At the same time, it is hard to credit the argument that the oil market has experienced a “paradigm shift” in which oil is harder to discover and produce than before, demand is growing much faster, and prices have little effect on demand. Many argue that non-OPEC has peaked, or is near it, and that OPEC’s market share will grow rapidly from now on, so that even if so-called “peak oil” is not here, ever higher prices will be. Thus, many forecasts put long-term prices at or above $60, but it is worth remembering that only three years ago most predicted much lower prices.

Much of the current market wisdom reflects recent developments – and clichés, such as “the easy oil is gone” and “demand is soaring” – not unlike the projections of many superficial analysts that the latest trend will last forever. Present demand growth is one-half to two-thirds the long-term trend, and while Chinese oil demand is growing rapidly this year, it is much slower than in the past – about 6 percent now, versus 8 to 10 percent previously. The easy oil didn’t suddenly disappear five years ago, and OPEC surplus capacity has been low for most of the last 15 years, without prices soaring.

The primary geopolitical troubles – unrest in Iraq, conflict over the Iranian nuclear program, poor management of the Venezuelan oil industry, and ethnic unrest in Nigeria – appear unlikely to improve dramatically in the near future, and could conceivably worsen. Sanctions against Iran could be toughened, Iraqi or Nigerian politics could become more chaotic, Caspian pipelines could be sabotaged, and there is always the possibility of political unrest in any of a number of oil exporting countries.

On the other hand, the situation has recently improved in two important areas, Iraq and Nigeria. Iraq has operated its Ceyhan export pipeline at nearly 50 percent capacity (or 300,000 barrels per day) for about two months now, reportedly due to better security on the pipeline, which had previously been sabotaged whenever it operated. And Shell is in the process of restoring its Nigerian production, as Nigeria’s new president, Umaru Yar’Adua, attempts to stabilize that region through negotiation.

The past several years have seen an enormous flow of capital from investment funds into energy derivatives, which has definitely raised prices above what the fundamentals would justify. The recent push towards $100 oil seems to have been driven more by hedge funds and traders – that is, speculators, not investors – (over)reacting to relatively unimportant news. However, while a short-term reversal (taking prices back to $70 to $80 per barrel) is probable in the next few weeks as speculators sell off, the “investors” who have been buying energy derivatives for several years are less likely to pull out.

What could cause a reversal of that? First, a sense that the commodity boom is largely over. This would happen if, say, a significant economic slowdown occurred, particularly if it affected the Chinese economy and its commodity consumption.

An increase in non-OPEC supply would also go a long way towards convincing many investors that the oil sector is not experiencing a paradigm shift. Although over the past decade non-OPEC producers have performed poorly, growing only very slowly – excluding the former Soviet Union (FSU) – after rising rapidly in the 1990s, it seems that this is not a permanent condition. Our research at SEER suggests that growth should resume over the long-term. Should this occur over the next one to two years, much of the belief in permanently higher prices will be undercut.

Similarly, growing evidence of conservation would undercut the argument that price isn’t relevant to demand. Investment analysts have argued for several years that soaring oil demand will prop up prices and that economic growth in India and China will offset the price effect on demand, but if those countries continue to show evidence of slowing demand growth, or if U.S economic weakness drags them down, sentiments could change.

Finally, there is always the ultimate arbiter of markets: the physical balance. If supply becomes glutted, the physical prices will force down the paper ones. While glut is almost always a subjective term, it occasionally becomes an objective issue – namely, when storage capacity becomes so full that there are no tanks left to fill, and oil prices are forced downward. This has happened in 1986 and 1998, and to a degree, in 2006.

What could the market look like next year? Aside from the likely geopolitical developments, the fundamentals generally do not look solid. As the table below shows, most official forecasters expect supply to outpace demand, although there is significant variation.

The IEA expects an enormous recovery in demand, with OECD oil demand growing by 750,000 bpd. This is not an unheard-of rate, but it is high, given weakening economic indicators in the U.S., Europe, and Japan.

With recent economic developments and warm late fall weather in the U.S. and Europe, it seems increasingly likely that the oil demand growth rates for 2008 are too optimistic. And if 500,000 bpd of Iraqi and Nigerian recovered supply is added, the market could be extremely weak. Overall, it appears that demand for OPEC crude will be flat to 500,000 bpd lower in 2008 when compared to 2007, while OPEC capacity and supply will increase.

