Outlook 2008 (On oil prices): What goes up

Today’s oil prices are well beyond what fundamentals suggest. That’s a bubble and bubbles ultimately burst — often swiftly.

World oil markets are on a tear again. Prices recently took a rapid run at the psychologically sensitive $100-per-barrel mark, falling short by a thread. Good news, perhaps, for oil producers. But with fears of a global slowdown on the rise, consumers of oil are worried. Will the price spike last?

Many market watchers believe the answer is yes. After all, the world is different than it used to be. We now must accommodate the voracious energy appetites of new players such as China and India, on top of growing demand from the rest of the world. And the hunger for resources doesn’t stop at oil. Tight supplies have led to a quadrupling of prices for key base metals. More recently, agricultural prices joined the fray. To many analysts, we simply don’t have enough supply on hand to keep prices at bay.

On top of this, world economic growth has been strong. Normally, we can count on periodic recessions to check growth in demand for resources. But industrialized economies haven’t experienced real recession for 16 years, an unusually long stretch. Why? This time around, previously less-accessible armies of surplus labour in emerging markets — into the hundreds of millions — are in the global labour force. This has extended the economic cycle, catching producers of natural resources unawares. Supplies have been tight, and with reason.

At first blush, the growth in oil prices since late 2003 seems to validate the story. Except for a downturn in early 2007, prices grew at a steady 27% each year, giving the appearance of a marketplace steadily coming to grips with its own supply-and-demand fundamentals. Nothing wacky here, or so it seems.

But looks can be deceiving. Oil prices last peaked in mid-2006 around $77 per barrel. At the time, supplies were constrained by the damage caused to U.S. Gulf oil installations by hurricane Katrina. Add a slew of geopolitical concerns in Iraq, Saudi Arabia, Russia, Nigeria, Lebanon and Venezuela, and it is surprising prices didn’t go a lot higher.

While geopolitical concerns remain, the situation has not changed in a way that influenced the recent price surge. Do current prices suggest a more intense supply crunch? Not according to some. Data from the U.S. Energy Information Administration portray global demand and supply as balanced through mid-year. CEOs of two international oil companies recently stated that there is no lack of crude oil supply, and expressed bewilderment at current prices. Moreover, large state-owned producers have admitted they have ample spare supply, while OPEC itself went further, blaming financial markets for the recent surge.

Oil-price swings always attract attention. Back in late 1998, prices dipped close to $10. Serious analysts wondered how the market would react when prices hit $5. What followed made the analysis laughable: in the next 12 months, oil staged a run to about $30 — on the heels of a decade where it was stuck at $20.

This time, the overreaction is in the other direction, but it’s no less muted. Worried about future supplies, oil users overbought. Speculators clearly tagged on for the ride, giving the market more lift. When commodity markets reach the boiling point, bubbles result. These can grow for a while, but they ultimately burst — often swiftly. With global economic growth obviously slowing, demand for oil is sure to weaken in its wake, suggesting softer prices to come. While the $100 level may yet be achieved, it’s not likely to last long. We expect an average of $66 next year — a mere $2 below the 2007 average, thus far.

Global oil supplies have indeed tightened, lifting average prices. But today’s prices are well beyond what fundamentals suggest. While volatility is likely to persist in the coming weeks, fundamentals are the gravity that brings frothy markets back to reality. For the oil industry, those fundamentals suggest that the market is in for quite a shakeup.

Peter Hall is vice-president and deputy chief economist at Export Development Canada in Ottawa.