Breaking The Record

Six weeks ago I crunched some numbers and arrived at an inflation-adjusted all-time high oil price of roughly $91/barrel. I also explained why that was lower than the $101 figure that has appeared in numerous publications. With the market currently trading above yesterday's record closing price in nominal dollars of $90.46, we are within a gnat's eyelash of setting a new real-dollar record for oil prices. An article in today's Wall Street Journal provides a good analysis of the factors that brought us here from $80 only a few weeks ago, while one on Canadian royalties offers useful hints about where things might go from here. Although I remain skeptical that we are encountering geologically-driven Peak Oil, the current market is beginning to exhibit the practical effects of a peak, in which production can no longer keep up with demand. If that's so, then it's impossible to say just how high prices might go before destroying enough demand to right the balance.

In a peak, producers lose the ability to bring on enough new output to meet growing demand. I don't think it matters much to consumers of oil whether that occurs because there aren't enough large new oilfields to tap, or because resource nationalism and geopolitics have made those fields inaccessible or unaffordable. The announced increase in royalties for the Alberta oil sands provides an example of this in a country that has attracted billions in foreign capital, because it looked safer than places like Venezuela or Russia, which have lots of oil but don't honor their contracts. Boosting the oil sands royalty rate to as much as 60% of revenue (combined federal and provincial take) might not bring new development to a halt, but in combination with global project-cost inflation and the steady rise of local costs in Canadian dollars that have risen dramatically against the US dollars in which the oil is sold, it makes the whole proposition a lot less profitable. Thus, at the stroke of a pen, hundreds of thousands of barrels per day of future production have probably just vanished.

That highlights an important difference between the current oil price excursion and past spikes that ended in a flood of new production. Production in the OECD countries is barely replacing the natural decline of mature reservoirs. The non-OECD output that has enabled the expansion of demand in the last several years has come mainly from projects that were planned under more attractive fiscal terms, in host countries that have since cooled towards international oil investment, at least from the western oil companies. Producing countries may be entitled to a fair share of the rent on their own resources, but they are also quite capable of killing the golden goose. Meanwhile, spare OPEC production capacity that might have been adequate a decade ago is now too small to dampen the volatility of an 85-86 million barrel per day market.

What all this means is that the safety valve, if there is one, must be found on the demand side. Any adjustments are unlikely to be evenly distributed, however. The continued growth of the large emerging economies is tied to oil, and many of their consumers are artificially insulated from its true price by government intervention. The price that European consumers pay is already dominated by taxes, so changes in oil prices result in smaller percentage increases in fuel prices there than in the US, which has so far been sheltered by weaker refining margins, at least for gasoline, though heating oil is now starting to spike. Nor are measures such as the 35 mpg CAFE standard I discussed Wednesday going to have any impact in the short run.

On balance, then, the mechanisms by which high oil prices might tend to self-correct look weaker than the factors driving them higher. It worries me that this seems to be as true at $90 as it was at $50, a couple of years ago. For some time now, my trading instincts have been telling me that we ought to be approaching a big correction in prices. However, it's getting harder to construct scenarios that would produce that outcome, and the ones that do pivot on economic events that would be even less pleasant than high oil prices have been.