Sunday, April 23, 2006
The more oil rises, the bigger the fall
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Even if you do not track hourly movements on the International Petroleum Exchange in London, or the New York Mercantile Exchange (Nymex), the latest rise in oil prices has been hard to miss.

Forecourt prices for petrol and diesel have been edging ever closer and in some cases beyond the £1-a-litre mark, as anybody out over the Easter break, Britain’s own mini-driving season, will have noticed.

The real driving season, which kicks off in America on Memorial Day (May 29) weekend, and lasts until Labor Day on September 4, is only weeks away. That is when Americans take to the roads in even larger numbers than usual. And it is approaching at a time when oil has risen to record levels.

Last time it took Hurricane Katrina’s devastation of New Orleans and surrounding areas, to give us a record crude price of $70.85 a barrel. This time Iran’s nuclear programme, and the fear of American military strikes, have pushed US crude above $75 and North Sea Brent crude above $74. This might be a useful time, then, to revisit my prediction that oil prices are unsustainable at these levels and will fall, in due course, to $40 a barrel.

Let me start with the basics. Are high oil prices being pushed up by runaway demand from China and India? Is the strength of the world economy in general pushing oil demand up at such a rate that it is ignoring the rise in prices? The global economy, according to the International Monetary Fund’s twice-yearly world economic outlook, published last week, has “never had it so good”. This is the fourth year in which global growth will top 4%, with this year’s expansion set to hit a blistering 4.9%.

The IMF thinks the current oil-price shock has worsened global imbalances, directly and indirectly adding to America’s current-account deficit, and that it may prove more enduring than its predecessors. But it also notes that the economic impact has so far been modest, while adding the caveat that we may not be out of the woods yet.

In the context of the strength of the global economy, the surprise is that oil demand is not stronger. In many ways we are still paying the price, literally, for a sharp rise in world oil demand two years ago. In 2004 it jumped 4% to 82.5m barrels a day, according to the April oil-market report from the International Energy Agency (IEA). There was indeed a big increase in Chinese demand that year, more than 15%, as there was in America. But since then oil-demand growth has slowed. Last year it rose 1.3%, and only 0.3% in the advanced economies of the OECD (Organisation for Economic Co-operation and Development).

This year demand may increase a little faster — the IEA predicts 1.8% growth, other forecasters slightly less — but this is still subdued in the context of a booming world economy. So what’s the problem? There are, contrary to the impression one often gets, extra oil supplies coming through. Last year oil production averaged 84.1m barrels a day, 1m barrels up on 2004, and up strongly on its levels of 79.7m in 2003 and 76.9m in 2002.

In the past three to four years supplies from Opec (the Organisation of Petroleum Exporting Countries) have risen by about 4.5m barrels a day to about 30m — Opec also produces more than 4m barrels a day of liquefied natural gas — while non-Opec output has risen by 2m barrels a day. Supply, so far at least, has risen to meet the extra demand.

So why the spike in prices? One reason is actual supply disruptions. Action by militants in Nigeria has knocked out a fifth of the country’s production. The US-led invasion of Iraq, directly and indirectly, has imposed a huge cost for oil consumers in terms of higher oil prices. Iraq’s production, now 1.9m barrels a day, is 30% down on its pre-war levels, and the war has escalated Middle East tensions. Claude Mandil, head of the IEA, last week also cited political uncertainty in Venezuela, Russia and Chad.

Add to this the future uncertainty over Iran, and whether George Bush’s last act as president will be to bomb the country’s embryonic nuclear industry out of existence, and you have a recipe for uncertainty that could last for years.

That is not the only factor pushing up prices. Lee Raymond, the recently retired chairman of Exxon Mobil, received $686m in pay and perks between 1993 and 2005 and retired with a pension and stock options worth, on some estimates, $400m. He has become, to critics, the ultimate oil-industry fat cat.

He is also uncompromising, saying in a Columbia University lecture last week that oil will not be supplanted by other fuels for the foreseeable future and predicting that neither Exxon nor its rivals will be building new refinery capacity in America because the risks would be “extraordinarily high”.

This lack of investment in refinery capacity, in America and elsewhere, is helping to drive prices higher — both because a shortage of capacity has the effect of restoring refining margins but, more important, because it feeds back to a higher oil price. Big users of oil products, such as airlines, hedge by buying crude oil futures, which helps to drive the price higher, and keep it there.

So what’s the outlook? In the short term anything is possible. A bit more tension on Iran and a couple of nasty hurricanes and $80, $100 or $120 a barrel could result. But the history of oil is that the bigger the upward spike, the sharper the subsequent fall. That is what gave us ultra-low prices, $10 oil, after big rises in both the 1980s and 1990s.

The current boom in the world economy will fade, leading to a fall in global oil demand. There will be more supply, stimulated by current high prices. Dr Leo Drollas, chief economist at the Centre for Global Energy Studies, argues that through the current mess and confusion the fundamentals have not gone away, and they point to oil being too high at these levels.

