Prices a Stimulus, So Better Watch It!

Adam Smith would have loved $60 oil and $10 gas.

Not just because energy folks are prospering (that's the inevitable other side of his "invisible hand" concept), but because he would have grasped immediately that elevated energy prices, especially if they are sustained, will stimulate various individual initiatives leading to an improved energy future for everyone.

Of course, that assumes that our society has finally learned to let the free-market economy work its wonders, for the magic of free pricing to influence, and distribute and reward buyers and sellers, consumers and producers, explorers and land-owners, entrepreneurs and financiers — and employers and employees.

>On an inflation-adjusted basis since 1970, today's $60 oil prices are now at about P10 percent, about $25 less than their peak during the 1980-81 period (Figure 1). Today's elevated prices, if sustained, should encourage us to drive smaller, more efficient automobiles, improve the energy-efficiency of our homes and offices and promote public transport, thus reducing air pollution in our cities. That's precisely what higher energy prices accomplished in the energy crunches of OPEC I and II, and their aftermath. Higher energy prices motivate us to make our power generation and transmission, as well as our industrial power usage, more efficient. Higher prices can stimulate us to innovate, with respect to finding and developing unconventional new energy sources, and to diversify our sources of power.

Sustained higher energy prices will encourage young people to study geoscience and engineering, responding to increasing demand for young professionals to pursue careers in a dynamic, technologically advanced industry whose healthy function is better recognized today as essential for the maintenance of the world economy and improvement in standards of living. As a petroleum geologist now in his 46th year of professional practice, I derive great personal satisfaction from the enormous — but mostly unsung — contributions my fellow geologists, geophysicists and engineers have made to the economic, material and cultural quality of life to peoples around the world. The many advancements of industrial and developing nations around the world have been built upon dependable and affordable energy. Our skills and labor and dedication and courage have enabled that remarkable progress over the past 150 years — and I have no doubt that we will continue to respond to the challenges of the future.


But as E&P professionals, we also know by bitter experience that higher oil and gas prices, even as they stimulate innovation and enterprise, also tend to encourage us to relax our economic discipline and technical standards. Spurred by higher prices, the demand for new exploratory and development prospects outstrips the ability of the geotechnical community to generate them. Seeking perceived fat profits, outside investors — often inexperienced in E&P matters — come knocking, like goldfish coming up to feed. Projected $90 oil in a prospect's DCF analysis can make even a doggy prospect look promising.

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Adam Smith would have loved $60 oil and $10 gas.

Not just because energy folks are prospering (that's the inevitable other side of his "invisible hand" concept), but because he would have grasped immediately that elevated energy prices, especially if they are sustained, will stimulate various individual initiatives leading to an improved energy future for everyone.

Of course, that assumes that our society has finally learned to let the free-market economy work its wonders, for the magic of free pricing to influence, and distribute and reward buyers and sellers, consumers and producers, explorers and land-owners, entrepreneurs and financiers — and employers and employees.

>On an inflation-adjusted basis since 1970, today's $60 oil prices are now at about P10 percent, about $25 less than their peak during the 1980-81 period (Figure 1). Today's elevated prices, if sustained, should encourage us to drive smaller, more efficient automobiles, improve the energy-efficiency of our homes and offices and promote public transport, thus reducing air pollution in our cities. That's precisely what higher energy prices accomplished in the energy crunches of OPEC I and II, and their aftermath. Higher energy prices motivate us to make our power generation and transmission, as well as our industrial power usage, more efficient. Higher prices can stimulate us to innovate, with respect to finding and developing unconventional new energy sources, and to diversify our sources of power.

Sustained higher energy prices will encourage young people to study geoscience and engineering, responding to increasing demand for young professionals to pursue careers in a dynamic, technologically advanced industry whose healthy function is better recognized today as essential for the maintenance of the world economy and improvement in standards of living. As a petroleum geologist now in his 46th year of professional practice, I derive great personal satisfaction from the enormous — but mostly unsung — contributions my fellow geologists, geophysicists and engineers have made to the economic, material and cultural quality of life to peoples around the world. The many advancements of industrial and developing nations around the world have been built upon dependable and affordable energy. Our skills and labor and dedication and courage have enabled that remarkable progress over the past 150 years — and I have no doubt that we will continue to respond to the challenges of the future.


But as E&P professionals, we also know by bitter experience that higher oil and gas prices, even as they stimulate innovation and enterprise, also tend to encourage us to relax our economic discipline and technical standards. Spurred by higher prices, the demand for new exploratory and development prospects outstrips the ability of the geotechnical community to generate them. Seeking perceived fat profits, outside investors — often inexperienced in E&P matters — come knocking, like goldfish coming up to feed. Projected $90 oil in a prospect's DCF analysis can make even a doggy prospect look promising.

