By Michael Lynch
BOSTON (MarketWatch) -- Although a number of books and many articles have been written describing how to profit from ever-higher oil prices, not much has been said about what will happen when prices come down, as they are all but certain to do.
With oil prices soaring in recent months, the primary focus in the investment community has been on the potential ceiling, which some have put at $150 or $200 per barrel, possibly attainable within a year or two.
Certainly, a political disruption of oil supplies -- civil war in Nigeria, major fighting in southern Iraq, attacks on Caspian pipelines -- could occur and would send prices sharply higher, but overall there is a greater likelihood that prices will drop in the next few years, and perhaps sharply.
Oil is a mean-reverting commodity. Since the industry's early days, price revolved around a mean of less than $25 a barrel for over a century, despite world wars, the market monopoly of Standard Oil, the cartelization by the Texas Railroad Commission and finally the U.S. import quotas in the 1950s and 1960s. Only OPEC was able to raise it above those levels.
Others have made the very pertinent point that oil production seems to be increasing only slowly of late, while demand continues to grow and the booming economies of Asia are creating new, wealthy consumers in large numbers, suggesting a 'new oil market paradigm' where prices will not retreat cyclically.
However, these arguments represent the typical characterization by analysts of a cycle (or a bubble) as a permanent change, not unlike what was heard in the late 1970s, when nearly everyone studying the oil industry -- except for a few contrarians -- predicted ever rising prices. Oil companies diversified away from their areas of expertise (Mobil bought Montgomery Ward, and Exxon (XOM:exxon mobil corp com
GM 17.10, -0.28, -1.6%) introduced the diesel Oldsmobile, while Chrysler briefly abandoned its large car lines), and investors searched for the silver bullet that would be the foundation of the next new energy industry.
The situation is roughly the same this time. Global demand growth has been slightly over 1% the past several years, even when the global economy was strong, down from the nearly 2% growth seen in the mid-1990s. Serious conservation has been slow to appear but all signs are that it is arriving and gathering strength, just as it did in the 1980s.
And while it is true that the supply side suffers from various problems, none of these are permanent. The loss in oil production from Hurricane Katrina alone would be enough to take OECD inventories to near-record levels, and supply losses from Iraq, Nigeria, and Venezuela have meant an ongoing loss of between 2 and 3 million barrels a day. Without these transient events, the market would be in glut.
Tipping point
What could cause oil prices to fall? A variety of short-term and longer-term factors can suggest an impending drop in prices, based on the recent explanations by traders for the perceived value of oil.
Given that the weak U.S. dollar has been cited as a major reason for the recent run-up in oil prices, signs that the U.S. economy is bottoming out, that the U.S. Fed is planning to cease cutting interest rates, that inflation in Europe is moderating and/or the European Central Bank is planning to cut interest rates, would tend to discourage oil price bulls and see some weakness.
More immediately perhaps, the likely rise in 2nd quarter OECD oil inventories -- which due to data lag won't be apparent until mid-summer -- should cause the market to move to contango, which eliminates profits from a rollover strategy. U.S. inventories have already begun to rise notably, reflecting a likely increase (globally) of about 1 million barrels a day.
Longer term, concerns about oil demand, particularly in China and India, would be assuaged by signs of weaker demand in response to higher prices; not shrinking demand, but slower growth which would suggest long-term trends would be below the bulls' expectations. And, of course, a recovery in supply would do much to deflate the bull market, whether from resumption of production in Nigeria (possible but unpredictable), strong increases from Iraq (likely in the next year or two), or improved performance from other non-OPEC sources (likely but of uncertain timing).
Macroeconomic benefits
Once prices do drop, there will be a variety of effects at all levels of the economy. In general, less money spent on petroleum products would provide a boost to many economies (not Russia or the Middle East), bumping up GNP while moderating inflation as costs decline across a wide variety of industries. This will reduce pressure on interest rates in places like Europe and Asia, and thus could lead to a stronger dollar. Consumer confidence will receive a boost from lower prices, and the retail sector will certainly benefit as consumers have more money in their pockets.
