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Another wild ride in 2008

My interest is in the future because I am going to spend the rest of my life there
     —Charles F. Kettering

2007 was a good year for peak oil prognosticators. Prices almost reached $100/barrel, an event that was ascribed to speculators, the weak dollar, the disruption du jour, OPEC's stinginess, falling inventories, double-digit demand growth in China, and, occasionally, the market fundamentals. What will 2008 bring? The best answer is more of the same—continued market tightness and nominal prices finally breaking the $100  barrier and perhaps going much higher. At least that what the fundamentals say, as we shall argue here.

MarketWatch's Triple-digit oil prices expected after 2007 records sets the tone.

About 54% of a Barclays survey of 150 commodity investors expect the average price of oil over the next five years to top $100 a barrel, with 27% responding that it would be $80-$100 a barrel and 16% expected $60-$80 a barrel...

Eric Bolling, an independent oil trader at the Nymex, said conditions that led to a record-breaking year will likely persist over the next 12 months at least.

"It's a weak dollar, it's a strong global economy, it's China growing quickly at 13%," he said. "It's been a perfect storm for a commodity bull run. That's going to continue to go. There's no signs of its slowing down, by any means." He sees oil ranging from $60 to $120 a barrel next year, with spikes as high as $130 or more in the case of a major hurricane or geopolitical flare-up. "Oil is going to be very volatile," he said.

EIA 2008 Oil Price Even the EIA has jumped on the price bandwagon, albeit in their usual understated way. All EIA oil price graphs, whether they appear in the Short Term Energy Outlook (STEO) or in the Annual Energy Outlook (AEO), have the characteristic shape shown in their latest projection (left). The rising price trend is shown up to the present moment, represented by the vertical line. The price is always projected to fall thereafter. A rough straight line fit has been added to illustrate the disparity between the trend and the EIA's customary expectation. The price dip that began in the Autumn of 2006 may be viewed as an anomaly. The sharp rise in 2007 was a case of prices playing catch-up to levels dictated by fundamentals of supply and demand that have ruled the tight markets since 2002.

EIA price graphs all look the same because they use a simple demand-driven model to set supply and price expectations. High prices automatically stimulate a supply response that drives prices down in the short term. While the EIA's most recent STEO report states that "monthly average prices for WTI [West Texas Intermediate] are expected to exceed $80 per barrel over the next year," they can not bring themselves to acknowledge that the volatile, rising price trend after 2002 will almost certainly continue in 2008.

The overriding concern as we enter the new year is whether the U.S. economy will go into recession. On any given day in the markets, the oil price goes up if traders are feeling bullish about the economy that day. When fears of a recession dominate, the oil price goes down on the expectation that oil demand will fall off.

How sensitive is world oil demand to a recession in the United States? There is good reason to believe that in less extreme cases the answer is not very much. The hypothesis that the surge in oil prices could sow the seeds of their own destruction, by crimping economic growth (Associated Press) is not supported by the evidence.

But record energy prices could sow the seeds of their own destruction. Along with the housing crisis, they are contributing to an economic slowdown that is sapping the country's energy appetite just as oil producers ramp up production. "The cure for high prices is more high prices," said Tim Evans, an analyst at Citigroup Inc., in New York.

That doesn't mean oil will plummet — unless there's a severe recession, said Evans, who expects prices to hover near $70 a barrel. In the face of such forecasts, OPEC could decide to cut production, as it did last year, to keep prices from falling too low.

Other factors will also keep a relatively high floor underneath prices. Demand is expanding in China, India and the Middle East. And political upheaval in oil-producing countries such as Iran, Iraq and Nigeria have sparked worries about possible supply disruptions. These concerns have prompted banks and hedge funds to make big bets on oil — investments that put further upward pressure on prices.

World Versus OECD Oil Demand Demand growth outside the OECD has accelerated in the oil producing and developing economies (graph left). This trend is set to continue to 2008. For example, China will be taking delivery on an additional 200,000 barrels per day from Saudi Arabia next year, an increase of 38% over their 2007 imports from the Kingdom. Saudi Arabia is consuming more and more of its own oil production, a trend described in Saudi Industrial Drive Strains Oil-Export Role (Wall Street Journal). A recession in the U.S. will have little affect on industrialization and subsidized oil consumption outside the OECD.

