The recent decline in oil prices, after a long run-up since 2001, has some people wondering whether history will repeat itself. Sustained supply surges and fall-offs in demand have sometimes followed on the heels of past oil booms–such as in the early 1980s, after the 1979 Iranian Revolution caused a second oil shock.
Certainly, the oil market faces near-term drags as the global economy cools and some non-OPEC supply emerges in a lagged response to the earlier oil strength. Though impossible to predict, the price of a barrel of West Texas Intermediate crude might even drop below US$50, compared to a 2006 high of US$78. But there are larger forces at work here. We believe cheaper oil prices will not persist, for five main reasons.
The first is that there's no reason to expect a monetary squeeze or recession. Back in the 1970s, oil shocks stimulated higher wage and price inflation around the world. Inflation was too high for central banks during the 1980s and early 1990s, and they hiked interest rates aggressively whenever oil prices bounced, for fear that it would feed through into costs and prices. In contrast, today's global backdrop is one of low inflation and steady growth.
The higher oil prices of recent years simply reflected the emerging world's tremendous demand for resources. Fast-growing nations (particularly China) consume lots of oil as they flood the world with traded goods. In other words, strong energy prices are the flipside of weak traded-goods prices and downward pressure on global labour costs.
The second reason is that the emerging world's thirst for oil will only increase. China and India will import substantially more oil in 2007 than last year. This has been a trend for many years. These two Asian countries are attaining critical mass, accounting for nearly 12% of world oil consumption in 2006 versus just 6% in 1993. And there's still plenty of room for further growth. One example: Chinese car ownership is only 24 per thousand people versus 480 in the United States and 450 in Japan.
Thirdly, OPEC is poised to limit oil price declines below the US$55-to-$60-per-barrel zone. Even though oil prices are very high by the standards of the past 20 years, OPEC is not exceeding its quotas and has fallen in-line with the cut announced in October. Saudi Arabia's willingness to reduce production seemed to rise as soon as oil dropped below US$60 a barrel.
OPEC's job is made easier because it is getting much tougher to find oil globally. The number of oil (and gas) rigs actively drilling or exploring (“rig counts”) surged by more than 50% since 2003. However, the productivity of oil wells is falling sharply, as is the rate of new oil discoveries.
Fourth, the oil correction took the froth out of the market. Speculators in crude oil and refined product futures have dramatically pared the sizable long positions evident earlier this year. Less speculation means that energy prices are better positioned to benefit from positive underlying fundamentals.
And finally, geopolitical strains will keep oil price risks to the upside. Our surveys of global media suggest that the geopolitical risk premium embedded in oil has dropped sharply. The underlying belief seems to be that “lame duck'' U.S. President George W. Bush will be too preoccupied with extricating his country from the quagmire in Iraq to confront Iran. The risk is that an emboldened Iran will push the nuclear envelope and force a U.S. response. Meanwhile, Iraq is a powder keg, and Saudi Arabia and Nigeria remain politically vulnerable.
We believe oil prices are headed to between US$60 and US$70 a barrel in 2007. Prices far exceeded the US$50 equilibrium in 2005-06, as investors overreacted to geopolitical fears, a U.S. economic boom and surging Chinese oil imports. Cooling in all three variables prompted oil to correct, but the equilibrium price began rising again in mid-2006 to the high 50s. If the economy lands softly, as we expect, it would push the equilibrium toward US$65 later in the coming year.
David Abramson is a managing editor at BCA Research Group in Montreal