Drivers of a Price Decrease

Significant price drops can be caused by overflowing inventories and/or a price war within OPEC (or between OPEC and non-OPEC). The latter often causes the former, but not always, such as in late 2006 when inventories reached near-record levels and OPEC members reported difficulty selling oil before they cut their production.

It is difficult to quantify when tanks are full, given that no capacity data has been collected in many years, and outside the OECD the data is even more uncertain. However, in 1998, OECD storage went flat at 2.775 billion barrels, and tanks were said to be full; in the fall of 2006 when storage approached that level, producers reported difficulty selling oil and prices dropped by $20.

But it is hardly a given that inventories will be allowed to grow that much. At the moment, it appears there will be inventory builds in the fourth quarter of 2007 and the first quarter of 2008, particularly if the U.S. and Europe experience warm winters and negative economic trends continue. OECD inventories are currently about 120 million barrels below the 1998 peak, implying that those levels could be approached sometime in early 2008.

Last fall’s OPEC production cut was not completely honored by the members, with approximately 1.2 million bpd in reductions out of 1.8 million bpd proposed. Since then, production has drifted up, particularly in Iran and the U.A.E., so that they are well above their pre-reduction levels. Only Saudi Arabia and Kuwait are voluntarily producing less than in October 2006.

The ultimate arbiter in OPEC is Saudi Arabia. The Saudis are the policeman of the cartel, and have proven so in the past. Historically, they have also shown a desire to avoid excessive inventories and protect their long-term sales and market share, doing so in 1986 and 1998 to great effect. At the same time, their sales level is not under strong pressure, with production recently rising to about 8.5 million bpd, a comfortable level for them; their share of OPEC production has declined, but remains at a comfortable level.

Saudi Share of OPEC Production, 1991 to 2007

However, given flat or even declining sales of OPEC oil, and rising capacity in the African members (the IEA expects nearly 1 million bpd of new capacity there), Saudi Arabia could cut as much as 1 million bpd during the second quarter, pushing their market share down by 1 to 2 percent. Should those things happen, the Saudis might decide that prices are too high and need to be revised downward.

Likely Developments

It is all but certain that prices next year will be well below the current (as of this writing) $95 per barrel, but how far, how fast, and when cannot be predicted. It seems unlikely that prices can remain above $70 without a market readjustment similar to that of the 1980s, but that doesn’t mean it will happen this coming year.

In all likelihood, as the market heads into refinery maintenance in the second quarter, OPEC will be under pressure to cut production and should do so without too much difficulty. Under the worst-case scenario (weak economic situation, warm winter, Iraq and Nigeria recovery), inventories will be near a peak and prices will come under strong pressure, leaving us at about $70 by the beginning of the second quarter.

But towards the end of the year, particularly if U.S. drivers conserve and consumer prices in China are not abated, speculators might begin to reduce their holdings and prices should shrink further. How far they will go depends on how quickly OPEC reacts, what price the Saudis want to defend, and how buyers of energy derivatives behave. Prices could hold at $60, or at worst drop to the $40s.

If economic growth in the U.S. is higher than expected, the Middle East remains unstable, and Nigerian and Iraqi rebels rebound, then prices should remain elevated, but in the $70s and not the $90s. At worst, the supply/demand balance should be moderate, and this should confound the many bulls who believe that markets are ever-tightening. However, geopolitical risk with moderate fundamentals can be expected to keep investors in the energy derivatives markets.

This table is a simplification of the outlook’s four extremes, and at the moment it appears that the situation is heading towards the lower right-hand quadrant. However, demand has repeatedly been stronger than expected, the U.S. and Chinese economies have outperformed what was projected, and geopolitics are always a wildcard. Prices could easily remain high next year, but the high probability of weakening fundamentals suggests not only a pull-back from $95 but a floor that is not much higher than $70. However, as Keynes noted, it is the thinking of the traders, not the economics of the industry, that determines prices in the short-run.

Michael C. Lynch is the president of Amherst, Massachusetts-based consulting firm, Strategic Energy & Economic Research, Inc.

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