The sharp drop in oil prices in the past few weeks confirms the oil price forecast that I published back in May 2013, when West Texas crude sold for $94.50:

“Oil prices are headed down, and I mean down at least $20 a barrel. The key reason is that prices have been high. It’s not a paradox, but a result of the long time lags in oil production.”

Before going into the forecast, it’s worth mentioning that price can change faster than the fundamentals of supply and demand. In a recent 30-day period the price of oil fell by 20 percent. There was no change in the demand or supply over that month to justify such a large change. What happened is that commodity traders look at expected future prices, based on long-term supply and long-term demand. When the traders’ expectations change, they buy or sell and the price changes. Traders’ expectations can change due to moods, “animal spirits,” fear, greed, drugs, family strife or lack of coffee. Or too much coffee. Thus, short-term price changes can happen quickly. My own guess is that hundreds of very influential traders suddenly slapped their foreheads and said, “That Bill Conerly is right.” Which triggered a large drop in oil prices.

The fundamentals of demand are straightforward. Demand is moves up or down as the global economy moves up or down, but with a pronounced trend toward less energy use per dollar of economic production. The chart tells the story well.

Economists have been slowly lowering their projections for global economic growth in the coming years, triggering lower expectations for oil demand.

On the supply side, think of three distinct steps involved in getting oil to market: exploration, development, and production. Exploration is very sensitive to projected prices of crude oil. The price of oil had seemed stuck at $20 for many years, from roughly 1986 through 1997. Then prices started to rise, breaking through $60 in 2005. The price break, plus maybe talk about peak oil, lead to a surge in exploration around the world. With prices now dropping, new exploration activity will decline.

Development is the process of sinking more wells in a field that has already been proven by exploratory drilling. Development also includes building the local pipelines and terminals required to get the oil to a transportation facility. Development expenses are often worthwhile even at lower prices. For example, suppose that the all-in cost of oil from a brand new field is $80, of which $30 per barrel constitutes exploration. That means that development and production only costs $50 a barrel extra. If the exploration costs have already been paid, then companies will continue with development even at today’s $60 price.

Production is even cheaper. Traditionally, production costs were very small compared to exploration and development, but wells that are fracked have higher production costs that old-fashioned wells. Nonetheless, once the exploration and development have been paid for, it almost always makes sense to keep the wells pumping.

The supply-side question for the future is not whether it’s profitable to find new oil at today’s low prices. The question is how long we can enjoy the new oil supply that has been discovered in the past ten years. I believe the answer is somewhere between five and ten years. Wells have a natural decline rate. For a particular well, the engineer might estimate that each year’s production would be 15 percent less than the previous year’s production, over the life of the well, asymptotically approaching zero. (I’ve never met a petroleum engineer willing to guess at an average decline rate, but I’ve seen figures such as ten percent and 15 percent cited as examples.)

My price forecast is that today’s $60 price is likely to be the high end for the coming two years. There may be temporary market volatility higher, but don’t expect a higher price to be sustained. At the low end, $50 seems like a floor absent a global recession.

However, it’s worth looking at the 1980s to recall how low things can go. Oil had sold for less than five dollars a barrel every year prior to 1973, when the price shot up past ten dollars. Then in 1979 the price zoomed into the high $30s. By 1986, though, global exploration had brought more oil to market. Energy conservation efforts had been triggered by the higher prices, and they limited demand. The price of oil plunged, sinking Texas into recession and causing the bankruptcy of many oil companies and banks.

For the next few years, take our current $60 price as a ceiling, and consider the floor indeterminate.