Tuesday, August 07, 2007

Why Oil Will Hit $100/Barrel

Following the recent slide in oil prices, CNN is already jumping on the bandwagon with their story "Why oil won't hit $100." From the article:

"If this market can continue going lower without OPEC disrupting it, it's very possible that by 2010 we could be substantially lower than anyone is imagining," said Peter Beutel, an oil analyst at the consultancy Cameron Hanover. "Four to 8 years from now, we could come down and break $20 a barrel."

Beutel bases his prediction on the fact that oil is historically a cyclical commodity. In the early 1980s it hit $38 a barrel, far higher than today's price when adjusted for inflation, only to fall to $10 a barrel by the late 1990s.

. . .

EIA says by 2010 the amount of oil OPEC can pump should increase by 2 million barrels per day, largely driven by Saudi Arabia. The EIA, like most analysts, does not agree with the view that production has peaked or will soon peak in Saudi Arabia, although a small but growing number of experts say it might.

EIA says more oil from Central Asia and the Gulf of Mexico should offset production declines in the North Sea and and Mexico.

And co-called "non-traditional" fuels, such as oil sands from Canada and corn-based ethanol, are expected to double, going from the current 3 million barrels a day to 6 million barrels a day by 2010.

While demand is expected to continue growing, EIA says conservation measures should slow the rate of growth to 1.3 percent a year from 2 percent.

Let's just ASSUME that all of those assumptions are correct--which, by the way, I strongly question. A quick math exercise: 86 mbpd * (0.013 ^ 3) = 89.4 mbpd in 2010 based on 1.3% increase in demand each year. That's 3.4 mbpd that that needs to appear over the next three years. Where will it come from? The article calls for 3 mbpd to come from increases in "non-traditional" fuels like ethanol and oil sands. The article also expects a 2mbpd increase from OPEC, mostly from Saudi Arabia. IF both of those come true, then there should be 1.6 mbpd more spare capacity than exists today. IF either one of those fails (for example, if Saudi Arabian production has actually peaked), then there will be LESS spare capacity than today.

My opinion is that neither of those projections for new production will pan out. Analysis of Saudi Arabia suggests that they have already peaked, and if anything OPEC production will decrease over the next three years. While it does seem likely that ethanol production will increase--driven by politics and subsidy--when one accounts for the energy needed to produce that ethanol the increase may be meaningless.

There does seem to be good reason for the recent 7% drawback in oil prices. Technical analysis suggests that there will be strong resistance at the prior record level, and this is exactly what happened. The problem with using technical analysis to justify a prediction of the future is that NO ONE understands why, or even IF, technical indicators have meaning--best guess is some combination of group psychology among traders, a kind of self-licking ice cream cone. An economic slowdown--quite likely, in my opinion, in light of the current debt issues--could certainly curb the increase in demand for oil. However, it is my opinion that it would take a major recession to fundamentally change our driving habits, and it is by no means clear that such problems are in the cards in the very near future. In the interim, any savings from energy efficiency will likely be negated by Jevons' Paradox.

So do I think that oil will break $100? Certainly--the only question is whether that happens this year or four years from now, and assumes that we aren't using 2007 dollars to calculate that record. In the absence of a catastrophic economic collapse (which regular readers will know is something that I see as likely in the medium-term), oil prices will keep going up. They will keep oscillating around a steadily increasing supply-demand equilibrium, with a spread of perhaps $20 up or down. So we may hit $55 before we hit $100. But $100 is far, far more likely than $20.