That Falling Feeling

Understanding the oil market is difficult. making reasonable forecasts is almost impossible. That's why most analysts were surprised by the dip in prices from the Aug. 8 historic high of $79 per barrel to below $60 in recent days. Suddenly the alarmists who foresaw an imminent era of oil scarcity are silent, OPEC is again discussing supply cuts, oil share prices are down. And new conspiracy theories are flowing, like the one about the Republicans' pushing down gas prices before the U.S. midterm elections.

What's going on? Over the last few years the public has been bombarded by pessimistic warnings about a world inexorably running out of oil, in the midst of growing instability in oil states from Iran to Nigeria, and rising demand--particularly from China, India and other emerging economies. As this bleak scenario gained acceptance, it became easy to assume that the price of oil would defy the laws of gravity and break the barrier of $100 per barrel.

In fact, the current oil crisis has nothing to do with a catastrophic shrinking of global oil resources, while the specter of rising Asian demand is largely a myth--China has huge potential to reduce its oil consumption. Supply is tight because two decades of low prices discouraged the exploration and development of new fields in the world's most oil-rich areas. That has cut spare production capacity--the critical cushion needed to cope with crises--to just 2 to 3 percent of global consumption. This makes the price of oil a hostage to political and climatic events. There has been no objective rise in oil-state instability, only in the market's vulnerability to speculation--gloomy or not.

What has happened recently is a global-market mood swing, in the face of evidence that consumption growth is slowing while production is still rising. U.S. oil inventories--and even reserves--have turned out to be higher than had been previously thought. Forecasts for the hurricane season in the Gulf of Mexico switched from severe to mild. Temporary shocks, particularly the BP spill and shutdown in Prudhoe Bay, Alaska, proved less disruptive than expected. And geopolitical risks seemed to recede, as confrontations involving Iran and Lebanon eased, at least for now.

In a situation where fleeting news can move markets, almost anything can happen next, from a new spike to a further drop in the oil price. Right now, the spike is the most likely scenario in the medium term--say, one year or two. But a bit farther out, between roughly 2010 and 2012, there is a good chance that supply trends will overtake demand, raising spare production capacity to a range between 7 to 10 percent of demand. That large a cushion would drive down both the price of oil and the market's major vulnerability to minor rumors. Let's try to understand why.

Essentially, the underlying causes of the new century's first oil crisis are in the process of being solved. Since 2002, the major producing countries and oil companies have gained the confidence to invest in exploration, development and refining. We are in the midst of a real investment boom, although it needs time to bear fruit. Oilfield development takes several years, and there is now a serious shortage of equipment and qualified personnel.

If investment continues at current rates, however, the global production capacity of crude could increase by 12 million to 15 million barrels per day between 2010 and 2012, outstripping expected demand growth of about 7 million to 9 million barrels per day. This would boost spare capacity and drive prices down. Of course, the spending boom depends on high prices, which depend in turn on demand. And while much of the industrial world seems to assume that global demand will continue to rise sharply, oil producers most assuredly do not (following story). They worry demand may pop like a bubble, as has often happened in the past.

In recent years, the belief has grown that the world economy has become almost indifferent to the price of oil, ignoring the simple truth that any economic system will react to big price changes for any vital good. Even after the oil shock of 1973--much more intense than the current crisis--oil consumption continued to grow for six years before a backlash set in. This time, however, the data suggest that high prices are already affecting consumption. While oil-demand growth began to recover from the 2002 recession by 2003 and then jumped by a startling 4 percent (3.2 million barrels per day) in 2004, it slowed again in 2005 to 1.3 percent. What's more, the International Energy Agency (IEA) has steadily lowered its forecast for 2006, which now stands at a modest 1.3 percent.

There is also the China myth, which holds that the growing Chinese economy will absorb ever-more oil. This ignores several important factors. First, China's oil consumption is growing fast, but it amounts to only about 8 percent of global demand, and need not be a source of concern in a normal market. Second, China's booming demand in the last two years largely represents a rebound from the stagnation of previous years. It's been driven partly by the rapid buildup of inventory, as well as by delays in the building of coal-fired and water-powered electricity-generating plants. Indeed, alarmists began screaming $100 oil when Chinese demand registered astonishing increases of 12 percent in 2003 and 16 percent in 2004, only to slide back to 1.5 percent in 2005. It is now on pace to reach 6.1 percent in 2006, according to the IEA.

Third, China and Asia's thirst for oil has been heavily subsidized by local governments and price controls, making oil products much cheaper than on the international market. In China, the price of gasoline and diesel in April 2005 was 44 percent lower than on the open Asian market. As a result, China consumed three times as much oil per unit of output as Europe. Starting in mid-2005, however, the Chinese and most Asian governments announced plans to end or reduce subsidies.

Fourth, China continues to use oil where it can be replaced by other sources of energy. The transportation sector (in which oil remains largely irreplaceable) absorbs less than 40 percent of China's consumption, as against more than 75 percent in the United States. This means, contrary to all the scare scenarios, that China's oil-consumption growth has the potential to ease substantially, while in most industrial countries consumption growth is approaching zero and may start to drop.

It is too soon to say whether all these elements are already reducing consumption growth below current trends. In the oil sector, short-term data remain poor, due to the lack of reliable statistical systems in most developing countries and imprecise information on oil inventories. One thing is certain: if prices should drop significantly before the investments now underway reach the point of no return, they could come to a screeching halt, precipitating another price spike. Only a major recession could prevent this, by killing demand. Hardly comforting. But remember the main point: it's not possible to forecast oil prices with real accuracy--so it's not wise to place great stock in any one forecast.