Before we get the party going in celebration of falling crude oil prices, beware. This decrease could well be just a pause before prices march to yet another record.
I am suspecting so not because I subscribe to Malthusian logic. Malthusians all over fail to notice that humanity has an amazing capability to adapt. As prices of typical energy rise to a sufficient level, the search and utilization of substitute sources will take place. As a result, the demand for expensive source of energy will fall, bringing along its prices down.
The prices will stay down, given all else being equal, if technological, or rather increase in efficiency in consumption of the energy occurred. Improved efficiency produces a situation where fewer fuel is required for the same amount of production.
I suspect that it is possible that we may be seeing merely a dip in prices of crude oil because I am unconvinced at how the recent fall in prices is caused by structural changes.
On the surface, three factors seem to be causing crude oil prices to fall. They are contracting demand curve probably due to high crude oil prices, appreciating greenback and the slowing down of several world’s major economies. All factors are possibly cyclical and none is structural. When I refer to cyclical changes, I refer to changes in volume and when I refer to structural changes, I refer to changes in efficiency.
The relationship between crude oil price and the health of the global economy is easy to pinpoint. A slowdown causes demand for crude oil to decrease. While the relationship may well be the reverse, the point is that it is a matter of typical business cycle and has nothing to do with improvement of technology.
The strengthening of the US dollar also has little to do with improvement in technology. To understand how stronger dollar leads to cheaper crude oil, it is important to understand the mechanics that works between trade and exchange rate. Weaker dollar causes cheap export and cheap export causes foreigners purchasing more US product. With weak dollar, the strength of the USD has to return as improvement in net export accumulates capital. If theory does not convince you, then let the number must do the job: the US trade deficit already dropped for the month of June.[1] With stronger dollar and with crude oil priced in riyal or some other currencies, fewer dollars is required to buy the same volume of oil.
Now, the third factor — contracting demand curve — may come closest to encouraging structural changes. The problem is however, I am not convinced that there is a actual improvement in technology. What I see is people using smaller instead of larger vehicles, public transportation, etc. But that is merely temporary lower consumption because once prices become sufficiently low, consumers would abandon small cars and public transportation and anything that only reduce volume of crude oil consumed rather than substituting it.
While there is indeed greater usage of electricity, natural gas and biofuel to replace crude oil, I am unsure how widespread it has been. Besides, the fall in crude oil prices have been too drastic in such a short time that I have trouble accepting the fall is caused by technology.
Why after all the adoption, the decreases in crude oil prices come only now and in such a dramatic pattern? Effects from structural changes should come gradually due to various lags that exist in the real world, not abruptly.
This has led me to speculate that the trend we are seeing is caused by merely and mostly reduction of consumption with little substitution energy consumed as replacement. It is likely that what we are seeing is merely reduction in volume rather than increase in efficiency. If my take is correct, then once prices reached a level somewhere down below, consumption would return to assume its record breaking rise performance which we saw weeks earlier as volume would go up while efficiency level would stay constant. This might be so due to little structural change in the global economy.
[1] WASHINGTON (AP) — The U.S. trade deficit unexpectedly fell in June as exports advanced to an all-time high, offsetting another big surge in oil imports.
The Commerce Department reported Tuesday the trade imbalance dropped to $56.8 billion in June, down by 4.1 percent from a revised May deficit of $59.2 billion. It was the smallest deficit in three months and much better than the $61.5 billion deficit Wall Street had been expecting.[June trade deficit shrinks as exports climb. Martin Crutsinger. Associated Press. August 12 2008]