Where next for oil?

The question everyone has been asking lately is: has the oil price peaked? Brian Durrant looks at the key trends on both the supply and demand side to find out where the oil price will head next.

The question everyone is asking in the markets is has the oil price peaked? The best way to answer this question is to get a sense of perspective by looking at the cyclical nature of the oil market.

From interest rates to embargoes: what affects the oil price?

During the Yom Kippur war in October 1973, the Arab oil producers discovered that it had another weapon, an oil embargo. Arab oil ministers agreed to cut production by 5% from the September 1973 level, and to keep cutting by 5% in each succeeding month and also applied a total ban on oil exports to the US and the Netherlands, countries friendly to Israel. The oil price quadrupled.

This was the beginning of a new era and oil prices ended up peaking at around $40 a barrel in 1980 in the aftermath of the Iranian revolution. The upheavals in Iran coincided with a drop in Iranian crude oil production from over 5m barrels per day (b/d) to nearly 1m b/d.

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But there was a reaction from both producers and consumers. The high price of oil encouraged oil exploration outside OPEC's sphere of influence like the North Sea.

Meanwhile, in 1980 US interest rates were jacked up dramatically to quell inflation that high oil prices had helped provoke. This caused the world's largest economy to tilt into recession and demand for oil declined.

Saudi Arabia, in its role as swing producer, varied its output to support the price and ended up by cutting production itself from nearly 10m b/d in 1980 to 2.2m b/d by June 1985. A level below UK output from the North Sea! At this point the Saudis abandoned the policy, moving from defence of the price to rebuilding market share. The price of a barrel of West Texas Intermediate crude oil fell by nearly 70% from close to $32 a barrel in November 1985 down to $10 in early 1986.

This climate of low oil prices from the mid-1980s led to a serious under investment in the long-term infrastructure for oil exploration. Oil tanker capacity peaked in the late 1970s, while refining capacity and oil rig numbers reached maximum levels in 1981. In the 15 years from 1985 there was little incentive to maintain spare oil production capacity.

Then in the present decade demand for oil went through the roof, principally by means of an injection of demand from China and to a lesser extent India. At the same time the era of low oil prices encouraged the US motorist to switch to the craze of gas-guzzling SUVs. Global oil consumption in the last six years has risen by 10m b/d to 85m b/d, a rise of over 13%.

Oil producers could not keep pace with this boom in demand. The supply response was inadequate with North Sea and US production past its peak. And if supply cannot come on-stream to meet demand, prices have to go up and they have.

Have oil prices peaked?

Now back to the original question: have oil prices peaked? It is worth pointing out that a 20% fall in the stock market or a 20% decline in house prices would be described as a 'crash' or a 'meltdown'. But for the oil market such moves are more commonplace and are viewed as corrections.

In the context of the current bull market in oil, there have been two other noticeable corrections. In the spring of 2003, the oil price fell by 37%, as the initial stages of the invasion of Iraq went smoothly with little damage to Iraq's oil producing capacity. There had been a fear that Saddam would disrupt Iraq's oil producing infrastructure as he retreated. Then in the period of September 2005 to December 2005 oil prices came off 22%, as the squeeze in energy prices, following the refining capacity disruption caused by Hurricane Katrina was unwound.

In both instances the prospect or reality of major supply disruptions caused feverish speculation in the oil markets resulting in an oil price spike, the corrections occur when these fears of supply disruption abate.

How have recent conflicts affected the price of oil?

A similar state of affairs occurred last month. The markets were extremely nervous about prospective supply disruptions from a number of sources. Relations between Iran and the West were extremely rocky. Israel was retaliating against Iranian backed Hezbollah militia in the Lebanon.

At the same time there was a fear that Iran's firebrand president would cut off oil production and block the straits of Hormuz if the West interfered with Iran's uranium enrichment programme. Moreover, August is the start of the hurricane season and the markets were nervous of the prospect of disruption in the Gulf of Mexico. To cap it all, BP's Alaskan oilfield at Prudhoe Bay was closed.

One month on we have a ceasefire in Lebanon, Iran has hinted that it will suspend its nuclear enrichment programme for two months, the Gulf of Mexico has so far been spared the ravages of destructive hurricanes and there is also news that Prudhoe Bay may be reopened earlier than previously envisaged. These factors, together with news of a major oil discovery in the Gulf of Mexico by Chevron, conspired to push oil down by 20%.

But what has really changed? On the political front Mr Ahmadinejad is still president of Iran. The stand-off in Lebanon is still uneasy, the hurricane season is not over and even if the Chevron discovery is an elephant field, production will not come on line for five years at the earliest.

True there has been some wilting of gasoline demand as the driving season comes to an end. Indeed the US consumer is showing signs of retrenchment following the weakening of the housing market. There is some anecdotal evidence of thousands of unsold 4X4s and pick-up trucks clogging up dealerships. But this is to be expected.

Why you should keep an eye on the supply side

But it is on the supply side that there is an interesting twist. The laws of supply and demand dictate that as a price of a commodity rises there is a greater incentive to supply it. Hence it was the background of oil at $60-$70 a barrel that has encouraged Chevron to dig deep into the Gulf of Mexico. However high oil prices also make opportunist governments more hostile to the oil industry, which will ultimately discourage oil companies from investing in countries where property rights are arbitrary to say the least.

In Venezuela, for example, production is continuing to decline as Hugo Chavez's political appointees prove unable to operate the nation's oilfields as efficiently as the technicians they replaced.

Meanwhile, the Russian authorities are muscling in on Shell-led oil and gas production in the Sakhalin region. They have cancelled a key environmental permit which could halt work on one of the world's biggest oil and gas ventures. In response Claude Mandil, executive director of the International Energy Agency, said: 'We have been very cautious with our supply projections for Russia. We see this kind of policy is not conducive for foreign investment.'

Back in April last year when the oil price was $50 a barrel, I regarded a return to oil prices below $30 a barrel as out of the question. I still hold to this view and am still entrenched in an era of expensive oil.

Indeed OPEC has explicitly recognised this fact. Not so long ago it had a pledge to keep oil prices below $30 a barrel. That is now forgotten. Last week members of OPEC signalled they might reduce output later this year to limit any further falls in oil prices. This was when the oil price was $65 a barrel.

In conclusion, we regard the recent slide in oil prices as a correction and supply difficulties will continue to help keep oil prices firm.

By Brian Durrant for The Daily Reckoning. You can read more from Brian and many others at www.dailyreckoning.co.uk

Editor's Note: A Cambridge economics graduate with nearly 25 years experience in the City, Brian Durrant is investment director of The Fleet Street Letter.

Brian has contributed to MoneyWeek with his expertise in investment strategy, for example how to quadruple your dividend income and how to navigate through the stock market in the 2008 financial crisis. He’s also touched on personal finance such as the housing market and the UK economy.