The Era of Cheap Crude Is Ending

 |  Includes: DBO, OIL, USO
by: Joseph Trevisani

Since the 1973 when the Organization of Petroleum Exporting Countries [OPEC] unleashed their oil embargo during the Yom Kippur War and engineered the first violent oil price rise, there have been three major oil price spikes. After the first two spikes prices eventually dropped to levels below where the rise began; after the third they fell seventy five percent.

The first spike began in 1979 with the Iranian revolution but prices did not return to pre-revolution levels until seven years later. The 1990 spike was prompted by the Iraq invasion of Kuwait. By early 1992 the price retreat was almost complete, though it did not drop below the pre-invasion price until mid-1993. The third spike, which began in early 1999, peaked in late 2000, and by late 2001 had given back 75% of its increase, but went no lower.

The 1979 and 1990 hikes, like the earlier embargo, were largely supply disruptions. In 1979 the return of the Ayatollah Khomeini, the founding of the Islamic Republic and the Iran Iraq war led to several years of uncertain supply and political and military risk in the Persian Gulf oil producing nations. The 1990-91 spike was closely tied to the Persian Gulf War and prices began a sharp downward run as Operation Desert Storm, the United States led re-conquest of Kuwait began. In both cases, as the supply normalized, prices resumed their pre-disruption levels.

The third spike which lasted from January 1999 until September 2000 was created by a combination of strong worldwide demand and OPEC production cuts. The 2001 recession in the United States and the terrorist attacks in September of that year which sparked fears of a worldwide economic downturn, brought prices to about $17/barrel by the beginning of 2002 from a high of $30/barrel a year and a half earlier.

The United States and global economic expansions which began later in 2002 still have not ceased and neither has the rise in oil prices. This current price increase, far more than the previous three, four if you count the original embargo, is demand driven. But demand is not the only factor driving the price of oil.

Oil is a limited resource. Limited in the sense of the amount that is available at any particular price at any particular time. The world is not running out of oil, but it is running out of immediately accessible inexpensive oil. It has become increasingly hard for oil producers to supplement supply by the 1.4 million barrels a day that is needed annually to keep up with demand. The time lag for bringing new production to the market is long, far too long for the discovery of new sources, as in the Brazilian continental shelf finds, to affect current prices.

The United States, the world's largest consumer of oil is also its third largest producer, behind Saudi Arabia and Russia. America has substantial untapped oil and energy resources, on the outer continental shelf, in natural gas, in nuclear energy and in coal. The United States also has the most technically advanced, environmentally regulated energy sector. By refusing to develop its own resources the US has permitted external producers to determine marginal production. The world's largest oil consumer is hostage to some of the world's smallest. Unwilling to increase its own production it should not surprise US consumers that others refuse to do so for their benefit.

Oil is the industrial world's chief raw material and the entire world's transport fuel. The world is rapidly industrializing, far faster than at any previous epoch, and the model is, whether environmentalists like it or not, the consumer societies of Western Europe and America. The United States today has 250 million vehicles and 307 million people. China has 37 million vehicles, over 1.3 billion citizens and an economy that has grown faster than any other in history. Little imagination is required to predict that these cars will not be powered by wind turbines, biofuels or hydrogen.

Even the currently available hybrid engines add a third to the price of an automobile. Tata Motors (NYSE:TTM) of India has introduced a basic car for $2,500, it is not dual drive. This is not to say that alternative energy sources will not play an increasing part in supplying the world's energy needs, even in its transport system. Sustained high prices will bring forth more efficient technologies and supply but development takes time and the oil price responds to a short term market.

The third factor in the oil price ascent has been the steady fall in the value of the dollar since 2002. Graphs of the price of oil this decade and the value of the euro in dollars have a striking resemblance. As the dollar has weakened, more greenbacks are needed to buy internationally traded commodities such as oil. But the scale of the decline in the dollar against the euro - approximately 50% since 2002 - and the rise in the dollar price of oil - 640% in the same period - are on entirely different scales.

The last factor is the speculative urge fueling trading profits in the oil and commodity markets. At almost any time in the past six years long crude oil futures was the preferred position. A trading market that has vaulted sharply higher in so short a time as has oil is ripe for profit taking. A ten or fifteen percent rise in the dollar against the euro could be the trigger for traders to reap some of those profits.

But in the long term oil prices are a classic supply and demand question. Demand for oil is rising, supply is not. And, perhaps more importantly for oil prices, the perception of future demand is even stronger. Indian and China are the current industrializers, but there are huge swaths of the world that are waiting their turn to join the consumer future. It is blindness not to see their desire for a better life, and blindness not to understand that the era of cheap natural resources is ending; even if it is a future that only oil traders seem to perceive.