Balance of Risks

The year ahead looks every bit as unpredictable for energy markets as the year just ended. The three-year old bull market for oil has paused in an unstable equilibrium, waiting either to be driven higher by a new string of bad news or lower by weakening demand or new production. At the same time, alternative energy is gathering momentum and could begin having a modest effect on the price we pay at the gasoline pump. As always, oil prices will be set by the complex interaction of supply and demand fundamentals, geopolitical risks, and market psychology. Predicting the outcome is a crapshoot, no matter how sophisticated one's models. Here are some of the key inputs to watch in the months ahead:

• West Africa rivals the Middle East in supplying high-quality oil to the countries of the Atlantic Basin. Angola's admission to OPEC and the risk of widening unrest in Nigeria could choke off the growth of this valuable contributor to supply diversification, at a time when other key suppliers are also looking less reliable.
• Iraq and Iran together account for roughly 10% of the world's oil exports. The US occupation of the former is approaching a strategic and political crisis point, and we are on a collision course with the latter over its nuclear program. The odds of a significant disruption in supply from this region look about even with those of going another year without one.
• At its present rate of growth, the US ethanol industry will add the gasoline equivalent of a new "grassroots" oil refinery every year for the next several years. When the supply of ethanol exceeds the needs of mandated fuel oxygenate--to replace MTBE--it will enter the gasoline pool at its blending value. That will put downward pressure on both ethanol prices and refining margins. Refiners could end up pushing "E85" as a way to keep this excess in a premium niche, rather than depressing traditional gasoline.
• Many economists are worried about the effect of continued trade and fiscal imbalances on the economy as a whole, and on the dollar in particular. A significant fall in the value of the dollar would ripple through the entire oil industry. The impact would be compounded, if major oil producers responded by going off the "dollar standard" for oil. We could see oil prices rise for US consumers, but fall globally.
• Large volumes of new oil production are expected to come onto the market within the next two years, including major new projects in Saudi Arabia and the output of expanded oil sands extraction in Canada. If the sum of these turns out to be larger than the incremental demand growth from Asia and the US over the same period, oil prices will weaken further.

This list is far from exhaustive, ignoring Russia's slide back into totalitarianism, the ramifications of the deflating housing bubble, the possibility of another Hurricane Katrina, and the uncertainties associated with the incoming Congress. Considering that the price for the entire 85 million barrel per day market is set by the last couple of million barrels per day of supply or demand, we are currently blessed or cursed with a large array of factors that could move the market up or down by that magnitude. We could find out fairly soon whether the present $55-65/barrel range has permanently replaced $25-35, which prevailed as recently as 2003.