I agree. I haven’t given up on $40 oil. It is just taking a bit longer to get back there.

PS: My observations last week on the high inflation rate for haircuts produced offers of free coiffures, the kind of perk that rarely comes my way. There was also some criticism of my neglect of rising council-tax bills in listing the increases squeezing household finances.

While haircuts are rising, plenty of things are still falling, which set me musing about the best-value product you can buy these days. My vote would go to the humble bicycle. You get a lot of steel, rubber and technology for your money, and prices start at about the cost of a tankful of petrol for a large car. Readers may have other ideas.

Meanwhile, the rise in inflation expectations was confirmed by the Bank of England’s quarterly attitudes survey last week. People think inflation has been running at 2.8% and expect it to be 2.7% over the next 12 months, compared with the official 2% target. Last week’s astonishingly good figures showed inflation running at just 1.8%, and 2.1% on the old RPIX measure (Retail Prices Index excluding mortgage-interest payments).

The minutes of the April monetary policy committee (MPC) meeting showed a 7-1 vote in favour of keeping base rate at 4.5%. Steve Nickell was the lone dove, and is likely to end his MPC career next month in similar vein. He thinks the labour market is telling us inflationary pressures are likely to weaken further.

Peugeot’s announcement of the closure of its Ryton plant in Coventry was a reminder, after a year in which the claimant count has been rising, that all is not well. Nickell may yet get his wish, though not until after he has left the MPC.

From The Sunday Times, April 23 2006


Yes you could say that. However have not previous shocks been supply side in nature. Once the supply restored oil have fallen. This time shock is demand in nature. Different.

P.S. Could not say that the same for the housing market. Previous big rise followed by a big fall??

Posted by: Hugo at April 23, 2006 09:05 PM

Fair points. I'd argue that we've already seen a demand response from high prices - and we'll see more - growth in global oil demand being weaker than one would have expected relative to GDP growth. I'd also suggest there are supply factors at work here - Iraq, Nigeria, the threat from Iran - and so on. But you're right to point out that OPEC could not click its fingers and bring the price down; they don't have enough spare capacity.

There is a parallel between oil and housing, though not in my view in the way you suggest. On oil, I think enough has changed to produce a rise in the long-run fundamental price, from the low $20s to the high $30s. I also think enough has changed to produce a revaluation of housing.

Posted by: David Smith at April 24, 2006 09:01 AM


As always a great analysis. I have one problem. On the world/UK Economy you are the uber bull (and you've been right to be). You argue that oil will fall to $40 as demand falls away. Surley demand will only fall if there is bust to the current boom in the world/UK economy. Otherwise, even with supply increases surley demand is high enough to maintain prices >$40 (even parts of Africa is enjoying 5% growth).

Does this mean David Smith has become a bear now?

Posted by: ash at April 24, 2006 02:51 PM

I'd question uber bull, but let that pass. The world economy is currently enjoying an exceptional period of growth, exceptional being the operative word. This is the fourth year of 4%-plus global growth and the third in which it will have been close to 5%. Sooner or later we will slow, perhaps to something closer to 3%. When this happens the growth in oil demand should slow sharply, perhaps even fall. How so? Last year we had global GDP growth of nearly 5%, but only a 1.3% increase in oil demand.

Posted by: David Smith at April 24, 2006 05:09 PM

I would just like to challenge one point David - airlines in general are not big hedgers. They do not have big enough credit lines open to them to cover the margin calls. And to hedge jet fuel through crude futures would involve a huge amount of basis risk.

To hedge jet fuel requires buying gasoil futures and an OTC swap for the differential between gasoil futures and jet prices published by price reporting agencies, which carries additional costs. So most do not bother, they just buy on term contracts against published prices (which oil companies are able to exert a heavy influence on through spot market manouevres). In fact the person buying the fuel is often the same person buying the paper clips.

But the general point you are making here about demand is correct in my view. Although I think you should also have highlighted how stretched the ability of the US to meet its peak gasoline demand is. This, in my opinion, is as big a factor in current prices as the geopolitical situation.

Posted by: El_Pirata at April 24, 2006 06:02 PM

Various points:
The price of oil is currently high, but demand is STILL rising, in contravention of basic economic theory.
I think it is important to reiterate it is not just supply capacity but refining capacity that is important. American refining capacity is expected to be shut down for longer maintenance than normal this year. Further, some oils are easier to refine into petrol than others (light, sweet as opposed to sour).
We do not know what impact the American reserves reporting standard will have on the oil market when it comes into force in July this year.
When oil is over $50 barrel various marginal supplies become economically viable (Canadian & Venezuelan oil sands), but that won't happen if oil falls to $40. Venezuela believes it has more oil than Saudi Arabia, so this point is important.
What would be the demand for oil if it fell anywhere near $40? Large, fast growing, but currently poor countries like Indonesia would be able to afford more and raise demand.
Not much good cheering about low oil prices if the World economy has gone belly-up and you're fearing for your job!