Nearly 20 years ago, Richard Nehring reviewed exploratory finding efficiencies of the 1970s and 1980s. The most efficient exploratory year, in terms of barrels found per exploratory foot drilled, was 1986, when oil fell to $10 a barrel. Exploration was extremely selective that year — only the most promising prospects were being drilled.

Conversely, 1980 — when oil was $40 a barrel and rising — was the most inefficient year. Investment money was being thrown away when we thought that oil was going to $100 per barrel. I shudder at the thought of some of those doggy prospects to this very day!

As professionals, we have to remember that investment capital is also a precious resource, endeavor to maintain our objectivity and our standards, and to make those investment dollars count. This is hard to do. Independents can make money just selling the prospect and the land, even if the venture itself may be technically and economically weak. Corporate geoscientists may feel substantial pressure to generate prospects and get them drilled, using cash flows suddenly available and burning holes in corporate pockets.


I well remember the cold hard realities of 1986, having very nearly gone belly-up as a consequence. Like a drunk sobering up after a long binge, we realized that oil and gas were indeed commodities, and the laws of supply and demand still operated. Hundred-dollar oil? "This time it's different." What were we thinking? But the sustained low prices of the late 1980s (and again briefly in the late-1990s) reminded us inexorably that it is the nature of commodities to fluctuate substantially.

Now, I don't know whether $60 oil is sustainable for the next year or so, and neither does anyone else. It may climb to still another price-plateau. What I do know is that oil and natural gas are commodities, and their prices will fluctuate. It certainly does appear that world demand is impinging on world supply at the present time, bringing upward pressure.

So, without wanting to "rain on anyone's parade," and just to keep ourselves honest, let's indulge in some brainstorming — let's explore some possible scenarios by which the pressure on global supply might be relieved, causing prices to fall:

  • A cooling-down of the global economy, especially the United States, India, and China (remember the collapse of the Asian tigers in the mid-late 1990s?).
  • Political stabilization of Iraq, allowing Iraqi production to maximize (mid-term to long-term, think what would happen if exploration in Iraq discovered major new fields).
  • Increased production from Russia and the Caspian region, or from Venezuela, enters world markets.
  • LNG imports into the United States become substantial, setting a $5/mcf floor on natural gas prices.
  • Energy efficiency in the Western economies improves significantly, reducing demand.

Of course, we could also list some developments that would work in the opposite direction, causing energy prices to rise even more! Even so, folks caught up in the present price-rises could get badly hurt in a drop from $80 back to $50, especially if they are overextended.

The Bottom Line: Maintain your technical and financial discipline and invest your excess cash flow wisely. Just because you're making a lot of money right now doesn't mean that you have to spend it right away!

Also, accept that some good projects that you would like to be involved in are going to be priced way out of your reach by some buyers who don't know what they're doing, and who don't think oil and gas are commodities.


Consumers don't like paying 50 percent more for their gasoline than they did last year. They pay taxes and they vote. Their representatives properly listen to them. And that means our E&P industry is going to come under increasing public scrutiny. It's a time when all of us need to be especially cognizant of our public images. It's easy for the whole industry to get tarred with the brush of a single big foul-up.

In late August I heard Sen. Lindsey Graham (R - S. Carolina) on one of the Sunday TV talk shows. He was suggesting that it may be time now for congressional hearings in which oil industry leaders come and talk to Congress, the U.S. citizenry and the world community about "these high ($2.60/gallon) gasoline prices."

Looking back on the huge amounts of public moneys the U.S. government squandered on ill-advised energy projects in the 1970s and 1980s, as well as Windfall Profits, two- and three-tier FERC price controls, etc., one is filled with foreboding: "Here we go again."

Here's hoping we have finally learned. The most important agent in maintaining adequate future world energy supply is not government intercession, or new geotechnical breakthroughs or drastically accelerated drilling and producing infrastructure. It is in the continued maintenance of a vibrant free-market world economy.

Adam Smith would have understood that.


Recommended reading:

Naked Economics, by Charles Wheelan (2002, W.W. Norton & Co., NY), is the best, most readable book on modern economics available.

I personally believe that the single most common failing of most contemporary geoscientists is an all-too-common naiveté about economics, finance and business. It hurts society, their employers, and their own careers. More than ever before, it is imperative for geoscientists to be well versed with economics and financial principles. Wheelan's book is a great first step.

Read it, you'll like it!