100 Oil: Moving Deeper Into Uncharted Territory

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Crude oil prices have risen to a historic $100 per barrel (West Texas Intermediate [WTI]), the culmination of a $25 price increase over several months, to reach a record that once seemed untouchable. Until now, the world has never experienced a triple-digit oil price. The all-time inflation-adjusted high was in April 1980, when, CERA calculates, crude oil hit $99.04 per barrel in terms of 2007 US dollars. The broader significance of a $90-$100 price range is that it highlights in dramatic fashion how different the oil market environment-and indeed the world economy-is today compared to the past two decades.

The jump in price from $75 at the beginning of September to $100 in early January 2008 highlights the dominant sentiment driving the oil market-that oil supply will be unable to keep pace with rising demand. However, if oil demand growth hits the brakes because of an economic slowdown or an easing of supply anxiety, we could see a steep fall in price.

Hundred dollar oil, give or take, is an exclamation point for two major trends: the rapid rise of Asia and the shift in economic power to exporting countries.

Today's price levels bring us further into the range where the oil price can contribute to an economic slowdown. The effect on economic and oil demand growth depends on the duration of $90-$100 oil. Although this is overshadowed by news of the current record price, for 2007 the annual average for WTI was $72-not $100.

Historical assumptions about the dynamics of oil prices, demand, supply, and the global economy have given way to a new, but still unfolding, paradigm. This new paradigm is not without risks and dangers. The world economy can withstand the headwinds of very high oil prices much better than in the past, but prices of $90 to $100-plus push geopolitics and the economy deeper into uncharted territory.

The high prices of 1980 were at the beginning of the worst three-year period of economic growth of the past four decades. For the oil price to potentially play a similar role in a significant economic slowdown, prices would have to average from $100 to $120 per barrel for six months to a year.

The relentless march to the $90-$100 price range began in response to the growing market sentiment that supply will not be able to keep up with rising demand. Several factors have fostered this sentiment:

Growing shadow of fear over oil supply reliability. Rising heat in the cauldron of geopolitics is fueling anxiety about the future adequacy of oil supplies. For example, crude oil prices rose because of concern that violence in Nigeria, Africa's largest oil producer, might cause additional output cuts. The oil markets have been closely following the potential for escalation in the Iranian nuclear issue. Some events with no direct effect on physical oil supplies have also contributed to the anxiety, resulting mainly in price spikes. The recent terrorist attacks in Algeria, the rise in tensions between the Turkish army and Kurdish movements in northern Iraq, and the current crisis in Pakistan, particularly following the assassination of former Prime Minister Benazir Bhutto, are all elements of the mix.

In each case, there are concerns that the situation may have spillover effects that could potentially threaten regional oil output. In reality, preliminary estimates indicate that for 2007 the annual average production of Iraq, one of the main contributors to the anxiety in oil markets in recent years, will be the highest since the start of the war in 2003.

Despite high oil prices, demand continues to rise. Global economic expansion and oil demand growth have, so far, proven remarkably resilient in the face of high prices, although there are now signs of some slowing. CERA projects world oil demand to increase 1.3 million barrels per day in 2008, with Asia and the Middle East accounting for 800,000 barrels per day (bd) of this growth.

In addition, CERA expects that constraints in the oil refining sector will underpin the transportation fuel markets for at least the next several years.

Oil inventory levels have steadily fallen for the seventh consecutive week. The latest data show that US crude oil inventories have fallen 18 percent from the peak of 354 million barrels in July to 290 million barrels in late December.

This also represents a decline of about 12 percent year on year for 2007. US distillate inventories (including highway diesel fuel and high-sulfur home heating oil) stand at 127 million barrels. This is 6 percent less than this time last year, but 5 percent higher than the recent five-year average.

Crude oil inventories held by industry in the countries of the Organization for Economic Cooperation and Development (OECD) were most recently assessed to be at the upper end of the normal range for this time of year, although they were below normal in Asia Pacific. OECD inventories including crude and products are in the middle of the normal range, supplying 54 days of forward demand cover.

Human resources and equipment constraints. Research for CERA's Capital Costs Analysis Forum indicates that the costs for new upstream production have nearly doubled since 2000 and increased a full 80% just during the past three years. New refining project costs have increased by about 50% during the past three years. Shortages of skilled labor, equipment, and services have limited capacity expansions and are resulting in delays.

Growth rates of oil reserves and oil production have generally fallen short of expectations. The continued rise in costs and the personnel shortages are adding to the sentiment that supply will not be able to keep pace sukanto tanoto with demand.

