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September 29, 2008

Where Is Oil Headed?

Geoff Heal
Paul Garrett Professor of Public Policy and Business Responsibility
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Prior to the recent financial crisis, the biggest economic story of 2008 had arguably been the rising cost of oil. After hitting a low of $50.48 a barrel in January 2007, oil prices have spent much of 2008 above $120. When the price of oil reached a historic high of $147.27 on July 11, Goldman Sachs’ prediction that oil would soon rise to $200 a barrel seemed well on its way to coming to fruition.

However, since the peak in mid-July, prices have fallen sharply, reaching $96.36 on Sept. 29. What caused this decline? Will it continue, or will oil prices quickly rebound?

Contrary to what we commonly hear from business commentators, speculators have little impact on the oil market, and storms, like Hurricanes Gustav and Ike, only cause a blip in the data. The fluctuations caused by the current financial crisis are also blips, short-run effects; however, if the crisis causes or reinforces a recession, its impact on oil prices will be more durable.

There are two main causes of the recent drop in oil prices: the global economic slowdown and the rise in value of the U.S. dollar. While the idea of a U.S. recession is something we’re all familiar with, Europe, too, has been dragged down by the recent credit crises, and even China has seen a slowdown in growth. Together, these slowdowns have caused global demand for oil to fall, resulting in lower prices.

Oil’s connection to the dollar stems from the fact that while oil is priced in dollars, most oil-producing countries — Saudi Arabia, Russia, etc. — don’t want dollars but rather other currencies. As the dollar fluctuates, these countries mark the price of oil up or down to preserve the value of their exports in the currencies that matter to them. If the current crisis leads to a drop in the international value of the dollar — which it will do if it leads to less use of the dollar as a reserve currency — we can expect some subsequent increase in the dollar price of oil.

Over the next six to 12 months, I expect the price of oil to fall further than it has. Aside from another war in the Middle East or the Caucasus — both of which are possible — I don’t see any forces on the horizon that will be strong enough to counteract slumping global demand and cause prices to increase. While OPEC will undoubtedly try to stabilize or raise prices by keeping a lid on supply, they are often not very effective in doing so. Only once have they clearly managed to raise the price of oil and hold it there for a while, and that was back in the 1970s in the context of an Arab-Israeli war.

In the long term, however, global demand will rebound, causing oil prices to rise again and eventually surpass their July 2008 highs. The growth of the economies of developing countries will play an important role in this, as early stages of growth are particularly energy-intensive.

Supply, on the other hand, is not likely to increase much. Quite simply, we are not finding much oil. For example, the Tupi field off the coast of Brazil, which was hailed as a giant find when it was discovered, has about 10–20 billion barrels of oil in it. That may sound like a lot, but when you consider that the world consumes about 31 billion barrels every year, it only adds up to six to nine months of global consumption. That certainly doesn’t represent a fundamental increase in supply. Neither would more drilling in the U.S., which would generate finds that are peanuts relative to global or even U.S. demand (which represents one quarter of global demand).

While lower oil prices may seem like a silver lining of the world’s current economic turmoil, we must realize that when we recover, the laws of supply and demand will once again force us to confront the issue of rising oil costs.

Photo credit: Jouni Lehti

Comments

by Catherine New | September 30, 2008 at 5:50 PM

Oil may be down for now, but prices — as Prof. Heal points out — will inevitably creep upwards again under supply-and-demand pressures. The question of nuclear energy (if, who, how, where) and other sources capable of producing base load supply are necessary now more than ever. Last week, as part of the World Leaders Forum at Columbia University, Anne Lauvergeon, chairman and CEO of French nuclear engineering giant AREVA addressed the role of nuclear energy in developing countries. (watch video) She hit on the key point that developing countries are affected to a far greater degree by high oil prices and their demand for energy is steadily increasing (3 billion more people by 2050). “[Nuclear energy] is not only a rich-country option. … It is a mistake to discard it a priori.The reasons against it that have been expressed are historically unwarranted, legally unfounded and morally unacceptable,” she said. “Nuclear energy is not a privilege granted to rich countries; it is an efficient option for developing countries.”

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