Monday, March 23, 2009

Oil Prices : Part 8 - here we go again.

As you can see on the graph, oil prices are climbing again. In the big picture a price of $50.00/ barrel doesn’t look bad, especially in comparison to the peak of $147.00/bbl that we saw last year. However when you look at the past month, where prices have steadily climbed from the mid-thirties to $50/bbl, or an increase of almost 40%, it looks like we are headed for trouble again.

In my opinion, this climb in prices is a signal that the stock market has hit bottom and the economy is beginning to recover. This is probably an effect of the major stimulus package that has been passed by the Obama administration. Increasing the money supply has been effective in slowing job losses and segments of the economy are beginning a slow and cautious recovery. In turn, this increase in the US economic activity is associated with an increase in oil consumption. Unfortunately, while the government can arbitrarily increase the money supply, it cannot increase the oil supply in the same way.

If we look at the past few months, the US GDP has fallen about 8%. Not coincidentally, US oil consumption has also fallen by the same amount - from nearly 21 million bbl/day to around 19 million bbl/day. This drop in demand is the result of lay-offs (fewer commuter trips and disposable income for shopping/travel), less transport runs (due to less purchases and retail orders), and reductions in manufacturing, air transportation and construction.

While we might welcome signs of economic recovery, in reality it could be the signal of much larger problems. While US oil consumption has dropped by almost 2 M. bbls/day, world-wide demand has only decreased by about 1 M/bbls. This is because China has been taking advantage of low oil prices and have actually increased their consumption by something close to 1 M bbl/day. This could signify the start of a significant shift in the power balance between the US and China. It also means that if the US economy recovered to it’s previous level, worldwide consumption would be considerably higher than mid-2008 levels.

There is a small surplus supply of oil that is sitting offshore while traders are waiting for prices to recover. This may delay an inevitable spike in oil prices for a few months. However, in the longer term, we are facing major problems. Oil companies have delayed development on a wide range of production projects in response to low price levels. This means that actual oil production in the coming 2 to 5 years will be significantly lower than earlier forecasts.

In light of this, I would like to make a few predictions:

1) Significant inflationary pressure caused by increased money supply and limited oil supply.
2) Oil prices will exceed $200 /bbl before the end of 2010.
3) This price spike will be followed by another economic crash.

I sincerely hope I am wrong - but if it happens - you read it here first.

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