Oil price to slip as economies slow

US$200 a barrel oil is unlikely any time soon

Spikes in the price of oil are upon us at a time when tightness in the oil market appears to be abating. Oil prices have shot up to US$125 per barrel and sights have been set on US$200 over the next few years, according to prominent analysts and economists. This event is conceivable but highly unlikely in the near term. It is far more likely that oil prices will recede over the next two years as the developed world undergoes a phase of below-potential economic growth.

First let us set out the bull case for oil, of which I have long been a proponent. Cost inflation in the oil sector is raising the marginal cost of production. Higher oil prices have prompted increased spending across the oil sector. Nominal investment has increased 70% from 2004 to 2006 to more than $240-billion per year. Factor in cost inflation, however, and the real effect of that spending increase is essentially nil. The marginal barrel of oil now costs roughly US$90 to produce, according to a recent report by Goldman Sachs.

Staying on the supply side, production has increased, but not overwhelmingly so. Supply has increased by 5.8 million barrels per day (mbd) since 2006, about one million barrels more than demand. Much of that supply has come from OPEC, most from Saudi Arabia.

Non-OPEC supply rose by 1.8 mbd over that time, but there are doubts whether Non-OPEC supply can continue to increase at a meaningful rate. Many countries are seeing production peaks. Russia, currently the world's biggest producer, has seen production fall over the past four months, with some industry experts questioning whether it will ever rise again.

The emerging and developing economies account for more than 90% of the rise in oil consumption since 2002. China alone accounted for 30% of oil consumption growth from 2004 to 2007, according to CLSA's Greed and Fear report. Growing oil demand in the emerging markets has tipped the balance in oil markets to one of higher prices.

What is most surprising is that oil prices have more than doubled over the past year during a recessionary period for the United States. North American oil demand is expected to fall by 0.4 mbd in 2008, according to the International Energy Agency.
The aforementioned bull case for oil is not a new story. I laid it out quite clearly in January, 2007, when oil prices were close to US$50 per barrel. It is strong evidence that we are in a new era of higher oil prices.

High oil prices are one thing, but US$200 oil is highly unlikely any time soon. There are a number of reasons why oil prices appear to be excessively high in the near term and could soften over the next year or two, most obviously weaker demand in the OECD.
The IEA has repeatedly cut its estimates for oil demand for the OECD over the past few months, lowering associated demand from North America, Europe and Japan by 0.57 mbd in the first quarter of 2008. A mix of high prices and flagging economic activity are the reasons for the change.

The prognosis for the U. S. economy is poor over the next 18 months given the deterioration in its housing market. House prices continue to decline and are expected to fall by as much as one-quarter on average when all is said and done. Japan and Europe are expected to suffer knock-on weakness, too.

China is certainly picking up the slack in oil demand and will play its part in driving demand higher this year by roughly 1.0 mbd in total, according to the IEA. This means that there is less respite for oil supply to recover, despite falling demand in the OECD, than would otherwise be the case.

Still, oil prices may rise for the time being. The cost of capital for the average oil producers is roughly $45 per barrel, up from roughly US$20 per barrel in 2004, according to the Goldman Sachs report. However, the current price of oil per barrel is nearly three times the average cost of capital, which would seem excessive.
Rising supply is the factor that could cool off oil prices in the near term. The oil market is adequately supplied, currently. There are no oil shortages and OECD stocks are high, near the top of the five-year average range.

There is every reason to believe that they will continue to move relatively higher over the balance of the year as demand for oil remains weak in the developed world. OPEC spare capacity is low but rising, and is on its way back to levels last seen in January of '07 when oil prices had plummeted.

Investors tend to suffer from myopia when valuing securities, the recent housing bubble being a case in point. Yet a rise in oil prices beyond current levels suggests that investors are uncharacteristically looking well past the current cyclical economic downturn in the U. S. to potential oil supply issues five years out. This is a case of euphoria driving the herd.