The oil price bubble

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The U.S. retail price of gasoline has been more than $2 a gallon since March of last year, and peaked over $3 last September. Fortunately, geological evidence indicates current oil prices are unsustainable. Barring any significant geopolitical disruption, that means cheaper prices at the pump for the American consumer.

All geologists agree the total amount of petroleum in the Earth's crust is fixed and must decrease with continued production. Over the last 150 years, almost exactly a trillion barrels of oil has been withdrawn. As the world's endowment of oil is slowly drawn down, it is a virtual certainty the price eventually will increase to where the cost of extraction exceeds the value of energy obtained.

Recent increases in the cost of crude oil have given rise to renewed speculation that world oil production is about to peak. At the beginning of 2004, oil was $34 per barrel, but the price briefly reached $70 in late August of last year. The current price of about $60 is high by any historical standard.

However, the surge in oil prices we have seen over the last two years is not a sign the world is beginning to run out of oil. On the contrary, it is a positive indicator of increased economic activity. High prices will encourage development of more of the world's enormous petroleum reserves.

In 2000, the U.S. Geological Survey estimated the amount of conventional oil that would ultimately be withdrawn from the Earth's crust was 3 trillion barrels. One-third of this has already been produced. Another third consists of petroleum reserves that have been identified and can be extracted using current technology. The last trillion barrels remains to be discovered.

One way to determine if the world is beginning to run out of oil is to look at the ratio of petroleum reserves to annual production. In the 1960s, the average ratio of world petroleum reserves to production was 35. During the energy crises of the 1970s, the ratio decreased to 32. In the 1980s, it increased to 37. During the 1990s, the ratio of reserves to annual production rose to 45. In 2005, the ratio of oil reserves to annual production was 49, nearly a record high.

If the world were beginning to run out of oil, our technological ability to generate new petroleum reserves through exploration and technology would begin to be outstripped by consumption. The ratio of reserves to production would start to decrease. Yet for the last 50 years, the trend is one of increasing, rather than decreasing, supply.

So, why has the price of oil doubled in less than two years? From 2002 through 2004, demand for oil increased by an average 3.7 percent annually. This is more than triple the rate of increase from 1990 through 2000, which averaged an anemic 1.1 percent. Low demand during the 1990s, combined with surging reserves, caused oil prices to bottom out near $10 a barrel in December 1998. In February 1999, the average retail price of gasoline in the U.S. was 90 cents a gallon. As a result, oil companies were reluctant to bring more reserves into production.

The largest mistake would be to start to move away from petroleum, a proven and economic energy source, to more speculative and expensive sources. Not only do we have a trillion barrels of conventional oil in reserve, there are huge unconventional oil resources awaiting development. The International Energy Administration recently estimated that, at a current price of $60 a barrel, it will be economic to recover at least another 2 trillion barrels of petroleum from tar sands and oil shales.

The world will eventually leave the age of oil, but there is no geologic reason for this to happen until near the end of the 21st century.

David Deming is a geologist, an adjunct scholar with the National Center for Policy Analysis (NCPA), and associate professor of Arts and Sciences at the University of Oklahoma.