Now, with crude hitting $100 a barrel on January 2, this is a good time to do a review of what we have been writing about in this column and explain why the $200-per-barrel scenario is a certainty in the years ahead.

Of course, economists and oil company CEOs have been maintaining “back-to-normal prices soon” forecast for the last several years. They believe that new supply would come in at higher rates that would bring prices back to more reasonable levels.

One of the reasons for such a miscalculation stems from the faulty assumptions of micro-economics.

Classical demand-supply studies tell us that if prices were to go up, then new supply, or substitutes, will come into the picture. This seemingly innocuous “Law of Supply” has an unstated underlying assumption — that is, of having no resource constraints.

What is happening today is that there is a fundamental change happening in the way oil is priced — and the change is happening because we are transitioning from a buyers’ market to a seller’s market. The transition started around 2004, when spare capacity fell to one million barrels per day and will be obvious to everybody in a few years time.

There are many ways to predict this and some of them are analysed here.

Value of Equivalent Human Energy: By some estimates, a barrel of oil delivers as much energy as 25,000 person-hours. How much would we price this at?

Sustainable Energy Creation Costs: Economist Herman Daly suggests that non-renewable resources should be priced such that the rate of use can be no greater than the rate at which a renewable resource, used sustainably, can be substituted for it.

For example, an oil deposit would be used sustainably if part of the profits from it were systematically invested in wind farms, photovoltaic arrays, and tree planting so that, when the oil is gone, an equivalent stream of renewable energy is still available.

Affordability of the Least Rich Marginal Consumer: In a seller’s market, oil will be priced so as to be affordable to the last marginal buyer. This is very similar to the way in which pricing was based on the least efficient marginal producer in a buyer’s market.

So how should oil be priced? In an ideal world, pricing should be according to the second option — that is, sustainable energy creation costs. In the real world of consumerism that we live in, it is likely to be the third option — affordability of the least rich marginal consumer. For better or worse, prices are likely to be determined by the US consumer, who consumes 25 per cent of the world oil supplies today.

Before getting into the details on how much this should be, let us do a simple comparison to see the price of various liquids in the US. Crude oil continues to be one of the cheapest liquids that you can purchase in the US. On a per-gallon basis, crude is a $2.38, gasoline is $3.5, low-fat milk is $4, spring water is $7 and Budweiser is $9. So why are the consumers complaining? It’s because we have been used to a low price of oil that did not reflect its utility, scarcity and non-renewable nature. There are not many options other than to say: “Get used to a triple-digit price”.

The way oil is likely to be priced is according to the affordability of the least rich marginal consumer. While there is no direct way to calculate the above, there are a number of indirect methods to estimate the same.

The easiest method is to do a top-down analysis by assuming that the current energy spends on 85mbpd get distributed over the decreased supply over the next decade and also that the contribution of energy, as a percentage of the GDP basket, is increased due to shortages. Due to the inelasticity of demand for energy, it is reasonable to assume that the percentage contribution of energy would go up by 50 per cent or more.

Using the above assumptions, a figure of $200/barrel seems a reasonable projection. This number of $200 is in terms of today’s dollars, without factoring in the monetary debasement which is a certainty. After all, Mr Bernanke has indeed earned his “helicopter” surname, with the rate-cuts during the sub-prime crisis.

So, how much of this debasement will flow into energy prices? Energy will be one of the commodities in short supply, in spite of the increased money chasing it. Unlike stocks, bonds and real estate, the supply of energy just cannot be increased and so a lot of the excess money supply that would flow into this sector will cause the prices to increase dramatically.

And if Mr Bernanke does what Alan Greenspan did every time he faced a crisis (such as the collapse of LTCM, the Nasdaq bubble bursting, and so on) and carries through his promise of helicopter money, then in a few years we might well be writing another article titled “Cheap at $200 a barrel” .

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