Oil Price Will Fluctuate, But How High Can It Go?

In the last week of 2007, I predicted that oil prices would finally top $100/barrel. Well, it didn't take long, two days in fact. Ironically, it appears that the first time a barrel of oil changed hands for more than $100 was solely because a trader wanted to own that distinction forever. Nevertheless, those who espouse the so-called "peak-oil" theory will no doubt use the recent climb through $100 as additional evidence that oil production is nearing a crest and will soon move into irreversible decline.

Indeed, recent analyses by Energy Watch Group and Earth Policy Institute claim that the peak is imminent or perhaps already past us. Now that the psychological threshold of $100 has been broached, and with peak oil production a possibility worth serious consideration, the question is: how high will oil prices go?

One provocative view is presented by Jim Kingsdale in the blog Seeking Alpha. His is the first work I've seen that projects oil prices over $200/barrel, with the staggering forecast of $275-500 by 2012. My back-of-the-envelope work suggests that each $10 in oil price increase translates to about $0.40 per gallon more at the pump. If that's about right, then $500 oil means gasoline at about $16/gallon more expensive than today, or close to $20/gallon.

When asked what will happen to stock prices, J.P. Morgan was once quoted as replying, "They will fluctuate." That is my sentiment about oil prices; they will go up and they will go down. I suspect that the long-term trend for oil prices is upward, even beyond today's $100, but it's hard for me to subscribe to anything approaching $500. Before prices reach that high, there will be so much demand-curtailment, and so many economic alternatives emerging from the woodwork, that the price-setters in the oil markets -- yes, OPEC -- will adjust production to maintain equilibrium.

Unfortunately, oil is not a market that lends itself well to rational economic analysis: either fundamental analysis of supply/demand basics, or technical analysis of price movements. The optimization calculus of the oligopolists, who control most of the remaining reserves (and the lowest-cost reserves to boot), is not always to maximize profits but to maximize geopolitical power.

Even worse, if radical forces gain control of the key supplies (e.g., a coup in Saudi Arabia), they won't be afraid to turn off the spigots, because they're perfectly happy living in the 12th Century and they want to see the developed Western powers fall back into the Dark Ages.If the Middle East shuts off the oil tap, the sky's the limit for oil prices, and maybe Mr. Kingsdale's forecast will turn out to be too low.