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Lehman Bros. Report: Oil Bust in the Cards
Friday, April 25, 2008 5:56 p.m. EDT
Is $120 oil even real? Not if you ask the Saudis, or even Lehman Bros.
The investment bank’s oil expert said this week that the oil boom is due to bust. Economic growth across the globe will slow just as new refineries kick in, raising supply.
Recession or not, a U.S. slowdown will slacken demand sharply, right as new oil hits the market. "Supply is outpacing demand growth,” said Michael Waldron, Lehman’s oil strategist.
"Inventories have been building since the beginning of the year. We have pretty significant projects starting soon in Saudi Arabia, and large off-shore fields in Nigeria,” he said.
Lehman is now predicting prices at $83 a barrel in 2009 and as low as $70 in 2010.
Although some years off, Brazil too has found as much as 8 billion barrels of light oil and gas offshore. The South American giant’s president says his country might well join OPEC when the Tupi field begins to pump, in 2011.
In addition, Middle Eastern sovereign wealth funds have pushed up the oil price by investing billions of their oil gains, ironically, in commodities index funds.
Now they could be looking to get out, warns Waldron. He figures the money effect has driven anywhere from $20 to $30 into the barrel price.
In addition, a weak dollar is holding oil prices high, according to a series of statements from OPEC leaders over the past week.
If you buy the views of OPEC’s various leaders, that’s at least another $20 of oil price that is not supported by the actual supply and demand situation.
In addition, Europe’s central bank seems bent on containing inflation there. A rate increase in Europe is sure to contain the euro’s rise against the dollar — if serious steps are taken soon.
Couple that with a lower-than-expected rate cut in the U.S. next week, or perhaps no cut, and the oil price drops as the dollar gains ground.
All this is having little immediate impact now, of course. U.S. gas prices at the pump hit $3.58 a gallon just as the summer driving season kicks off.
If nothing changes, analysts now expect gas to rise to as high as $4 a gallon in as little as a month.
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Oil Demand Dropping, Bubble Will Burst
Ronald Bailey, Reason.com Science Correspondent
Monday, May 5, 2008 11:50 a.m. EDT
Oil prices climbed to their highest level ever, flirting with $120 per barrel. And consumers are feeling this price spike at the pump, with gasoline averaging $3.61 per gallon in the United States.
An analysis released by the investment firm Goldman Sachs suggested that oil prices might soar to $200 per barrel. Does this make sense?
Not really. Although U.S. crude oil inventories have fallen, gasoline inventories are at their highest since March, 1993, notes Tim Evans, an energy futures analyst at Citigroup's Futures Perspective. World oil production was up 2.5 percent in the first quarter of 2008 over the same period in 2007 while world oil consumption rose by just 2 percent.
In fact, world production is projected to be 3.3 percent higher in the second quarter and 4.1 percent higher in the third quarter than the same periods a year ago. On the other hand, world demand is projected to rise by just 1.6 percent over the next six months.
In fact, demand is falling in some countries. According to economist John Kemp at the commodities firm Sempra Metals, the U.S. consumed 4 percent less petroleum in January 2008 than it did the year before. Evans agrees, noting that the U.S. demand for petroleum products began falling off last July.
Interestingly, this drop in U.S. oil consumption began before crude prices turned vertical and before we began to see weakness in the broader economy. Even China's thirst for oil is abating somewhat.
Its demand for oil, which once rose at 10 percent per year, has now dropped to 6 percent per year. In addition, world surplus oil production capacity has gone from a very tight 1.5 million barrels per day a couple of years ago to more than 3 million barrels today, says petroleum economist Michael Lynch.
So supply is up; relative demand is down and yet, the price of oil is soaring. What's going on? Exxon Mobil CEO Rex Tillerson just blamed a third of the recent run up in oil prices on the weak dollar, another third on geopolitical uncertainty, and the rest on market speculation.
Let's start with geopolitical uncertainties. Last year, oil consumers watched warily as unrest in Nigeria's oil fields, the possibility of war between the U.S. and Iran, and the antics of Venezuela's Hugo Chavez threatened to disrupt oil supplies. That analysis may have once made sense, but most of those tensions have abated in recent months.
Nevertheless, it remains true that most of the world's oil is produced in volatile regions and by erratic governments, so the price of crude must still include some kind of political risk premium.
What effect does the falling dollar have on the price of crude?
Most oil price contracts are denominated in dollars. The dollar has fallen in value by more than 30 percent against a Federal Reserve index of major currencies since 2002. This means that the price of imports, including oil, have gone up. To some extent, the chief of the Organization of Petroleum Exporting Countries (OPEC) Chakib Khelil was correct when he said earlier this week, "What's happening in the oil market is due to the mismanagement of the U.S. economy."
Continuing U.S. trade and fiscal deficits along with lower interest rates are stoking inflationary fears.
That brings us to speculation. Evans observes that since September 2003, the total number of open crude oil futures and options contracts rose by 364 percent. Meanwhile the global demand for petroleum rose by just 8.2 percent.
"So the futures and options market has become more important than the physical supplies in driving the price," concludes Evans. "We are seeing investment flows into the oil market that don't have anything to do with the demand and supply of oil."
Investors are treating oil as a hedge against inflation and a falling dollar. Oil markets are part of a negative feedback loop in which higher oil prices contribute to higher inflation, which in turn lowers the value of the dollar, which boosts oil prices, and so forth.
In other words, the oil market is coming to resemble the gold market (which has also been soaring). Evans notes that most gold traders don't even ask the question of how much gold was mined last year or how much spare gold mining capacity there is.
In the short run, oil prices are very inelastic: A large change in price produces only a small change in demand. If the price of gas goes up a dollar per gallon overnight, you still have to fill your tank to get to work.
However, over the long run, consumers and producers respond to higher oil prices. For example, Americans are driving less and have switched to buying more fuel efficient cars.
Higher prices also encourage innovation. Economist Richard Rahn from the Institute for Global Economic Growth believes battery technologies are improving so rapidly that the majority of cars sold in 10 years will be all-electric. This would certainly help drive down the price of oil.
Supply is also inelastic — it takes a long time to do the exploration, drilling, and refining necessary to boost production in response to higher prices. This inelasticity of demand and supply means that petroleum prices are very sensitive to relatively small changes in either. This means that prices can fall as steeply has they rose.
Whenever you begin to hear market gurus decree that "this time it's different," as we did during the dot-com bubble and the housing bubble, that's a sure sign of danger in the market. Naturally, proponents of the peak oil theory claim that the recent run up in prices is evidence that the end is nigh.
Evans responds, "Fears of peak oil are what this market has in common with the 1980s, not what is different." Recall that during the "oil crisis" of the 1970s when oil prices were as high as they are today, U.S. oil consumption declined by 13 percent between 1973 and 1983. The higher prices of the 1970s led eventually to an oil glut and prices fell to about $10 a barrel by 1986.
So what will happen to oil prices over the next few years? No one is predicting $10 per barrel oil.
However, once the current bubble bursts, both Evans and Lynch believe that the price of crude will settle at around $60 to $70 per barrel in the next couple of years.
"It's very hard to pinpoint just how long a bubble can expand before it breaks. Getting the timing right is not an easy matter," says Evans. But he adds, "I think that this is the riskiest time to be long in crude oil since 1980." |
