 30%.
The reason for this outsized reaction is the simple economics of competitive markets: the price is set by the marginal cost of the last, or highest cost, barrel sold. The marginal barrel is less costly to produce these days than 6 months ago, but most of the crude oil supplied is even less expensive. The recent oil price drop shows that a small increase in crude supply and/or a small drop in demand brings a much cheaper barrel of oil to the margin, and that sets the price.
The 2014 crash gave us a small glimpse of what reducing world crude demand would do to oil markets. There is a lot of conventional crude oil that is unpumped and an enormous supply of oil from shale and tar sands that is becoming cheaper to produce each year. The annual energy forecasts from the U.S. Energy Information Administration, International Energy Agency, BP, Exxon and others see consumption of liquid hydrocarbons increasing or flat for many decades.
If switching to alternative fuels took even 20% out of world oil demand – less than a third of the oil used for transportation — the price would surely crash further and for much longer than we have seen in the last year.
What would oil prices would look like if world demand fell to 70 million barrels a day by 2025? Anything above $40/barrel doesn’t seem very plausible, and below $30/barrel seems much more likely, possibly well below. Even at $30/barrel, the oil-cost component of gasoline is about $0.75/gallon. With transportation, refining, and retailing costs plus taxes (at today’s level), the U.S. price of gas would barely clear $1.50.
Alternative transportation technologies are indeed making real progress. Energy storage is improving and making electric vehicles credible, if still very expensive. Biofuels are improving and I read stories that some can compete at $3/gallon, though scalability is still an unresolved question. I hear frequently from some of my former students who are deeply involved in these exciting ventures.
An alternative fuel vehicle that is cost competitive (including amortized capital costs over the life of the vehicle) with $3/gallon gasoline has a shot at being a successful small or medium scale business. But to get to a technology that drives oil out of the transportation market for 21st century, that drastically reduces carbon emissions from vehicles, and that does it worldwide without imposing much higher gas taxes – which even relatively-wealthy Americans resist strongly — $3/gallon is still way too high. The cost of alternative fuel transportation would have to get to half of that or less.
I’m thrilled by the rapid advances we’ve seen recently in alternative energy. But when it comes to powering transportation, I don’t agree with the advocates who say the mission is nearly accomplished.
Scaling up alternative energy will greatly disrupt the conventional energy markets. That disruption will cause oil prices to plummet and ratchet up the challenge to alternative transportation. The economics of oil markets mean that the two major roles for government in the fight against climate change – pricing greenhouse gases and supporting research on alternatives – will remain critical for decades to come.
I’m still tweeting energy news articles and new research papers @BorensteinS
Severin Borenstein is E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business. He has published extensively on the oil and gasoline industries, electricity markets and pricing greenhouse gases. His current research projects include the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. In 2012-13, he served on the Emissions Market Assessment Committee that advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. Currently, he chairs the California Energy Commission's Petroleum Market Advisory Committee and is a member of the Bay Area Air Quality Management District's Advisory Council.