In Which Direction is the Price of Oil Headed?

As the price of a barrel of oil reaches new record high, there are two distinct groups of thought: one group asserting that the price of a barrel of oil will go to $125 by the end of 2008, and the other asserting that the price of a barrel of oil is too high and will go back down to $60 to $80 range.

Given that each groups’ assertions have support among well-respected economists, how can you monetize these disparate data sets?

Risk Manager’s Analysis of Crude Oil Price

All the articles I have read on the price of a barrel of crude oil contains speculative opinions on where the price of a barrel of crude oil will be in the near future. Now, there may have been analysis performed but that data is missing from the articles, leading an investor to either pony up tens or hundreds of dollars to buy their analysis report. Well, to save you a few bucks and to give you something to think about, here is my analysis on the price of a barrel of crude.

Historic Data Analysis

BP (BP p.l.c. and BP America Inc.) (BP) has a wealth of information on their website on oil prices, from which the data and charts for this analysis were obtained. Using the data obtained from BP’s website, here is the analysis of the historic oil price relative to production and refinery through-put, cross-index with major economic event timeline:

From the chart of crude oil prices up to 2006, indexed to major economic events, the biggest spike in the price of crude oil occurred in the late 1970’s with the Iranian revolution. The thought of Iran, a major source of oil to the U.S. and with 11.4% of the proven oil reserves, at the time, being controlled by a hostile government shot the crude prices to $65.14 per barrel in 1980 ($90.46 in 2006 dollars).

The price of crude oil collapsed in 1986 when the Saudi government introduced the "Netback price" as a way to stop other OPEC members from selling their crude below officially posted price. (The netback pricing effectively is where the seller charge the market rate for crude oil instead at the officially posted price.) This drove the price of crude down to a low of $14.43 in 1986 ($26.45 in 2006 dollars).

The price of crude went up in 1990 to $23.73 per barrel ($36.76 in 2006 dollars) when Iraq invaded Kuwait, which holds 8.5% of proven oil reserve. However, this changed with the U.S. invasion of Iraq in 2003. Since then the price of a barrel of crude steadily climbed to our record levels.

Chart Source: BP Global - Reports and Publications - Oil Prices; Chart URL

Recent Price Drivers (Factors)

1. Cost of the Iraq War: According to the National Priority Project’s calculations, the monetary cost of the Iraq war is approximately $245 million per day with over $500.2 billion spent so far. This cost has strained the U.S. national budget, leading to other domino effect.

2. Increased National Debt: From the combination of funding the war in Iraq, additional spending in military build-up, and pumping the economy through tax cuts and rebates, the national debt went up from $5.67 trillion in 2000 to $9 trillion as of 2007.

3. Diminishing Value of the Dollar: As a consequence of the War in Iraq, increasing national debt, and lowering of U.S. interest rates, the overall sentiment in the international community toward the U.S. has increasingly grown negative. Since the dollar, like other currencies, is fiat money, the value of the U.S. dollar has been dropping against other major currencies such as the British pound and the Euro as foreign investors seek to diversify out of the dollar in search of better returns. Since OPEC pegs the price of crude in dollars, this has a direct effect on price.

4. Increased Demand for Oil worldwide: As countries around the globe, particularly China and India, continue their economic growth, their appetite for commodities, including oil, have increased, driving up the price. The import of oil by countries outside of the U.S, Europe, and Japan, has grown from 28% of the world’s total import in 1990 to 38.6% in 2006, a 37.7% overall increase in oil imported by the rest of the world since 1990. (Source: BP Global - Reports and Publications - Oil Prices)

5. Speculation by Traders: Traders seeking a source of positive return in a sea of red numbers have latched on to commodities as a way to profit from the slowing U.S. economy and uncertainty in the Middle East. It is Economic 101: simple demand and supply of oil. Supply of oil is relatively inelastic and finite (the caveat: new reserves of oil may be identified in the future, increasing the supply.). Moreover, its price is highly volatile, making it a great vehicle for traders to speculate in. Since OPEC produces more than 43% of the world’s crude oil, any bad news out of the Middle East will drive up the price of crude. This is now true for Venezuela, with its proven reserve of 6.6% of world’s total oil reserve and 3.5% of world’s total oil production threatening Columbia.

So, Where Does it Go From Here?

Price Floor: Saudi Oil Minister Ali al-Naimi stated that oil price will not fall below $60 to $70 range since the production cost of alternative fuels has a threshold of $60 to $70.

Assuming the price floor of $65, a midpoint of Minister Naimi’s range, then the difference of it and the current oil price of $104, or $39 per barrel, may be largely due to a combination of speculation and increased global demand.

If the current world geo-political situation does not change, then the price of crude oil will rise due to the increasing demand worldwide for oil. Traders are now betting that oil will reach $125 per barrel by the end of 2008.

If OPEC reverses itself and increases production, the current geo-political trend in the Middle East continue, the current tension in Latin America settles down, and/or U.S. begin larger pull-out of troops from Iraq, then the price of oil could come down to more realistic levels.

Disclosure: The author holds long positions in Oil Refining Companies at this time.

Comments

[Perspective]

I thought the major reason behind oil's run is the falling dollar. The countries that use the dollar or are pegged to it have seen it rise vs. countries that use Euros have pretty much seen oil at steady levels.

[jaimefpozo]

The extreme high price of oil in the USA is only due to the fall of the USA dollar in America. So, this article is misleading and most other articles everywhere else in the states seem to be avoiding the real true. I wonder why?
I believe that many people should know that oil is a global commodity and what happen In America is not the same world wide.
Take a plurality of ten or more currencies and find the real increase for the price of oil.

[iThinkBig]

To the comment made above, I agree. The price of oil is pegged to a diminished dollar and I don't see a fix until housing resets peak by the end of this year. And therefore, I am in the camp of the price of oil going up over the next year. Perhaps not to $125 as free market economics of sky high oil begin (or should I say begun?) to trickle on to other countries that buy our food and pay big increased costs of food and shipping it to them for example.

The other factor is investment and what money is available to build alternatives. Right now investor sentiment is bad and money availability low. This will delay the process of true supply and demand economics, although right now the speculators more or less control the cost of oil at this point.

[Zeb]

I think that the price of oil will rise relentlessly due to supply constraints. Most of the giant oil fields are in depletion worldwide. To maintain production at the present level of approximately 85 million barrels per day, 5 million barrels per day of new oil has to come on line every year. This is with CERA's optimistic depletion rates. Investing in oil is as close to a sure thing as exists. I don't expect that the game will ever change, because modern affluent people love to use this form of energy. Demand destruction will start with the poor and relentlessly work up the food chain to the rich (or the newly poor). In the end, only the politicians and military will be able to afford to drive and jet around....

[jjason]

Dear Ed, Thanks for the article. All your points are correct. I would like to add that there is a world wide monopoly that sets prices. It is OPEC. They set the price and others follow and we cannot do anything about it because the oil producers (governments and oil conglomerates) are very wealthy.

Other commodities where prices are set (monopolies)are gold and diamonds. However, there are large swings, sometimes, in all commodities. And the supply/demand relationship and speculation certainly plays a part in it.

I have no ideas, other than conservation, that will help reduce oil consumption in the US. It seems that solar is still not cost effective, environmentalists do not want to see more coal fired utilities, our President has his head in the sand, Congress is incompetent, and the public does not understand that your article is correct on the facts.

Thanks again for taking the time to explain it.