Dip in oil price is only temporary

by Levi Folk | July 26, 2008

A long-awaited correction in oil prices is upon us. Demand destruction from high oil prices and weak economic growth, combined with rising supplies over the next year, create an opportunity for oil prices to fall further. But it probably won’t last long.

Market demand for energy, not speculation by traders, is the main reason for higher oil prices over the past year. Therefore, oil prices are unlikely to keep falling for long unless emerging market demand falters.

The past year has been noteworthy for oil low inventory levels around the world and also for low OPEC spare capacity. Last year, I expected that both would recover on the basis of an expected rise in supplies and weaker demand from developed countries due to the U. S. housing recession and global credit crunch.

So far, that thesis has proved wrong in that oil demand has remained strong enough to create upward pressure on oil prices.

The thesis may in fact be delayed as economic weakness continues to worm its way through OECD countries, Germany being the latest victim of the contagion. Emerging markets are also set to slow too as high inflation is being answered with rising interest rates in many countries.

The spike in oil prices will also play a factor too in demand destruction in the developed world. Vehicle miles traveled in the United States actually turned negative in January—the first decline since the early 1980s.

In January, 2007, when oil prices were roughly US$50 per barrel, I argued that weak supply, especially from non-OPEC producers, and cost inflation in the oil patch would cause prices to rise over the long term. This thesis proved right and was the major factor behind the spike in oil prices in 2007 and 2008.

At the time, I also suggested that oil services companies were excellent buys due to rising cost inflation and major capital spending in the oil patch and indeed they were. These companies remain strong long-term bets.

The supply story, for 2009, however, appears much better than futures prices would suggest. The addition of OPEC conventional plus natural gas liquid (NGL) supply as well as global biofuel supply next year would appear sufficient to cause the oil market to soften into 2009:

• Saudi Arabia production capacity to rise by 1.6 million barrels per day (mbd) in 2009.
• Global biofuel supplies to rise to 336,000 barrels per day (bpd) in 2009
• Non-OPEC supply to rise by 640,000 bpd in 2009.
• OPEC NGL supply to grow by 810,000 bpd in 2009.

All told, the expectation is for 3.3 mbd in additional potential supply in 2009. In contrast, global oil demand is expected to grow by 860,000 bpd in 2009. Therefore, any tightness in oil markets should dissipate over the next year.

OPEC spare capacity is expected to rise to over 4 mbd in 2009 and 2010. This may be low by historical standards but represents a significant boost from current capacity levels.

We are likely to see a respite from the recent “super spike” period that saw oil prices rise to US$150 per barrel—but not an end to the long-term uptrend in oil prices. This rise has been fundamentally driven by emerging market and Middle East demand.

Demand growth will continue to come from non-OECD countries, rising annually by 1.5 million mbd on average to 2013. China accounts for nearly one-quarter of that demand growth and the Middle East accounts for roughly one-fifth of that demand growth over the next five years.

Unless the developing oil-importing countries such as India and China go through a pronounced economic bust, the oil price will keep rising. Inflation is a problem for most emerging markets, yet the growth stories remain on track.

Oil prices could easily correct to US$90 over the next year as fundamentals improve, but it would seem clear that the days of cheap oil are over.