Is oil pricing itself out of the market?

University of Alberta researcher Andrew Leach likes the way Saudi Prince Alwaleed bin Talal thinks.

A new paper by Leach, an associate professor in the Alberta School of Business, and fellow University of Alberta economics researcher Ujjayant Chakravorty, posits scenarios that parallel a statement Alwaleed made in May declaring that it is in the best interests of Saudi oil producers to keep oil around the $70 mark to prevent the West from developing alternative energy sources. Their paper, co-written with a colleague from the Toulouse School of Economics , hypothesizes scenarios wherein a narrowing of the gap between developing renewable energy resources and fossil fuel resources might mean a rush to drain the oil from its source.

Leach is quick to point out that the paper is not attempting to forecast oil futures or costs. Rather, he notes, they model results of possible outcomes if an alternative energy sources could replace oil quicker than producers expect it to. Citing resource economist Harold Hotelling's notion that "oil in the ground is like money in the bank," Leach notes that, if a bank adversely changed its paid interest rates, the investors would be quick to withdraw their money. In the case of producers, he says the response would be to curb the cost of oil per barrel and increase current production rates to maximize current profits.

"What we tried to do with the paper was get in to some of the climate-modeling results and say, 'what happens if you go back and look at how oil owners should behave if an alternative energy source is emerging and funded and how technology is improving,'" said Leach. "The answer is that you shorten your timeframe and you start thinking, 'well, I better get the value out of this asset now because it's not going to be worth anything in 30 years.'"

Leach notes that dropping prices might mean less market interest in developing and investing in new energy alternatives. However, he says that if other factors, such as increased production costs or carbon taxes, come in to play, oil prices would rise. And if there is an alternative resource that becomes more economically attractive, oil producers may have to adjust to make sure they don't hasten their own obsolescence. Leach says that, like Alwaleed, oil companies should be looking at these types of possible scenarios as they value reserves and make strategic decisions.

"From an oil company's perspective or an oil state's perspective, they're not going to sit back and price themselves out of the market. A lot of models that look at alternative energy deployment are quite dependent on this continued increase in oil price," said Leach. "If you just put that in your model, you're ignoring the story that says that, if oil is irrelevant in 30 years, then there's going to be a lot of incentive to get it out of the ground today."

Leach suppressed the notion of a worldwide conspiracy that states that oil companies are attempting to keep alternative technologies at bay. The conspiracy would have to be well-planned, he says, if it worked when an alternative technology was less than half the cost of a barrel of oil. He says even now, consumers have the ability to affect market decisions even when prices rise. Boycotting gas stations on Monday only to fill up on Tuesday carries no real message to producers and retailers, he says. However, changing long-term behaviours towards alternatives in the face of a gas hike would be a significant move—and one that would force producers and retailers to adjust behaviours and reduce profit margins.

"Right now they don't have to eat any oil-price increase because they know that whatever price gets posted on the sign, people grumble and complain and pay," says Leach. "If, in Edmonton, when gas prices went above $1.20 per litre- and suddenly 50 per cent of the market dropped out of the gasoline market, you could expect refiner margins, retail margins, everything, to go through the floor.

"The retailers would know that, 'if I increase my margin by $.10, I'm going to lose 50 per cent of my customers because they're all going to be on the LRT, on their bikes or they're going to be walking.' Even in the short term, it's going to force the producers to eat that world oil price increase."