Oil Prices: Will Crude Fall Substantially In 2013?

Column

on October 20 2012 3:18 PM

Concerning where the price of oil is headed in the next 12 months, my local car mechanic’s analysis here in the New York metropolitan area probably is as good as any other oil market analyst's:

“The price of oil? Over the next year it’s guaranteed to be between $40 and $140 a barrel,” my mechanic said.

Oil closed Friday at $90.14 per barrel, down $1.96. (Oil hit an all-time high of $147.27 per barrel in 2008, or $158.29 in 2012 dollars.)

What’s more, talk with five oil analysts and you’re likely to get…five different forecasts for the price of oil in the year ahead - from bearish, to mildly bullish, to downright oil shock-ish.

Forecasts may differ, but there’s one constant regarding crude: oil remains the lifeblood of the global economy, and certainly the U.S. economy. Other energy forms have made inroads (natural gas, nuclear, renewables) on oil’s dominance in the modern/postmodern era, but investors and consumers should know that - barring a major energy or technological breakthrough - oil will remain the dominant fuel of thr developed and developing world for at least this decade. And, by extension, high oil prices will lead to bad things for the U.S. and global economies (save oil producing nations); low oil prices, the reverse.

Right now, the price of oil is high: $90 per barrel. And don’t let anyone fool you: crude is not cheap today, and is ridiculously high compared to its 150-year average price (1861-2011) of about $25 per barrel. The compelling questions for investors and consumers are: 1) why are oil prices high today? and 2) where are oil prices headed over the next year, and in the next five years?

Regarding oil prices today, it’s not simply a supply and demand equation. If it was, oil would be selling for $50 or even $40 per barrel, not $90. Despite increased demand from emerging market economies, primarily China, there has not been a sustained disruption in oil’s supply anywhere in the world. In other words, in the globalization era that began in 1989, whenever a nation, be it the United States, Japan or Germany, sought oil, it has been able to buy it. With no shortages during that 30-year span, why then has the price of oil remained at such high levels?

You guessed it: geopolitical risk. Ongoing civil unrest in the Middle East (Syria, Egypt) near major oil producing nations, has placed a “geopolitical risk premium” on the price of oil, adding roughly $10-15 per barrel to oil’s price.

Add the above to the possibility of supply disruptions in Venezuela and Nigeria, and U.S./E.U. sanctions imposed on oil producer Iran over its nuclear program, and the result is an oil price that has been bid-up substantially - far above where oil would be trading if solely supply and demand factors ruled the day.

Second - and this may surprise some consumers – oil is not just an energy form, it’s an alternative investment, particularly for institutional investors (hedge funds, investment funds, and other high-net-worth investors). Frustrated by this decade’s inadequate returns in the stock and bond markets, institutional investors (IIs) have bid-up the price of commodities, and one of their favorite commodities is: oil. Further, so long as IIs believe the likely rate of return from oil futures (and other commodities) is substantially greater than the rate of return from stocks, bonds, real estate etc., these investors will continue to pour money into oil futures - and the price of oil will remain well above where supply/factors would place it.

Any Good News On The Horizon?

So now you know two major reasons (geopolitical risk, oil as alternative investment) why oil prices are so high today. Given the above, is there any good news on the horizon for businesses and consumers who use oil? Indeed there is.

Natural gas, and in particular unconventional natural gas stemming from new hydraulic fracturing or “fracking” technology, has become a comparatively cheap, abundant source of energy in the United States, and major, new supply additions are also possible in Europe, Russia, and the Middle East.

In North America, natural gas closed Friday at $3.58 per million Btus (MMBtu) – which means it sold for the oil equivalent of $20.74 per barrel. In other words, natural gas costs about one-fourth of oil, for the same amount of energy delivered.

To be sure, those huge increases in natural gas’s supply are contingent on fracking technology deployed safely. In some areas, fracking has led to environmental damage and it is not appropriate for all, potential drilling areas, but if those approved fracking sites continue to produce at current rates in the United States, natural gas will continue to displace oil in factories, home heating, and displace coal (and other fuels) in electric power generation.

Natural gas is also making in-roads in transportation, in the fleet vehicle market (buses, garbage trucks, short-haul delivery trucks), or where vehicles return to the same site to re-fuel. (The long-haul, 18-wheeler truck and civilian car/SUV markets will have to await the build-out of the U.S. natural gas filling station network.)

In other words, natural gas will decrease U.S. oil consumption, and in the process take some pressure off global oil demand.

Second, as the International Energy Agency (IEA) indicated in its latest global oil outlook, just as it has with natural gas, fracking and other, new drilling technologies applied to shale and tight formations in North America is increasing oil production. The IEA confirms what President Barack Obama has stated on the campaign trail: oil production in the U.S. has increased 13.1 percent since 2008 to 5.658 million barrels per day (bpd) in 2011, according to the U.S. Energy Information Agency, with the IEA calling the new oil drilling techniques, “a game-changer in the making.”

In other words, new drilling techniques will continue to increase U.S. oil production, and will play a role in increasing international oil production, boosting global oil production by 9.3 million bpd to 102 million bpd by 2017, the IEA said. Meanwhile, global oil demand is expected to rise to 95.7 million bpd by 2017.

The net result? The world’s spare capacity or “safety cushion” for oil is expected to roughly double - to 5-7 million bpd in 2017 - a safety cushion size the world has not seen since before 2003.

On Supply, Demand, And Spare Capacity

Hence, there’s good news on the horizon for businesses and consumers who use oil. Comparatively cheap, abundant natural gas is displacing oil in the United States for several energy uses, decreasing oil demand, and new drilling technology is increasing oil’s supply from areas previously thought to be unfeasible for oil production. Each trend is likely to continue as the decade progresses. If each trend does continue, the result will be a slow, gradual lowering of oil prices over the next five years, the IEA said.

And that’s the view from here, as well: of course, a war in the Middle East or another impossible-to-predict event could substantially change oil’s supply/demand equation, but barring that, a period of lower oil prices is likely to be up ahead for the United States, and for the world.

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