Why the oil price slump is bad news

First published in The Independent on Sunday, 26 October 2008

Once again Gordon Brown has energy policy all wrong. Even before OPEC announced an output cut of 1.5 million barrels per day, the prime minister had denounced the move as “absolutely scandalous”, fearing it would force the oil price higher just as the world slides into recession.

He needn’t have worried, since the cost of crude continued to fall on Friday to $64 per barrel. But what Mr Brown fails to grasp is that the recent collapse is as damaging in its way as the previous spike, and that had OPEC managed to boost the oil price it would have done us all a favour.

A falling oil price has real short term benefits. Petrol has dropped below £1 per litre for the first time in almost a year; domestic heat and power bills should eventually follow; food prices and inflation should also ease, giving the monetary authorities greater freedom to cut interest rates.

But these benefits may prove fleeting because the collapsing oil price is bad for supply in the medium term. The cost of building new oil production capacity has soared in recent years, and many planned projects that were viable just a couple of months ago are uneconomic today. Christophe de Margerie, chief executive of Total, recently warned that if the oil price settles at $60, “a lot of new projects would be delayed”.

Others put the investment bar much higher, and that means the oil supply could soon fall short of demand – depending on the severity of the recession – forcing the oil price sharply upwards once more. A recent research note from Barclays Capital argues that if oil prices stay below $90, large amounts of expected oil production capacity will not be built, and “the world faces a serious supply side crunch as little as two years away”.

The oil price collapse threatens not only the oil supply, but also renewable energy projects, because their viability is judged against the cost of electricity produced from natural gas, which is itself determined by oil. So wind farms face yet another hurdle, just as Ed Miliband, the Secretary of State at the recently created Department of Energy and Climate Change, has raised Britain’s commitment to cut emissions to 80% by 2050.

Like low oil prices, high oil prices are a mixed blessing. On the one hand they spur conservation: America is now consuming almost a million barrels per day less than a year ago. On the other, they cause recessions: oil price spikes have precipitated every major downturn since WWII. What’s needed, then, is a ‘Goldilocks’ oil price – say $100 per barrel – high enough to sustain capacity and moderate consumption, but not so high that the economy tanks.

But don’t hold your breath. OPEC, for all its fearsome reputation, has never had the discipline to keep oil prices high for long. Even if the cartel cuts enough officially to compensate for falling demand, its members always cheat on their quotas. What is more certain is that whenever the economy revives, OPEC will again struggle to raise output – the cause of the recent spike to $147.

Non-OPEC oil production is widely expected to peak around 2010, and the cartel is likely to reach its geological limits soon after. We are condemned to a sickening rollercoaster of oil price spikes and economic slumps until we finally rid ourselves of our dependence on petroleum.

Gordon Brown has just shelled out £500 billion to bail out some dodgy bankers. Surely we can afford whatever it takes to get off the black stuff?