How Low Can Oil Go?

 |  Includes: DBO, OIL, USO
by: Investment U

A few weeks ago, I wrote a column commenting that the price of oil had outstripped fundamentals and was running on fumes. So count me unsurprised that oil has plunged $32 from its high of $147.27 on July 11.

A reader recently wrote to ask just how low will oil go? Unfortunately, my crystal ball is in the shop this week. (And next week isn't looking good either.)

But let's take a dispassionate look at what's happening with oil, beginning with the obvious: No one from Ben Bernanke to T. Boone Pickens can tell you how high or how low oil is headed with any certainty. If it were possible to forecast supply and demand this way, we'd all be trading oil futures from our beachside huts in Bora Bora.

However, there is always a sure sign that the price of anything has reached La-La Land: People start spouting nonsense. For example, a few weeks ago, The Washington Post, in an article explaining why oil had nowhere to go but up, quoted one consumer who said: "If you don't have gas, you can't get to work. And if you can't get to work, you don't get paid. And if you don't get paid, you can't buy food. We're at their mercy."

Is this what passes for economic analysis these days? Come on. We're all dependent on oil. That's a given… Yes, the world's major oil deposits have already been discovered. There will be no major supply increase anytime soon. Furthermore, the future trend in oil demand is higher, especially from major emerging markets like China, India and Brazil.

How Low Will Oil Go? Past to Present

But, as I pointed out before, this is just the back-story on the price of oil. It doesn't tell us where oil should be trading. Ultimately, that will be decided by supply and demand, not by this week's headlines. And while the price of oil is still roughly double what it was at the start of 2007, there are good reasons to believe it will keep coming down.

For starters:

  • The United States is the world's largest oil consumer.
  • Yet our economy is in the dumps.
  • Despite the sharp rise in the price of oil this year, U.S. oil demand is actually down.

The situation is similar in many other parts of the world. The International Energy Agency [IEA], the Paris-based energy watchdog of the world's richest nations, has lowered its forecast for world oil demand growth by 460,000 barrels a day.

The IEA also sees supply from outside OPEC growing by over a million barrels of crude oil a day, the strongest growth since 2004.

The price of oil always sows the seeds of its own collapse. People say consumers are trapped. But not entirely. We can drive less. We can use mass transit. We can buy more fuel-efficient cars.

Consumers will conserve. More money will be invested in alternative energy sources. Producers, too, will search for and bring to market oil that was once too costly to extract.

Eventually, supply and demand will come back into balance.

We'll Never See Oil As Low As $30 Again

Don't get me wrong. You won't see $30 oil or $1.50 gas again anytime soon. And probably never.

Two decades ago, the world could pump 15% more oil than it needed. Today that spare capacity has practically vanished. It's now about 2% beyond the world's total daily consumption of roughly 85.5 million barrels.

That makes the oil market exquisitely sensitive to rumors of anything that might endanger existing production. A terrorist group in Saudi Arabia or insurgents in remote parts of the Niger Delta could turn the world oil market upside down very quickly. (And send oil to new highs.)

But barring a major supply disruption, fundamentals suggest that oil is headed back under $100 a barrel.