Tricks of the Mind Turned Oil Into Gold

oil productionMy Comments: Once again, I have a blog post about OIL. Clients are asking me how was it possible for the price of oil to rise as far as it did just a year ago and yet here we are, with the per barrell price 40% of what it used to be. If it’s economically realistic at $50 per barrell, how come the price was $140 or more just 18-24 months ago?

A basic premise found in Economics 101 is that the price of anything is a function of supply and demand. That rule is working now, but it still doesn’t explain where the money went when the price was $140 per barrell. These comments will help you better understand this phenomena.

Mikhail Fridman / January 28, 2015

In 2007 I made a bet with a fellow Russian businessman. The price of oil, he told me, would never drop below $80 again. This was the consensus among oilmen at the time. And that, I thought, was the surest sign that the oil price would soon start falling.

I told my acquaintance that the oil price could easily go down to $40. What determines it, I said, is not supply, demand or the cost of production. Rather, what matters is the mere perception of a potential shortage.

The price of oil stayed high only because people believed there was not enough of it to go around. But once people believe that, consumers start looking for an alternative while producers try to pump more of the stuff — and then prices fall.

I am not a professional oilman and my assumptions were based not on knowledge of geology or the rate of economic growth in China, but on the simple fact that humanity usually finds a way around any obstacle in its path.

While many of my colleagues in Russia and elsewhere are arguing about when the oil price may bounce back, I am convinced that we have entered a new period of low oil prices. It is like alchemy, but in reverse: black gold, a precious substance whose price was determined by its scarcity, has turned into a black, smelly liquid that makes wheels turn.

It is not the first time this has happened. The price of oil was relatively stable until the 1970s brought the psychological shock of an embargo imposed by Saudi Arabia on the export of oil to America.

In 1975, the US started its petroleum strategic reserve, contributing to the perception that oil was scarce. Oil producers saw their main objective was to guard their oligopoly. No one cared about such trifling matters as efficiency — the distribution of licences was far more important. A good lobbyist was worth more to an oil company than a good engineer.

To deal with this challenge, developed countries started to invest in energy saving and new technologies, and by the early 1980s this started to yield results. The ensuing fall in oil prices eventually sapped the Soviet Union of its economic lifeblood.

The price of oil stayed high only because people believed there was not enough of it to go around. But once people believe that, consumers start looking for an alternative while producers try to pump more of the stuff — and then prices fall.

Rapid economic growth in China and India in the early 2000s changed the perception about the balance between demand for oil and its scarcity. And once again developed countries with high levels of entrepreneurial freedom set themselves to work on solving the bottleneck.

There was no single solution, but everyone thought of something: biofuel, wind energy, oil sands, shale.

It was no accident that the countries that led the innovation were liberal market economies with strong property rights, while the countries that wished to thwart these efforts were resentful of competition and riddled with monopolists. They treated private property as a concession that could easily be taken away.

Political systems based on the distribution of rent demoralise people. Political regimes based on free competition motivate people. It is because of free initiative and competition that humanity can overcome bottlenecks.

The reason America has led the way in the production of shale oil and gas is not that it has a lot of shale — many other countries have a similar geology. It is that America has a lot of economic freedom.

This is a precious resource that many other countries lack. Its government does not sell licences for onshore drilling. It lets people buy land, and promises that nobody can take away from you what it is yours.

The dizzying oil prices of recent years were profoundly abnormal. The fall will turn oil production into a proper business where costs and efficiency matter more than lobbying power. This stands to make the world freer and safer, by reducing the power of illiberal regimes that thrive on oil rents.

Two years ago, I found myself in Manaus, a unique city in Brazil’s Amazonas, in the middle of the rainforest. In the late 19th century Manaus became one of the richest and most extravagant cities thanks to the rubber it had.

It built a splendid Belle Époque-style opera house out of Italian marble with vast domes and gilded balconies. But a few years later the seeds of the rubber tree were smuggled out of the Amazon and Brazil lost its monopoly.

Then the invention of artificial rubber finally buried the entire prosperity of this tropical Paris. Manaus fell into poverty, electricity generation became too expensive and the opera house went dark. It is a powerful lesson to the futility of suppressing competition.

The writer is an international businessman and chairman of LetterOne Group and Alfa Group Consortium

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