Long-term thinking about oil prices

Too many otherwise-serious discussions about oil prices and production costs are marred by the failure to take inflation into account.

Statements like "the era of $20 oil is over" or "oil prices will hit $140 per barrel by 2025" are typical examples of the prevalence of money illusion in the oil market.

Forecasts about nominal prices far in the future, and statements about prices which make comparisons with prices in the 1990s, are meaningless.

No one would compare the current price of bread, or expected bread prices in 2025, with the cost of a loaf in 1995. Yet this type of statement about oil prices is surprisingly common.

The general debasement of currencies has an enormous impact when comparing oil prices a decade or more apart.

For example, OPEC's price band of $22-28 per barrel, adopted in 2000, would now be equivalent to $28-36 or $32-41, depending on whether inflation is assumed to have run at 2 percent or 3 percent a year over the last 13 years.

A nominal price of $140 in 2025 is equivalent to just $110 today in real terms, after allowing for inflation at 2 percent.

Oil prices (and prices for derivatives such as gasoline and diesel) are the most familiar of all prices for both investors and consumers. A history of oil and fuel prices is seared into the collective memory of both producing and consuming countries like no other commodity or product.

Unfortunately, familiarity with the past leads analysts and commentators to make mistakes when thinking about the far future. Too many debates are set up in terms of straw men, which are satisfyingly easy to knock down but obscure deeper analysis.

Misleading yardstick

It is easy to state the era of $20 (or $30 or $40) crude is over because costs have escalated as the industry has been forced to produce more challenging forms of oil (shale) and in tougher environments (deepwater) but that does not actually say very much about the real cost of energy.

In 1995, it was possible to state with similar assurance that oil prices would never sustainably be below $10 per barrel, which was the official posted price two decades earlier, at the height of the 1974 price spike.

But if oil prices cannot sustainably decline to $40 per barrel in the next few years, that does not mean they could not fall to $60, $80 or $90 - all of which would be fairly high in historical terms after adjusting for inflation.

A nominal price of $90 this year would be equivalent to $53 in 1995, assuming 3 percent inflation in the interim.

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