Posted by: David Goldfinch at April 24, 2006 08:29 PM

One other point I'd like to throw into the mix

If a market is tight, you would expect it to be in backwardation ie oil for prompt delivery is more expensive than oil for delivery further out.

Yet this market is and has long been in contango (except briefly during the hurricanes) ie prompt oil is cheaper than oil for delivery further out, indicating ample supply

what does this tell us about the market? I don't have the answer but would be interest to know what others think.

Posted by: El_Pirata at April 24, 2006 11:04 PM

You're stretching my technical knowledge, but here's an explanation from Mike Wittner, global head of energy market research at Calyon. It is taken from his weekly report last Friday:

"As we have stated before, prices can be the most current indicator of the physical fundamentals. Preliminary data on supply, demand, and stocks suffers from time lags and is subject to large revisions, so the shape of the forward curves (in the front months) can either confirm, or raise questions about, what we think we know.

"Currently, the forward curves for crude and products make sense. Brent crude has moved into shallow backwardation (dated to ICE front month), indicating tight fundamentals, which is consistent with the Nigerian outage. Tapis, the Asian light sweet marker, is also in backwardation, also due to Nigeria, recent Tapis maintenance, and Australian light sweet outages caused by a series of cyclones. In contrast, WTI is in steep contango, weighed down by stratospheric US crude stocks.

"Tight US gasoline is in backwardation, but this is the only key product in the Atlantic Basin that is not in contango; everything else is well supplied. In Singapore, naphtha and gasoil are in backwardation, due to several recent unplanned outages of Japanese refineries, heavy planned maintenance for Asian refineries, and recent strong demand from China."

Posted by: David Smith at April 25, 2006 10:37 AM

What about OPEC? Are they not now looking to defend a $60 barrel? Any significant fall in oil price will be followed by a reduction in output and moderation of any price falls. In a world where oil isn't going to last for ever it would make sense to flog it for all it's worth.

OPEC obviously doesn't have complete control of falling oil prices, but for the foreseeable future defending a $60 barrel doesn't seem too difficult.

As previously stated this shock has a significant demand bias. The western powers have to contend with a rapid increase in the eastern use of the oil resource. Growth continues and so does oil consumption. Greater consumption results in a higher price.

P.S. The hurricane season isn't too far away. Hold onto your hats and cats...

Posted by: Werewolves at April 25, 2006 04:13 PM


You say: "I also think enough has changed to produce a revaluation of housing." Releive me of the faint hope I have that you DONT mean house prices are fundamentally over valued? (sigh)

Posted by: Ash at April 27, 2006 04:50 PM


How much research have you done on peak oil? With the North Sea, Burgan oil field in Kuwait and the giant Cantarell field all peaking do you not think that we may never see $40 again. Have you read Twilight In The Desert by Matt Simmons? What's your opinion on this.

The other point I might make is with the Fed printing so many dollars (and stopping the publication of M3 so you don't know how many dollars have been printed) - maybe you are suffering from money illusion

Posted by: Alex A at May 3, 2006 11:13 AM

I'm very familiar with the peak oil argument, in fact I've a copy of M. King Hubbert's original article on my desk. I just don't think we're there, or even very close, yet.

The M3 point is a bit of a red herring, though it is the case that if the dollar were to fall very sharply, oil producers would seek to protect a higher dollar price.

Posted by: David Smith at May 3, 2006 09:28 PM


A month from publication and oil is still above $70. Have you got any date by which you think we will reach this $40 a barrel figure? Predictions are not really that much use without a timescale?

Thanks Alex

Posted by: Alex A at May 28, 2006 06:42 PM

The longest modern-day spike in oil prices we had was in the early 1980s, which lasted 5-6 years. Usually they are a bit shorter than that. As I said in the piece, the short-term risk is of yet higher prices from hurricanes and so on. Add to that the fact that there is a lot of speculative interest in maintaining a high price and I think it could take 2-3 years to get back to a sustainable (lower) price, though I would hope it will be somewhat sooner.

Posted by: David Smith at May 28, 2006 08:09 PM

The guys at the oil drum (an obsessives* site on peak oil) have graphed the average of the EIA and IEA output. Given the current high prices you would have thought output would be higher? Cantarell in Mexico seems to be on course for a decline of 8% a year. Saudi Arabia production doesn't seem to be rising further. I note today Oil prices have stubbornly remained above $75 a barrel even after hurricane Chris has become a damp squib.

Do you not agree this is looking horribly like a plateau?

The only way I can see $40 a barell is a global depression - is that your prognosis?

* obsessives on the internet are very useful as the tend to be right.

Posted by: Alex A at August 3, 2006 09:55 PM

the price of crude is finally creeping up again. the devastation the gulf with the BP oil spill plus the hurricane season I guess is contributing to that.

Do you think the price will go as high as above $100's?

Posted by: Crude Oil futures trading guy at July 25, 2010 06:21 PM