Monday, November 21, 2005
Not betting on a high oil price
Posted by David Smith at 11:00 AM
Category: David Smith' s magazine articles

When we look back on 2005, will we think of it as one of those odd years when oil prices temporarily spiked higher, to subside just as quickly? Or is this the beginning of a new era of expensive oil, with permanently high prices.

The record, $70.85 a barrel for crude oil at time of writing, may well have been broken by the time you read this. The American government has said that prices will top $70 a barrel again before the winter is out, and will average $63 next year. Morgan Stanley agrees, expecting a 2004 average of $64 a barrel (a barrel is equivalent to 35 imperial gallons).

If that sounds like an aggressively high forecast, what about Goldman Sachs, which has warned of the possibility of a “superspike” to $105 a barrel, and expects prices to average $68 a barrel next year and $60 a barrel over the next five years?

Or how about the Canadian Imperial Bank of Commerce (CIBC), which predicts an eye-catching average price of $84 a barrel in 2006 and $93 in 2007? The price, it says, will rise to $100 a barrel by the fourth quarter of that year and stay there.

These are big numbers. Some of them, it should be said, come from organisations that have taken large positions in the oil market. That does not mean their forecasts are wrong, or in any way coloured by those market positions, merely that some people have a vested interest in high oil prices, at least for now.

So plenty of people think this is indeed a new era of expensive oil. The arguments are familiar ones. Oil demand is increasingly rapidly, most notably from China and India – rapidly growing and speedily industrialising. But demand is also strong elsewhere; in America and in the Middle East, where oil producers are developing their own “downstream” activities such as petrochemicals.

Supply, meanwhile, is tight and precarious. The margin between demand and supply this year has sometimes been 1m barrels a day or less, compared with a normal level of 2-3m barrels or more. Oil supplies are threatened by war, revolution, pestilence and flood. The insurgence in Iraq hangs over the country’s oil industry, which a couple of years ago the optimists expected to be firing on all cylinders by now. The death this year of King Fahd in Saudi Arabia resurrected fears about the longevity of the country’s pro-western regime. Governments in many oil-producing countries, for example Ecuador and Venezuela, are either unstable or hostile to America.

America itself, of course, suffered severe supply disruptions when Hurricane Katrina struck in late August, wiping out oil production and refinery output. The effect was temporary but underlined the fragility of supplies.

There are those who think these supply disruptions, which have been coming thick and fast, are a symptom of a more general problem for oil. Is the stuff running out? The idea of a global peak for oil, a so-called Hubbert peak (after M King Hubbert, a geologist who in 1956 correctly predicted the early 1970s’ peak for US oil production) is a popular one. Oil production in the UK sector of the North Sea, which was extraordinarily useful to the British economy, has already passed its peak and is now in decline.

Some forecasters, however, see the risks of decline even among those states we generally regard as having limitless supplies of oil. Matthew R Simmons, in a book published this year, Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy (John Wiley & Sons) argues that Saudi oil production comes mainly from mature fields that are looking long in the tooth, and that output is only being maintained by methods such as water injection. He argues that oil output from the Kingdom is at or near maximum sustainable levels and will go into decline in the near future.

So does this tell us that this is indeed a new era of expensive oil, and that $100 a barrel will soon become the norm? The first thing to say is that this has been said every time oil prices have spiked higher – in 1973-74. 1979-80 and 1990-91. Each time prices have subsided sharply, usually resulting in very low prices.

By 1984 the world had got used to the higher prices established by OPEC a decade earlier, but then prices collapsed, dropping below $10 a barrel. There was a similar sharp fall after the first Gulf War of 1990-91. The 1990s were largely a cheap oil era and the world economy benefited as a result.

The idea of unfettered demand also needs challenging. Last year saw an unusually big increase in oil consumption in China and America but that has not carried into this year. Nor, according to the International Agency, will it do so next year. Some of the more aggressive oil prices forecasts are based on an extrapolation of the 2004 demand rise. That looks unrealistic. For one thing, oil demand itself responds to high prices.

We should also tread warily on the idea of supplies running out. There are clearly geopolitical worries now and the threat of terrorist attacks directed at oil installations. But it is a stretch to move from these worries to the idea that the oil will no longer be there. Big supply increases are coming through from places like Russia. High oil prices are leading to a rise in exploration activity, including incidentally in the UK sector of the North Sea.

For all these reasons, part of the current high oil price looks speculative. History tells us that prices never stay very long above the equivalent, in today’s prices, of $40 a barrel. History is usually a pretty good guide on these things. The normal laws of supply and demand have not been suspended. I wouldn’t bet on prices getting to $100 and staying there. But I would bet on them dropping back below $40 a barrel.

From Professional Investor, November 2005

Comments

I was hoping an oil shock would help to bring the correction needed in the housing market. I have been slightly wrong with my economic predictions and suspect you are once again correct David. Will this madness ever end?

Posted by: Ash at November 22, 2005 10:29 PM