Where next for the crude oil price?

published 25 January 2007

After holding in the $60s for many months, crude has dropped precipitously in the past few weeks, and is now in the vicinity of $50 a barrel. A number of reasons have been given for the sharp fall in price, all of them more or less linked.

Why has the crude oil price fallen?

To begin with, warm winter weather has resulted in lower seasonal energy use than anticipated. (Global heating oil demand, for example, is estimated to be off by 20-30%.) At the same time, OPEC's production cuts are seen as ineffectual in the face of cheating, and Russia has been hesitant to slash its record output.

On top of this, commodity speculators have become bearish and institutional investors are getting cold feet. When spot crude fetches a higher price than the further-out futures contracts - a situation known as 'backwardation' - it becomes profitable to buy the back months and wait for prices to rise as the spot draws closer. The persistence of backwardation in 2006 led institutional investors and commodity index trackers to load up on long-dated crude oil contracts; now that the market is no longer in backwardation, those same players find themselves losing money.

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As icing on the cake, the crude oil market is suffering from intrigue fatigue. Like a jaded child desensitized to violence on television, the market has grown bored with overly familiar catastrophe scenarios. (Yet if anything, the geopolitical situation is more precarious today than a year ago: Israel leaking plans for a tactical strike on Iran; Saudi Arabia threatening to aid Iraq's Sunnis if the Shia majority pushes too far; US military morale at low ebb; escalating tensions between Russia and Europe; nationalization on the rise; Iran accelerating its nuclear program; and so on.)

The long-term outlook for crude oil

In light of all the recent bearishness, it is worthwhile to ponder the Energy Information Administration's recently released 'Annual Energy Outlook 2007 (Early Release version).' Here are the two most interesting sentences out of the whole thing (in your humble editor's opinion):

'Oil, coal and natural gas...are projected to provide roughly the same 86% share of the total US primary energy supply in 2030 that they did in 2005 (assuming no changes in existing laws and regulations...

'In 2030, the average real price of crude oil is projected to be above $59 per barrel in 2005 dollars, or about $95 per barrel in nominal dollars.'

Trying to predict anything 23 years out is a foolhardy exercise...but the EIA projections are nonetheless instructive.

For one thing, the projections show just how small the alternative energy base still is in comparison with fossil fuels. It is not that the EIA expects zero growth in alternative energy's slice of the pie over the next few decades; rather, the EIA expects total energy demand to overwhelm all else, with fossil fuels filling the breach. (For this same reason, the EIA expects nuclear power's share of the pie to actually fall in percentage terms, even as more nuclear power plants go online.)

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The EIA's second prediction is chuckle inducing. For crude to be just above $59 in 2030 - not far from where it is now - means little will have changed on the whole. And how helpful of the EIA to let us know that $59 in

2005 will translate to $95 in 2030. That's a wonderfully benign inflation rate...just over 2% per annum between here and there.

As you might have guessed, the point here is not to put faith in government agency predictions. Instead, it's to get some perspective on where we stand for the long term.

As a government agency and an offspring of the Department of Energy, the EIA is congenitally optimistic in its conclusions - much as the Bureau of Labour Statistics is congenitally blind to inflation. And with all the data at hand, the EIA's projected long-term price band of $50-60 crude (more or less) is truly the optimistic case.

Such a prediction almost completely writes off the ramifications of Peak Oil, and relies on heavily aggressive assumptions in regard to deep-water drilling and Canada's oil sands. Such a prediction also requires an almost touching naivet in terms of US monetary policy; can we really expect inflation to run just 2.1% per year for the next 23 years? (What happens when the dollar goes down in flames?)

Why the long-term energy outlook is unchanged

There are far too many variables to make an informed guess at crude oil's 2030 price. But we do have enough information to note that, given the piles of data presently available, the optimistic number crunchers at the EIA see crude trading solidly for the duration. In fact, their $50-60 price range represents the shiny happy scenario, leaving out the ugly but all-too-real possibilities looming before us.

The other thing we can gather from the EIA prediction is this: Nobody knows nothin'. Meaning, all the data points in the world can't predict the distant future. To grasp how ludicrous these types of specific predictions are, just observe the fate of those who make them. In the real world, the best you can do is marshal the facts to get a sense of what's possible and what isn't...what makes sense and what doesn't. In this sense, broad observations regarding the possible course of future events should be rooted in the laws of physics. What goes up must come down...that which cannot persist must eventually cease...and so on

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In the short run, a market can do most anything - especially one dominated by speculators with a quarterly, or even monthly, time horizon. But in the long run, as Jesse Livermore noted, the best and truest allies will always be underlying conditions. You'll see all kinds of numbers fly around in the coming weeks and months, feet stampeding this way and that...but through it all, the long-term energy picture won't shift much.

We're dealing with sweeping sea change here, not ephemeral seasonal stuff.

That's why I'm not inclined to worry too much about this recent crude oil slide. There's never any money in running around like a chicken with your head cut off.

Traders rely on speed and reflex, investors on patience and fortitude; to the best of my knowledge, nervous panic is no help to either discipline. If anything, the short-term roller coaster gives an edge to those with a taste for the long-term view.

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

Editor's Note: Justice Litle is an editor of Outstanding Investments, ranked number one by Hulbert's Financial Digest for total return performance over the past five years. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds.

Mr Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall).