« Soapsick | Home | Fallible »

April 25, 2005

Why oil prices will fall

I’ve held off writing about oil because I figured common sense would at some point prevail. But it hasn’t, so here goes. I’ll make this as painless as possible.

In many ways today’s oil market reminds me of the dot-com insanity, what with analysts like Goldman Sachs’ Arjun Murti channeling Henry Blodget, predicting $105-a-barrel “super spikes,” and scaring us all into trading our Hummers.

Not gonna happen: oil prices are going down, not up. Sure, there'll be some ups along with the downs, but a year from now oil prices will be sharply lower than they are today. My (hypothetical) money is on something around $40 a barrel.

Why? To answer that, it helps to know why oil has risen so far. In other words, strong global demand, particularly from China; the feeble dollar, which has pressured commodity prices in general; and speculation. Lots of speculation.

The problem for oil bulls is that, unlike diamonds, none of these is forever.

For one thing, the global economy is starting to look decidedly unwell. In Europe manufacturing output is flat, unemployment is rampant, and growth forecasts are being cut. Japan’s economy is dead in the water (again). U.S. consumers, the engine of the world economy, are looking nervous. And China is losing its appetite. The latest Oil Market Report from the International Energy Agency (IEA) predicts that Chinese oil consumption will grow by only 7.9% this year, compared with 15.6% in 2004.

And all this at a time when OPEC oil output is growing—as it inevitably does when prices soar, as each member of the conflicted cartel scrambles for dollars. The IEA estimates that OPEC production rose by 290,000 barrels a day in March; non-OPEC output grew by 60,000 barrels a day. Moreover, high oil prices have encouraged oil companies to develop new ways to find and extract oil. Over time, this will mean replenished global reserves.

As for the U.S. dollar, it’s actually strengthened a bit since the start of the year, and shows no signs of slumping dramatically. At best, it might take some pressure off commodity prices; at worst it won’t make much difference.

Then there’s speculation. The oil market’s behavior this past year has been perplexing. Sure, there’s been a supply/demand imbalance, but not enough of one to account for current prices. However, factor in the huge bets on higher oil prices being made by hedge and pension funds—largely via indexed products developed by companies such as, surprise, Goldman Sachs—and things look a lot clearer. Particularly with so few investors willing to short oil.

How big is that speculative premium? Last summer, when oil was around $45, the industry consensus was $7-8 a barrel. Which means—other things being equal—it's probably now at least $10.

If global oil consumption starts to falter and OPEC continues to pump for all it’s worth, the speculators—especially the pension funds—will bail faster than you can fill up a Prius. And poof! No more premium.

I rest my case.

Posted by Stephen at 11:06 AM in Energy + environment | Permalink | Comments (3) | TrackBack (4)

Trackback Pings

TrackBack URL for this entry:
http://www.disinterestedparty.com/cgi-bin/mt/mt-t.cgi/61

Listed below are links to weblogs that reference Why oil prices will fall:

» DISINTERESTED PARTY: OIL PRICES WILL FALL from Knowledge Problem
Lynne Kiesling Stephen at Disinterested Party has a post in which he argues that oil prices will fall. In short, he thinks it's a combination of slowing demand and fleeing speculators once that demand slowdown hits the market. His take... [Read More]

Tracked on April 26, 2005 8:50 AM

» Falling Oil Price? from The Liberal Order
Stephen Ayer believes so. Here's a post by Bryan Caplan on the reduced supply of oil into this country. From Ayer:And all this at a time when OPEC oil output [Read More]

Tracked on April 27, 2005 10:34 PM

» $100 a barrel-- what are the odds? from Econbrowser

Talk about where oil prices are headed is cheap, so at least we have plenty of that. But how seriously does the market take the various possibilities that are being bandied about by the pundits?

[Read More]

Tracked on July 6, 2005 2:23 AM

» $100 a barrel-- what are the odds? from Econbrowser

Talk about where oil prices are headed is cheap, so at least we have plenty of that. But how seriously does the market take the various possibilities that are being bandied about by the pundits?

[Read More]

Tracked on July 31, 2005 1:04 PM

» $100 a barrel-- what are the odds? from Econbrowser

Talk about where oil prices are headed is cheap, so at least we have plenty of that. But how seriously does the market take the various possibilities that are being bandied about by the pundits?

[Read More]

Tracked on January 5, 2006 9:38 PM

Comments

Two more months. So far, it looks like the direction is right, but the magnitude is not.

Posted by: Bob Dobalina at February 18, 2006 10:36 PM

Randall,

I have to agree with you about the influence of the U.S. Dollar. There is nothing to suggest $USD will strengthen over the next 18 months. Nothing of note is being done about the triple deficits (Current account, trade, federal budget) that have brought the $USD to this point.

Pure inflationary pressures (real inflation... money printing) will take the price of oil higher as denominated in $USD. Steven makes a good case though for the price of oil to stabilize as denominated in other currencies. We will see what happens.

Ta,

Posted by: Tom L at April 26, 2005 7:27 AM

I do not know where the price of oil is going. But I will point out a few things about it.

A strengthening dollar would raise oil prices for for well over half the buyers of oil who do not have dollars as their national currency or have a currency tied to the dollar. However, I doubt that the dollar will strengthen much for long.

In the medium term a weakening of the dollar seems inevitable due to the unsustainable US trade deficit. This will lower the cost of oil for most buyers. Therefore it will increase demand and lead to higher dollar prices of oil for the United States.

Production can not respond quickly to prices for oil because development of new oil fields takes many years and existing fields are all producing at very near capacity.

A decline in oil prices to $40 per barrel would still leave oil prices much higher than they have been for most of the time in the last couple of decades.

Posted by: Randall Parker at April 25, 2005 12:09 PM