Photo by Patrick Hesse: Flickr

Many of my colleagues have remarked that since supply and demand fundamentals in 2008 were not that different from historical levels, and prices approximately six times the hundred and fifty year mean, economics could not explain the elevated prices. Which might be true, but an economist can and did. John Maynard Keynes, after losing money on the stock market, remarked that the prices did not reflect industry economics but rather traders’ views of stock values. My own work focuses on market fundamentals, which is why the oil price collapsed well after I had expected, but for this article, I will consider both fundamentals and the likely perception of them.

While some thought market fundamentals were responsible for 2008’s wild price fluctuations, it now seems unarguable that “irrational exuberance” sent prices soaring to $147 by mid-year. Certainly, the market balance wasn’t behind at least the last $50 of the increase, given that inventories, while declining slightly, remained robust. Russian production proved lower than earlier anticipated, but was offset by lower than expected demand, as growing US economic weakness, combined with price-induced conservation, took hold.

The rapid price collapse began in mid-July in response to shifting fundamentals, as US consumers chose not to take long driving vacations, and US oil consumption dropped steeply. Oil prices’ long slide was intensified by the banking system crisis which led to a withdrawal of funds from the markets and into cash, prices only recovering after several OPEC quota cuts.

Still, it becomes clear that predictions of $200 oil were more a fantasy than a likely reality, excepting massive supply disruptions, and the longer term price will be closer to the historical price ($30 or so) rather than $100 a barrel now being forecast by many for the next couple of years. But the possibility for 2009 is more complex, as the issues of demand, OPEC production, and investor perceptions remain uncertain.

A few months ago, the market was heaving a sigh at the isolation of the US economy from the rest of the world, but in reality, the Asian economies were beginning to catch the contagion, and data lag was responsible for the misperception. Expectations that 2009 would see a strong demand recovery were clearly too optimistic, but that doesn’t prove next year won’t see some recovery. The 1998 Asian economic crisis saw a net loss of 1.5 million barrels per day from the trend, despite low oil prices, and this year, combined with higher prices, the IEA’s expectation that demand will grow by 0.5 MMbbl/d next year seems unrealistic.

What will lower prices bring? Probably not the supply crash many think. In 1986 (and even before that), it was widely asserted that: high prices are good for us; costs had risen and couldn’t decline; the industry couldn’t grow production at $18 per barrel; the demand revival would lead to a rapid reclamation of OPEC market power; and oil prices would not only recover but soar.

In fact, costs dropped sharply and supply ultimately recovered, which is likely to happen now. As of yet, there has been no major signs of a downturn in drilling, with oil rigs active in the US—the highest cost market—still above last year’s level as of early December. Internationally, the investment downturn primarily reflects companies’ seeking new, lower cost estimates and anecdotal reports, mainly complaints from upstream and service companies. Initial surveys of 2009 investment levels show that the industry expects to spend only about 10 percent less than in 2008, much of which will be offset by lower factor costs.

There should be some demand recovery, mostly towards the second half, as globally economies recover (hopefully). Also, the lower prices should see a summer vacation rebound in the US compared to 2008. But, even if demand for larger vehicles recovers, existing small cars will not be sold, and it is likely that we have passed the peak in US gasoline demand.

There is another feedback loop, in the form of OPEC indiscipline. Several members are in dire financial straits and can be expected to cheat, while the contributions from Russia and Azerbaijan could prove ephemeral. Also, new oil from Iraqi Kurdistan along with a revival of Azeri production and, possibly, improvement in Russia and Mexico, as well as bits and pieces of non-OPEC supply from around the world, should mean OPEC will need to keep quotas low.

The tables shows the relative views of the three main public sector forecasting organizations, the International Energy Agency, OPEC, and the Energy Information Administration, and they clearly anticipate that the demand for OPEC oil will drop next year, partly because of economic weakness but also because of a significant growth in natural gas liquids in OPEC (categorized in the table as Other Fuels). The projected demand levels are, in all likelihood, going to prove excessively bullish. Since OPEC’s current target production is about 2.5 MMbbl/d or more below this year’s average output, even with poor discipline, markets should roughly balance on average for the year.

Graphic by Seth Myers.

But the average is hardly the whole story. Inventories are likely to rise near-term, but by the end of the first quarter, the deep quota cuts announced in mid-December should begin to reverse this trend. Inventories will return to normalcy, reducing contango and, just possibly, tightening markets for light products during the summer. (Contango refers to a situation in the futures market where the immediate contracts have a lower price than those further out. It typically implies a surplus of physical oil in the market, and results in an increased willingness to buy prompt barrels, as they will be worth more later.)

If the hurricane season affects US and/or Mexican production, there could be a late summer price boost above $60. Recalling Keynes, it is possible that traders will take a much more bullish view, given that only oil has a producer organization that cuts production. OPEC’s cuts, better fundamentals, and economic recovery, coupled with fears of hurricanes, could restore a bull market and see prices soaring in the 3rd quarter.

Economic recovery will no doubt renew the debate over whether the market has just been through a commodity cycle or whether flat non-OPEC supply and rising Asian demand means the market has been transformed. And the potential for new supply disruptions in impoverished OPEC states is very real, particularly regarding Venezuela, Iran and Nigeria. Oil revenues have helped those governments maintain a shaky stability, and with prices below $50 per barrel Venezuela is especially vulnerable to a new round of protests and possibly industry strikes. Thus, the cash that is now out of the market could once again pour into commodities, particularly if OPEC’s production cuts restore the futures strip to backwardation.( Backwardation is the situation where the current price on the futures market is higher than that for contracts further out. It usually implies a tight market, in that buyers must pay a premium even though oil in the future will be worth less.)

The punch line: Longer term, prices are unlikely to remain above $50, but for 2009, there is a real possibility that prices will test $100 again in the second half of the year.

Michael Lynch is the president of Winchester, Massachusetts-based Strategic Energy & Economic Research Inc.