Oil Industry: Won't Get Fooled Again

"Everyone running an oil company today is a survivor of that massacre, and that affects their behavior on capital spending and the like. I don't think this point can be emphasized enough."

The quote of mine above, which concluded a Columnist Conversation exchange a week ago, triggered a number of e-mails as well as a request for elaboration from Cody Willard, who certainly has brought a great deal of insight to both oil and oil stocks on RealMoney.

I have tried over the years to establish several broad ideas, including a long-term skepticism about real commodity prices. The record is clear: Over time, real commodity prices must fall as a factor input to production; this reflects the effects of substitution, technological improvement and other efficiencies. Over the long term, betting against human ingenuity loses.

But between now and the long term -- a concept not marked on anyone's calendar -- supply and demand can move into imbalance and require higher prices to move back into balance. This certainly has happened in the energy markets. Whether the current imbalance reflects the inevitable consequences of Hubbert's Peak , which is to geology what the Laffer Curve is to tax policy, is immaterial. (Everyone can agree on three things about the Laffer Curve: At either a 0% or a 100% tax rate, the government takes in no money, and there is some optimum point for tax revenues in between. So profound.)

The reason we can ignore the gloomy endgame for Hubbert's Peak, the idea that the physical reserves of conventional crude oil will deplete at some point in time, is its silence on what comes thereafter. I am not one to wax euphoric over resources such as Canadian oil sands, oil shale in Colorado and Utah, or heavy oil in Venezuela: All of these require such massive investments of capital, and consume so much energy in their current methods of production, that the marginal barrel of conventional crude oil always will be cheaper.

The Sum Of Some Fears

Once production of these massive resources begins, the price will fall to accommodate the new source of supply. As is the case for nearly all resource projects, the cost of shutting down or even reducing production is quite high, and the fixed costs involved in the project do not disappear. As a result, resource prices can and do fall well below the marginal costs of production during a price collapse.