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The Universal Message of Falling Oil Prices

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The Universal Message of Falling Oil Prices

December 1, 2014

For American consumers, the recent dramatic decline in the price of oil appears as one of the most welcome economic developments in recent memory. The same barrel of West Texas Intermediate Crude that sold for nearly $100 at the end of last year now trades for about $66 – a decline of almost one-third.

Although some observers might worry that these prices are just too good to last, an interesting and thought-provoking blog post by the Wall Street Journal’s Alen Mattich suggests otherwise. Mattich usefully reminds us that it is the very recent period of extremely high oil prices that stands as a historical anomaly. Over the 20-year period from 1985 through 2005, by sharp contrast, the price of oil, even after adjusting for inflation by converting to today’s dollars, generally fluctuated between $20 and $40 per barrel. Thus, Mattrich’s observations suggest that oil prices could fall much lower in the months ahead and could easily remain at those low levels for years, if not decades, to come.

It is even possible to reinforce Mattich’s conclusions by extending his historical analysis back further in time. To do so, the figure below uses data provided by the British Petroleum Company’s Statistical Review of World Energy and analyzed more fully in a fascinating paper by Eyal Dvir and Kenneth Rogoff to plot the inflation-adjusted price of oil all the way back to 1863. The data from BP’s report, published earlier this year, end in 2013, before the most recent, sharp decline took place. But looking back in time, the figure reveals something amazing: the $20 to $40 “normal” range that Mattich quotes for the price of oil actually applies equally well over most of the past 150 years!


Only during three very exceptional periods, in fact, has the price of oil ever broken out of its otherwise very stable trading range. One of these episodes was driven by sharp disruptions in world oil supply, caused by the OPEC embargoes of the 1970s. The two other periods of exceptionally high oil prices occurred during times of heightened demand, reflecting rapid industrialization of the United States economy during the mid-to-late 19th century and the equally if not more rapid expansion of the Asian economies, especially China’s, during the past decade. In both of the two previous periods, however, prices remained high only temporarily, before declining rapidly back to more usual levels.

Besides supporting Mattich’s idea that this year’s decline in the price of oil might well provide a long-lasting benefit to the world’s economies, the data from the graph also remind us of a more basic lesson from economics concerning the stabilizing role that price movements play within a dynamic, free-market environment. When oil prices do spike, they provide consumers with a strong incentive to cut back on their energy usage, and they provide businesses with even more powerful incentives to find new ways of producing more fuel-efficient vehicles, buildings, and factories. Likewise, high prices encourage the discovery of new technologies that allow explorers to find and recover previously untapped reserves of oil. And high oil prices encourage the development of alternative sources of renewable energy, allowing us to shift away from the use of hydrocarbons altogether. In the graph, we can clearly see how these incentive effects worked to bring oil prices back down in the 1800s and the 1980s. Most likely, these same incentive effects will work to push oil prices lower in the years ahead.

Finally, looking at and thinking about these long-run patterns in the price of oil teaches us a broader and more important lesson as well. Countless writers, going all the back to Thomas Robert Malthus, have warned us that resource scarcity will ultimately place limits on the ability of the world economy to grow. But while these arguments often have a ring of plausibility to them when heard in the abstract, they have been contradicted quite consistently by the facts. If natural resource scarcity really was an obstacle to growth, we would tend to see in the data distinct upward trends in the prices of oil and other commodities. What we see, instead, are the much more powerful effects of technological and scientific innovations, which allow us to earn, produce, and consume more and more, even as we rely on scarce natural resources less and less, and keep prices for those commodities low and stable. Truth be told, there is no end to human ingenuity, nor are there limits to the wealth of nations governed by free, fair, and efficiently functioning markets.

 

Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee 

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