How High Will Oil Prices Go?

Recent increases in oil prices do not reflect the fundamentals of market supply and demand. Demand remains depressed. The market is well supplied. However, a falling dollar, money flows into commodity markets, and indications of a nascent economic recovery have all conspired to drive the price higher. Market fundamentals would lead one to predict that we shouldn't see much more upside in the market. However, because oil is now tied to so many other factors, it is very difficult to say just how high it could go.

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$70 Oil Not All Bad

Oil prices have rebounded this summer much quicker than anyone predicted. Most of the rebound is due to the falling dollar, hopes of an economic recovery, and financial buyers reentering the market. We have seen little rebound in demand in the United States.

It's doubtful that the current U.S. or global economy could support sustained levels of $75 plus per barrel, which would translate into $3.00 per gallon gasoline in some areas of the country. Thus, absent a geopolitical factor or a major hurricane, oil prices are probably approaching their high point for the year. Traditionally, oil prices increase the first half of the year, peak in the summer and decline in the late summer and fall.

While consumers enjoyed gasoline under $2.00, we can be thankful for the rebound. When oil dipped below $50, numerous projects were cancelled and the rig count dropped in half. A prolonged period of time at that price level would have led to further cancellation or postponement of energy projects, increasing the likelihood of a repeat of last summer as the global economy rebounds.

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Oil Begins its Upward Creep

OPEC's cuts are taking hold, rig counts have fallen, the value of the dollar is dropping as the Fed pumps money into the economy, and summer driving season is approaching.  These factors all point to increasing crude oil prices and accompanying gasoline prices.  While we are not likely to see the levels reached last year, we can expect continued increases at least through the middle of 2009.  The factor with the greatest variability is probably the dollar.  For some time now, the dollar has been poised to fall given the Feds action and growing U.S. debt.  Over the past few days, we have significant declines.  If this is the correction we have been waiting for, we could see a quick run-up in crude prices.  If this is a blip, we will likely see a more incremental increase. Unless, we get further dismal economic news, gasoline under $2.00 per gallon will shortly be in the rearview mirror.

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Highlights

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What Happened to $150 Oil?

My forecast and others that oil prices would remain stubbornly high this year were clearly wrong. What happened? Is it that consumers stopped driving? Did speculators pull out of the market? Were our forecasting abilities just poor? Looking at it with the benefit of hindsight, it was a little of all of the above.

First, our ability to forecast a single market in a global economy is limited at best. Perhaps the best analysis of the history of economic forecasting in a global economic crisis was published by Harvard economist Greg Mankiw in today's New York Times. If you don't read another article on the credit crisis, read this one:

Greg Mankiw's article


Second, demand destruction occurred. Demand by U.S. drivers year over year is down. Global economic growth began to temper even prior to the credit crisis, reducing overall demand.

Third, the credit crisis and fears of a global recession drove equity prices down sharply. Financial buyers were forced to liquidate commodity positions to meet margin calls in equities. In recent days, the equity prices have had a far greater impact on oil prices than the fundamentals of supply and demand.

Finally, fear. Just as at $147 per barrel last summer, the price of oil reflects as much of what we think supply and demand will look like as what it is today. In the current crisis, the price reflects more what buyers and sellers fear it will look like.

Just as we overshot a market equilibrium price on the way up, we will likely overshoot it on the way down. Most estimates show that the marginal cost of producing a barrel of oil is in the $70 range. In a free, rational market, price will fall to marginal cost plus some normal profit. Historically, the oil market has not been a free market but rather influenced, though not necessarily controlled, by a cartel, leading to excess profits. And, the supply/demand balance is still precarious. IEA estimates that the world will consume 86.5 million barrels per day in 2009 and will produce 85 million barrels a day. In rational markets, that is a recipe for increasing prices. In today's market, who knows.

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Cash is King and Consolidation Coming

Anyone who has looked at their 401K statements recently is probably understandably concerned. A look at stocks in the energy industry and oilfield service industry reveals some incredible value plays. A general market plunge combined with falling commodity prices have pushed energy and oilfield service stocks significantly lower, despite $90 crude oil which is historically high. These firms are likely to continue to generate significant earnings and cash flow over the next few quarters. However, these low values also bring about the possibility of further consolidation in the industry.

Large energy companies and oilfield service firms with significant cash on their balance sheet have the opportunity to pick up reserves, competitors, and complimentary product lines at great values. Stock deals are not as likely -- the currency value of most companies' stock has dropped substantially. But for large companies with a lot of cash, now is the time for them to strike. Once the economy rebounds, values will swing up and likely very quickly given their projected earnings. The oilfield service sector is particularly attractive given their large backlogs.

If we do experience another round of consolidation, it will be interesting to see how the Department of Justice and other Federal officials react. We have an industry that is already stretched to it limits. E&P companies are not not increasing their production. Many oilfield service companies are at capacity. Depending on the results of the election, we may see potential mergers and acquisitions reviewed closely to insure that they are in the best interest of the energy consumer. Time will tell and it will be interesting to watch.

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Fast Track Offshore Drilling

I have received several media inquiries in the last couple of weeks regarding the future of offshore drilling with the lifting of the legislative ban. The articles I have seen have been by and large accurate in their descriptions of next steps in the process. Last night, I heard one commentator on major business network make a comment to the effect that we don't see the oil companies running right out and drilling in newly opened lands. While I am sure it was stated in a rather flippant way to make a point, it does point out the need for an explicit path forward that is communicated to the American people. At the very least, the McCain campaign needs to lay out a fast track process for getting drilling going and the Obama campaign needs to at least provide assurances that it won't reinstate the ban.

Currently the MMS has indicated that it will work the newly available areas into its upcoming five year leasing plan. This plan will require normal regulatory review and comment. Companies will have to wait for the plan to be finalized. Companies will then have to go through a lease sale process. Even without a change in administration, this process could take a year. During this period or time, capital will continue to be directed at other projects overseas. Some type of fast track process is needed.

A fast track process would lessen our dependence on foreign oil, and more importantly create jobs and economic activity at a time that we desperately need them. Even at current prices, the energy and oilfield service industries are running at capacity. Expanded drilling activity would require increased plant capacity, jobs, and investment. With bailouts and job losses growing, fast tracking new drilling would provide immediate economic relief. The Administration as well as the two candidates campaigns should lay out their plan now.

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