Wednesday, October 20, 2010

What's Ahead for Oil?

Oil is an incredibly important commodity. When it's price rises to incredibly high levels it, it usually leads to a recession; in fact, a price spike in oil (the early 1990s and 2008) has preceded two of the last three recessions. Hence, some idea of where it's price is headed can help us understand where the economy might be headed.

First, here is a chart of oil prices:

Prices have stayed in a fairly steady and constant range for most of the year. Now there is a debate emerging about what will happen to oil prices in 2011.

Crude could enjoy its biggest annual increase in demand for three decades. A sustained economic recovery should support oil consumption next year, too, drawing down global oil inventories and forcing Opec, the oil producers’ cartel, to increase production, says Goldman.

It is not the first such forecast. Indeed, talk of $100 a barrel oil was first heard in April, when crude rose as high as $87 a barrel. That was premature but other banks are also forecasting higher prices. Barclays Capital says that risks “are continuing to build towards the upside”.

Yet many dealers in the physical markets, as well as officials at the International Energy Agency, the western countries’ oil watchdog, believe the bulls are wrong. The spot market, they say, is oversupplied and that puts a price ceiling on oil.

“At the risk of appearing a ‘party pooper’ for market bulls, our prognoses still suggest to us that benign market fundamentals could persist well into 2011,” says the IEA.

Mr Taylor argues that the concept of a price ceiling exists today in a way it did not when prices rose to $150 in 2008, before the effects of the financial crisis and the worst recession in decades sapped demand.

His and the IEA’s view is shared, privately, by other leading energy traders. Together, Vitol, Glencore, Trafigura, Mercuria and Gunvor dominate oil trading and, arguably, have better intelligence than anyone else about the state of the physical market. Other banks, including Société Générale, Deutsche Bank and JPMorgan are cautious about the outlook for oil, looking to a ceiling of about $90 a barrel over the next year.

What happens to oil prices will test whether the stability in the market since January – oil has traded at between $70 and $85 a barrel for 95 per cent of the year, in spite of sharp rises in other dollar-denominated commodities – is here to stay. For the four years up to 2008, oil was highly volatile.

Opec, one of the most important actors in the market, believes prices have found a new stability. Saudi Arabia, the cartel’s de facto leader, is working hard to keep oil within the $70-$85 range.

“It is an ideal situation we are in now,” says Ali Naimi, Saudi oil minister. “Nobody is complaining. Consumers are happy, producers are happy. Companies are investing.”

This “steady-as-it-goes” outlook is based on benign fundamentals. The IEA, like many of the big traders in the physical market, is forecasting that oil demand growth will slow next year to 1.2m barrels a day, down from 2.1m b/d in 2010, due to slowing usage in Asia, particularly China, the former Soviet Union and the US.

One of the main reason for the ceiling is prices a large amount of supply in the US:

However, also note the US demand has stalled a bit over the last several years:

However, the real wild card will be China and India; as their economies grow, their demand will be the real driver of prices.