Historical OECD Oil Demand A second graph (left) shows the historical oil demand for the U.S., Europe and Japan from 1990 through 2006. Two mild recessions occurred in the period, one in 1990-1991 and the other in 2001. (Follow the link to see that recessions are often announced after the fact—we could be in one now!) Neither slowdown had much impact on oil consumption. Oil demand hasn't varied much in Europe and Japan during those 17 years. Demand growth has been slow and steady in the United States. Both trends are invariant with respect to GDP growth levels and oil prices. This graph is like the I Ching—you can interpret it any way you want. However, there is nothing in the long data series to indicate that a recession in the U.S. will change American consumption habits much or affect oil demand in the other OECD countries. Most of the talk about lowered demand due to a recession seems overblown.

The OECD oil demand data can be interpreted to mean that the price elasticity of oil demand in the developed economies is very low. Oil prices have tripled since January, 2003 but oil demand in Japan and Europe hasn't budged. In Japan's Energy Wisdom, the Boston Globe extols their oil conservation efforts.

An island nation with no domestic oil supply, Japan offers a glimpse into the world's energy future, when oil reserves decline to unsustainable levels and alternatives are the only alternative. Unlike the vast and swaggering United States, Japan has confronted the reality of limited oil, especially in its energy conservation efforts. According to the International Energy Agency, Japan's energy consumption as a percentage of gross domestic product is the lowest in the world.

It's a pity that the Globe did not bother to look at Japan's oil consumption data, which shows that Japanese demand was still above 5 million barrels per day on average through 2006. The EIA demand data indicates that their consumption will be about the same in 2007. In all likelihood, Japan will demand roughly the same amount of oil in 2008. The Globe continues—

However, Japan has managed to drive down energy use dramatically without sacrificing the comforts of an affluent society. The per capita consumption of energy in Japan is nearly half that in the United States, but the per capita incomes are roughly the same. So prosperity alone doesn't explain why the United States burns so much more oil.

Japan's economy is still the second largest  in the world... How do they do it? Partly, the Japanese have invented their way out of energy abuse. Hybrid cars from Toyota and Honda are just the most obvious examples... [emphasis added]

Hold on! Japan did not drive down their oil consumption. The Japanese became more efficient as measured by total energy use per capita, which is a very different thing.

Japan's failure to alleviate their complete dependency on imported oil is the real story, not their ability to squeeze more affluence out of every drop. Hybrid cars and bullet trains apparently haven't helped much. The United States may become more oil efficient in the future, but this in itself is no guarantee that future oil consumption, and thus imports, will decrease.

Japan's cautionary tale provides further proof that oil addiction can not be solved by making the oil stretch farther. Japan is far more vulnerable than the United States to diminishing global oil exports in the near term, and declining world oil production over the longer haul. The energy future of the world's second largest economy looks bleak. American presidential candidates should take note.

A lot of new oil (Wikipedia Megaprojects) is scheduled to come on-stream in 2008. Rembrandt Koppelaar's Oilwatch Monthly reports that both the IEA and the EIA are showing a surge in global liquids production as 2007 comes to close. Higher sustained liquids production seems assured in 2008 but some caveats are in order. There are indications from both Brazil and Russia that expectations may be too high. The non-OPEC increment (including biofuels and OPEC natural gas liquids) will likely be smaller than the 1.10 million barrels per day predicted in the IEA's December Oil Market Report.

Much of the new crude oil comes from OPEC. Predicting the cartel's future production is always a risky business. OPEC is not afraid of high oil prices anymore because the oil exporters no doubt understand that world oil demand is still mostly insensitive to price as has been argued here.

We can be confident that the oil markets are in for another wild ride in 2008. Supply appears poised to take off but will still fall short of demand increases outside the OECD. This now permanent condition in the oil markets will drive next year's price increases. Only a global depression could reverse this trend. Supply will likely increase in 2008, so the world's liquids peak has not yet occurred. Check back in 2010. Gasoline prices may reach $4/gallon in the United States in the Spring, an event that is sure to influence the presidential election. All of this could be wrong, of course, but that doesn't appear very likely.

What do you think? Leave a comment below.

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