$60 on the way to $200
In 2005, when oil prices were about $60, I predicted on CNBC that the price of oil was inexorably moving towards $100. Others at the time were talking about pulling back to a more “logical” $40.
What happened? The price of oil began steadily climbing, and earlier this year (yes it may seem a lot longer ago) hit the century mark and then proceeded to climb to almost $150. But in September the credit crisis hit. And in October, it became a tsunami that surprised all, including me. Oil dropped back to $60, and it continues to languish at around that price.
In mid-October, OPEC tried to stem the tide by announcing a reduction in production quotas. The market shrugged it off. The price of oil declined that day by $4.
The price gyrations point to a key point with regard to oil prices: there is no linear relationship between supply and demand. This is a margin business where 1 percent of over- or under-supply can bring havoc to the oil price with 50 percent fluctuations down or up.
There was also never a real rationale for $100+ oil. If I were the king philosopher running the world oil business, with proper reservoir management, appropriate decline rates and logical cash flow discount rates the price of oil would be about $50, perhaps $60. But this price would be just about the statistician’s definition of well being: your head is in the oven, your feet are on ice and on the average you feel comfortable. There was no way that such a price could be achieved.
Here are the reasons. For the better part of a decade, the price of oil was not logical, its fluctuations almost entirely driven by headlines, most of them geopolitical in nature. The energy militant nations – Russia, Venezuela and Iran — had no interest in managing oil production or optimizing their resources by enlisting the best and the brightest technology and companies in the world. Their main motivation was to push the price up as much as possible with minimum effort. If, in the process, they could put the screws on the developed world, headed by the hated U.S. under George W. Bush, then that would be just about heaven.
Price hikes seemed to work for quite a while. Major multinational oil companies were booted or eased out and national oil companies took control. It was not helpful to the traditional consuming countries that new huge gargantuan energy appetites emerged in China and India. Nor was it constructive that the U.S., accused for going to war for oil, got stalled in the quagmire of Iraq. That country – which can demonstrably deliver 6 million barrels per day — has vegetated right at 2 MMbbl/d, along with all the suffering, brutality and uncertainty that war always brings.
But the economic crisis apparently trumped geopolitical headlines. In late October, the market shrugged off a stunning revelation by the International Energy Agency, which said that it now foresees natural decline rates of about 9.1 percent. Had the oil price trends of August and September not been interrupted by the dire economic headlines, this news, delegated to page 17 of major newspapers, would probably have sent the price to $200.
No one should sit back and think that $60 per barrel is here to stay. The same reasons that brought $100 are still in force. At that or higher prices energy-militant-nation leaders are the 1,000 pound gorillas both inside and in neighboring countries; at $60 oil they are reduced to monkeys. Saudi Arabia can, for now, play a world regulator. Just sustaining production for a period of, say, one year, can bring quite a lot of misery to the energy militants. That’s a role that Saudi Arabia played before, during the Ronald Reagan Administration, when over-production at his instigation, brought the former Soviet Union to its knees.
On the other hand, $60 is unsustainable. At that price nobody has to do anything drastic, just don’t drill a few wells, don’t stimulate others; let the physics of natural decline take over.
Recessions go away and I am one of those who believe this will not last as long as some masochists would like it to be. One of the reasons is the inertia of China and the infectious optimism of Americans. Imagine the horror of horrors. China is predicted to have “only” 9 percent growth in 2009. The world has become an energy hungry place where energy consumption and wealth have never been more intimately connected. Oil prices will bounce back and the old adage “the higher they get the harder they fall” has a direct retort in oil prices. The harder they fall the higher they get. My prediction: $60 oil will be at $200 within as little as 12 months.