Friday, June 27, 2008

Why Oil Prices will likely be Higher in 5 Years -- But not Necessarily in 10 or 15.

The current issue of The Atlantic has an excellent article by Jonathan Rauch about the herculean efforts by GM to field its plug in hybrid, The Chevy Volt, by 2010: "Electro-Shock Therapy". According to the article, the estimated sticker price of the Volt will be about $35k. The Chevy Volt will be able to travel 40 miles round trip powered solely by its electric battery (it will also have a small gasoline engine to recharge the battery for longer trips). Since GM estimates that most Americans' commutes are under 40 miles round trip, will the advent of plug-in hybrids such as the Volt in 2010 reduce demand for gasoline (and hence, oil) significantly? Not for a few years at least, as I see it. Although a Chevy Volt may use negligible amounts of gasoline, the cost of owning the car may make it more cost-effective for most Americans to continue to driving their current cars or buy conventional used cars. Even if gas is $5 per gallon in 2010, it may well be more cost effective to buy an older used Honda Civic or Ford Focus for under $10k and pay ~$75 per week to fill it up with gas, than it will be to drop $35k on a new plug-in hybrid (consider, too, that lingering effects of the credit crunch/deleveraging and higher interest rates may make it more difficult and expensive to finance new car purchases in 2010). The cost of new plug-in hybrids will be more prohibitive for drivers in poorer parts of the world.

Eventually, the arithmetic will shift in favor of plug-in hybrids, particularly as they become available for lower prices as used cars. In 2013, for example, it may be more cost effective to buy a used 2010 Chevy Volt than to keep driving a conventional (though still fuel efficient) car. I anticipate this sort of lag time, driven mainly by high switching costs, will delay the wide adoption of plug-in hybrids for at least five years, so I don't see this sort of technology materially reducing demand for oil over the next five years.

Similarly, lag times on the supply side will likely delay large expansions in oil supply for several years. As the FT's Lex column noted at the beginning of the year ( "Peak no Evil"), the world still has plenty of oil. The issue is that a lot of it is expensive and difficult to access. Although there have been huge recent discoveries (e.g., Brazil's Tupi and Carioca fields off the coast of Rio de Janeiro), it can take 5-10 years to bring these new supplies of oil on stream. In the meantime, production at currently producing fields will continue to gradually (and in some cases, steeply) decline.

Because of these lag times involved in reducing demand for oil and increasing its supply, I am confident that -- although there will be cyclical corrections between now and then -- oil prices will be higher 5 years from now than they are today. Oil prices may well be significantly lower (maybe $70-$80 per barrel?) 10 or 15 years from now, as new supplies will have come on stream and new technologies will have led to more efficient use of petroleum products.

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