The financial market-specifically the market for oil derivatives such as crude oil futures-has intensified the run-up in crude oil prices. The financial world did not unilaterally create the momentum toward $100, but it did react to growing perceptions about potential supply inadequacy and exacerbate the underlying oil price trend.

The number of New York Mercantile Exchange crude oil futures trading positions (open interest) reached an all-time high of around 1.5 million contracts (1,000 barrels each) last July and today remains close to that level. Combined open interest in oil futures and options averaged about 2.4 million contracts in 2007.
This represents a 37% increase compared with last year and continues the uptrend that has been in place since 2003.

Oil and the US Dollar

Oil prices have trended higher in recent years as perceived risks to supply have increased amid steady growth in demand. At the same time, the value of the US dollar has deteriorated relative to other currencies on concerns over the future of the US economy and the long-term sustainability of US fiscal and trade deficits.

This deterioration continues as sovereign wealth funds consider shifting their reserves from the US dollar to other currencies. The sharp decline in US housing prices, the spread of the credit crisis in 2007, and US Federal Reserve rate cuts have exacerbated these concerns.

The downside risks for many dollar-denominated assets (housing, US mortgage securities, financial-sector stocks, etc.) have jumped in recent months. Some portfolio managers are likely reallocating investment capital away from these assets in favor of others that are expected to appreciate in value, including many commodities. The ultimate result is that during the past few months, both trends (oil strength and dollar weakness) have intensified.

Global Shift in Income

An outcome of the steep rise in oil prices is a major shift in income. OPEC's total revenues have risen from $199 billion in 2002 to almost $700 billion in 2007. As an oil and gas exporter, Russia has benefited enormously, too. Essentially bankrupt in 1998, it now holds $466 billion in reserves and approximately $180 billion in its stabilization fund.

With the shift in revenues around the world has come an evident shift in the international political balance and relative positions of nations. How these nations allocate their reserves and sovereign wealth funds will, in turn, be of central importance to the world economy, including the price of oil.

There is no single oil price that leads consumers and governments to alter behavior and policy. Differences in income levels, oil intensity of national economies, taxes, and subsidies mean that the reaction to a particular price is not uniform around the world.

Indeed, some economies of growing global significance are clear winners in a high oil price environment. The global economy is less oil intensive today than it was in the 1980s, and per capita income is higher relative to real gross domestic product (GDP). In 1980 the global economy consumed 0.89 barrels of crude oil, or spent nearly $68, to produce $1,000 of real GDP in 2007 US dollars.

Today the global economy needs about 0.63 barrels of crude oil to generate the same economic output. CERA estimates that the 2008 global average price of crude oil would need to be around $110 for the global economy to have similar exposure to the type of economic pain seen in 1980.

Although $100 crude oil rings the alarm bell of the global economy, prices on average have been much lower. The WTI average for 2007 was $72. The degree of economic effect from $100 depends on its duration.

A year of $100 or $110 oil would play a role in an economic slowdown, particularly in economies that depend on oil imports and that are relatively oil intensive. It would also be particularly problematic for developing countries that are not major beneficiaries of the global commodity boom.

A major difference between 2008 and 1980 is that today there are more growth engines for the global economy. A generation ago OECD countries were the key source of growth. Today, in addition to OECD economies, China, Russia, Middle Eastern countries, and other major oil exporters play a much bigger role in the global economy than in 1980.

A more diversified base of global economic growth provides more protection against a severe slowdown, but it does not inoculate the global economy. Particularly important will be how oil prices interact with other economic developments. Moreover, still to be tested is the degree to which Europe and the Asian economies are actually decoupled from the United States.

How Much Higher Could Prices Go?

With crude prices hitting $100, how much higher can they go? CERA's Break Point scenario-one of our three long-term global scenarios to 2030-explores the impact of prices rising to as high as $150. The conclusion is that such prices not only would have a major economic impact, but also would stimulate much stronger policies among consuming countries and quicken the pace of innovation and diversification in the energy sector.

Part of the break point would be oil's gradual loss-over many years-of its virtual monopoly in the transportation sector. Fuels other than conventional oil gain market share in the transportation market.

The other part of the break point is the way that high oil prices (and environmental worries) help bring economics, technology, and policy together to systematically reduce the "double intensity"-the carbon intensity of economic growth and the oil intensity of that growth. The combined effect of changes in consumer behavior, innovation, and government policy eventually leads to lower oil prices in this scenario.