Victor: The Oil Paradox

Last week brought fresh evidence that the U.S. economy is slowing and may have slipped into recession. The news has not only dimmed expectations for world economic growth, but it has also hammered oil prices, which lost $15 from the $100 high just a month earlier. A year ago, more bullish thoughts lifted oil prices from the $50 level in January 2007. The question on policymakers' lips is whether a worldwide slowdown will bring an end to the boom in demand for oil and drive prices significantly lower. Although oil prices will eventually drop as new sources come online and biofuels and other alternatives take hold, crude price are likely to remain high and volatile for a while.

One reason is that today's oil market is precariously balanced between supply and demand. That's why small wiggles in expectations about how much oil the world economy will need, and how much supply is on hand, cause huge changes in price. Such gyrations explain why companies that are big oil users—such as airlines—owe their fortunes, increasingly, to how they manage their financial exposure to energy prices. Southwest Airlines, for example, is not just efficient in moving customers, but it is particularly notable for a string of good bets to hedge jet-fuel costs.

Oil is also not a normal commodity. A big part of today's high prices—and why they are still nearly double the level of a year ago, despite dark economic news—is that oil beats to backward economics. When the price of soybeans or steel rises reliably, farmers and steel millers boost output, and prices abate. When the price of oil rises, many suppliers do the opposite. This bizarre response comes not from the Organization of Petroleum Exporting Countries (OPEC), which is always in the news, but from the pernicious ways that oil wealth ripples through the societies that have most of the oil.

The most visible and worrisome effect of oil riches is the "resource curse." In poorly governed countries, oil wealth (and any other booty that is easily seized) actually impedes economic development because all politics is a struggle to loot the resource rather than to make long-term invests to improve human welfare. Governments that get easy money from natural resources don't need to rely so much on human productivity, which makes them less accountable to their populations. These factors explain why Venezuela, for example, is in perennial economic trouble despite having some of the world's greatest oil resources on its books. The current run-up in oil prices has allowed Hugo Chavez to bankroll a reckless foreign policy and has taken direct control over the country's oil fields. Having undercut Venezuela's oil company and scared away many of the most competent foreign investors, Venezuela's oil output is actually declining even though today's high oil prices would, in theory, make Venezuela's newest heavy-oil fields much more economically viable.

A similar story is unfolding in many other oil patches. Over the last few years, between 300,000 and 700,000 barrels per day of production in Nigeria has been offline due to local conflicts in the oil-rich Niger Delta, triggered in part by the fact that higher oil prices created stronger conflicts over how to allocate oil riches within Nigeria. Russia has had a harder time attracting investment in its oil fields because oil wealth has given the country a swagger that makes it less in need of outsider assistance.

Higher prices can also cause countries to hold back on oil production. When resources in the ground have greater value and state coffers are already bulging with earnings—this year, oil-exporting countries will earn about $800 billion—countries can afford to stretch their wealth further into the future. Several countries in the Persian Gulf have adopted policies consistent with this new view of depletion; gas-rich Qatar has gone the furthest, putting a moratorium on new gas projects for fear that it is exhausting the country's resources too rapidly.

Seeing this, you might think that countries in the West might make up the difference by allowing their own resources to be tapped more heavily. But this hasn't happened. In some cases, environmental rules and other restrictions stand in the way. The United States, for example, has put nearly all of its oil- and gas-rich coastline off limits for drilling despite huge advances in environmentally safe drilling practices. And in the Gulf of Mexico, the only place where new U.S. offshore drilling is taking place, the government is raising its take because it wants more of the oil wealth for itself. Governments worldwide have done the same—from Russia to Venezuela to the North Sea and Alberta—by raising the tax rate on oil production, which makes drillers think twice about investing handsomely in new supply projects. They know that when profits are too high, governments will find ways to strip away the excess.

The rising spiral in oil prices will eventually abate. Some of the relief will eventually come from new supplies, but the big surprise may be in demand. When prices stay high, consumers eventually start investing in more efficient oil systems. And entrepreneurs also look for substitutes such as advanced biofuels that are just being tested on a commercial scale this year. If America's economic troubles spread gloom across the globe, then demand will dampen further. And the trip down from today's dizzying oil prices could be faster than most people think. Once investors in oil commodities are no longer confident that oil will always be more valuable tomorrow than it is today, they will switch their money to some other investment.