How Low?

Oil is putting on a lively demonstration of what happens when the psychology of a market shifts; the reaction is pretty dramatic. The media are full of stories speculating on how low oil prices can go--and how long it will take sticky retail gasoline prices to catch up--and analysts are poring over data looking for the retrospective tipping point last year. I've been generally bearish for a while, in light of early indications of slowing demand and the prospect that 2007 would see more new producing capacity come on stream than new demand to consume it. That doesn't mean we're headed back to historical averages, however, and it's important to put the factors contributing to the price decline into perspective. We've been here before, but the specific configuration of influences looks rather different.

The last time we saw oil go into a deep slide was in the late 1990s, when the key factors were the sudden collapse of demand in Asia, as a result of an expanding economic crisis, and the to coincidental arrival of a large wave of new capacity that had been developed largely to meet the rapid growth of Asian demand. In effect, producers zigged when they should have zagged, and some grades of oil saw single digit prices before the trend reversed. That's not what's happening here. We've had a long bull market driven by steady demand growth, tight capacity, and political risk, none of which is unraveling all at once. Instead, a gradual easing of all three of these is being exaggerated by an unexpectedly warm Northern Hemisphere winter, drying up heating oil demand.

As an article in today's Wall Street Journal points out, another new factor is the growth in biofuels production, which some see expanding to the point of being able to absorb all of oil's incremental demand growth within a few years. The Journal cites some misleading figures for the degree of displacement involved, however, suggesting that current global biofuel production of 10 billion gallons per year, roughly 650,000 barrels per day, equates to a supply of almost 2 million barrels per day (MBD) of Saudi crude. The problem with this math, which assumes a 1/3 yield of gasoline and diesel in a "topping" refinery, is that it ignores the other 2/3 of the barrel, at least some of which also ends up as gasoline and diesel via the secondary feedstock market that fills up the spare cracking capacity of many refineries. It also ignores the lower energy content of ethanol versus gasoline, as well as the oil input to ethanol production.

By the time you factor these in, that 650,000 bbl/day of biofuel looks more like 1 MBD worth of oil on a gasoline/diesel-equivalent basis, and less than 200,000 bbl/day on its total energy contribution. Much of this was already in place in 2005, further reducing its contribution to the sudden shift of the oil market. Looking ahead, the potential incremental biofuels growth between now and 2011 is roughly the equivalent of between 0.3-1.7 MBD, depending on whether you are looking at energy replacement or motor fuels displacement, not the extra 3 MBD the Journal cites. This is hardly insignificant, and it will certainly affect prices, but it's not going to crater the oil market by itself.

The other thing to watch on the biofuels front is its reaction to changing oil prices. I have little doubt that the expected capacity will be built, largely because it looks cheap at roughly $1 invested per gallon per year of corn ethanol capacity. But with petroleum product prices falling and corn prices rising, I wouldn't expect all those plants to run full, even with the $0.51/gallon tax credit. In effect, as biofuels grow out of the niche market they've occupied until recently, they become more like other hydrocarbon liquids and are subject to similar forces of market self-correction as petroleum products, in spite of their environmental benefits.

If I learned anything from more than a decade as an oil trader, it is the tendency of markets to overshoot, in both directions. We are in for a very interesting ride with oil this year, particularly since none of the risk factors I described (1/2/07) a few weeks ago has disappeared. 2007 could even see both $40/bbl and $70/bbl, depending on how these risks play out.