Oil prices dip

I forecast in April this year - in the face of hysteria about $200/barrell oil prices - that the price of oil would approach $75US/barrell within 18 months and would settle around there. After I made my prediction it increased to a peak of $145-29US. Today- about 5 months later -  it touched $91-23US.  Indeed we seem to be moving back into what looks increasingly like an OPEC-determined oil price driven by supply rather than oil prices driven by surging developing country demands.  I'll stick to my earlier medium term forecast - there is plenty of exploitable oil in the world at $75US/barrell.  The OPEC cartel-type supply restrictions have a long history of repeated failure.

Of course, the current oil price fall is partly due to expectations of lower economic activity associated with the current capital market crisis. This capital market crisis has however dented speculative activity in oil markets that will make things easier for motorists and more difficult for OPEC and the Russians.

Oil subsidies in emerging countries

A standard economic proposition is that poorer people generally have more price elastic demands for many goods.  When a good's price rises it is those with constrained purchasing power who cut back their consumption most. Why then have oil demands not fallen in oil importing emerging and middle income countries when we know demands have fallen off markedly in developed countries?

This is partly because in countries accounting for 96% of the increase in demands last year oil prices are subsidised - often massively. Until recently Malaysia devoted 7.5% of its national economic output toward fduel subsidies.

Often provision of these subsidies is an intractable political issue. Sometimes too the subsidies are a second-best way of addressing the environmental problems of deforestation that would worsen were poor people to be charged the fiull price of kerosene.

These subsidies mean that the aggregate quantities of fuel demanded will not adjust in response to higher prices so as to stabilise these prices - they keep prices high in developed countries where oil products are generally taxed rather than subsidised.

Oil prices will fall substantially over the next 18 months

I have emphasised before that the effects of increased fuel prices will eventually come to reduce fuel demands and create incentives for new sources of supply - these reflect supply elasticity effects and cross price elasticity effects. In the US - which purchases one third of the world's petroleum - this seems to have already occurred with the first annual reduction in gasoline demand since 1991. Part of the decrease might be recession-related and part to changing demographics but most of it seems to be a direct effect of higher prices on demand.

Moreover, with higher food prices now a global reality one would expect these price effects to be relatively most intense in developing countries such as China and India which provide the bulk of the extra demands putting pressure on oil prices globally.

I'll stick my neck out with a bold forecast. Fuel prices will decline considerably over the next 12-18 months. Crude prices at present are having problems breeching the $120US per barrel level so how far do I think they will fall. Medium term prices of around $75US per barrel make investment in the provision of additional oil supplies attractive. That's where I expect them to settle. They might go lower than this - break even prices for tar sands are around $33 per barrel while oil from the Gulf states has a break even price of around $38.

The laws of gravity will eventually apply to oil markets - all cartels fail eventually but they die quicker when demands are falling and competitive fuel products look like they will gain significant market share.

Oil prices again

I have posted several times on the future of oil prices. One notion is that the US recession might put a dent in them and that longer-term the price of oil will ease. This article in The Times suggests that is not true. A US recession might cause a temporary brief fall but - through to 2015 - you can purchase oil 7 years in advance - the futures markets suggest that oil prices will remain high at something in excess of $100US per barrell.

Will the sickly US consumer drag the global economy into a massive slowdown that puts Chinese factories out of business and leaves the Saudi sheikhs floating face-down in a lake of unsold crude? The futures market tells a different story. It is not the crude price over the next three months or even a year that matters, argues Jeff Currie, of Goldman Sachs. If you want to understand where oil might be going, look at the long end of the crude futures market.

You can fix your cost of oil as far out as 2015, and the interesting thing about those distant prices is that they have been rising faster than the prompt prices of Nymex crude.

Oil for delivery in April was priced at about $107 yesterday, the price rising a couple of dollars as traders quickly forgot about Bear Stearns. December crude was cheaper, priced $102 to reflect the nervousness about Americans' continuing addiction to motoring when the bank is seizing the keys to their homes.

But look further out to December 2010, 2011 and 2012 and the crude price is virtually unchanged at $100 a barrel. The market seems to be saying there is a strong likelihood that demand for crude will remain strong and that the world's ability to supply it will remain restricted for years to come.

Look at what is happening in the world at large and you see ample evidence that the futures market is right. If rich-country appetites dwindle over the next 18 months, Opec will react. They need a crude price of more than $60 a barrel to pay their bills and their recent behaviour suggests that they like $100 oil. They can easily cut output - the Saudis will take the hit - if necessary. Meanwhile, there is little evidence that the oil majors will produce more oil. They are not finding much and they are unwelcome where it is easily found. What they have, they struggle to produce fast enough.

The evidence suggests that the price of energy will dip and then continue its upward climb.