Friday, November 12, 2004

Where Next for Oil Prices?
We've been living with oil at or near $50 long enough now that it has seeped into the collective consciousness and colored our views of the future. Psychologists refer to this phenomenon as an "availability bias." But as the end of the year approaches, expectations for oil prices for next year are beginning to diverge. The Energy Information Agency of the US Department of Energy has just issued a forecast of oil prices (based on West Texas Intermediate crude) in the mid- to high-$40s per barrel for next year, while the chief economist of Total has suggested it could fall back into the $30s.

The problem with forecasting prices now is that the range of possible outcomes has grown so large. With the world's excess oil capacity having been eroded to a whisker by a combination of booming demand and an array of supply problems and disruptions, the only safe prediction would seem to be for high volatility. Further disruptions could send prices soaring to record levels, while the gradual restoration of production in the Gulf of Mexico (post-hurricane repairs), Nigeria (easing unrest), Venezuela (continued recovery from the national strike) and Iraq (post-elections) should ease supply pressures. Add to this uncertainty about a Chinese economy that should start to slow in the wake of interest rate hikes by the central government. Taken together, this means we could see oil as high as $60 or $70 next year, or as low as the mid- to low-$30s. This range is so wide as to be meaningless for forecasting purposes.

As always, I have more confidence in scenarios than forecasts. Thus, one scenario might be the result of easing local tensions and promotion of supply from existing and new projects, coupled with healthy global economic growth. This would support Total's forecast, leading to gradually easing prices that might end the year near $30, much as we began 2003. Or we could see a repeat of 2004, with one supply disruption after another and unexpectedly robust growth in demand for petroleum products. Such a scenario would see prices more like the EIA forecast, with short-lived spikes into true record territory.

Fundamentally, it boils down to whether the trend is toward clearing up the numerous problems that have hampered supply, or drawing them out and adding new problems. My bet right now would be on the former, but I would have said the same for most of this year.

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