It is hard to believe that back in January of 2004, crude oil cost $US 25 a barrel. Over the next four and a half years, it escalated to a high of $US 147 a barrel (in July of 2008) before dropping back to less than $US 50 a barrel in late November of 2008. It took 4.5 years for the price to increase by $125 a barrel and then in the space of a few months, it dropped by $100 a barrel. Welcome to the wacky world of crude oil pricing.
There is no doubt that there has been a major economic contraction over the last year. This would certainly explain part of the price erosion. However, to the best of my knowledge, there have been no significant discoveries or huge supplies of crude oil that have been brought to market during this time period nor has there been a drop in demand that directly correlates with the price decline.
So how do you account for this wild ride? Why are oil prices showing such volatility and where are we likely to go from here? Last week I had the pleasure of attending a presentation given by Bob Costello, the Chief Economist for the American Trucking Associations. Mr. Costello made as good a case as anyone I have heard in explaining what has been going on and where we are headed. This is what I gleaned from his very informative presentation.
Why did crude oil costs increase to $US 147 a barrel?
There are a number of reasons why crude oil has escalated over the past five years. First while demand for crude oil has increased by approximately 20% per annum in the U.S. and Canada between 1980 and 2007, the increase in demand in China during the same period has been 364% and in India 327%. Second, during this period, demand growth has been reducing spare capacity. Third, as the years go by, the percentage of the world’s oil resources is increasingly coming from what are perceived to be nations with a higher “risk premium” such as Saudi Arabia, Russia and Venezuela. While all of this has been taking place, a fourth variable is the value of the U.S. currency that has declined significantly against other key currencies, (e.g. the euro) further driving up the cost of crude oil.
He then went on to explain how rapidly speculation, variable 5, has pushed up the cost of oil. In one of his most interesting slides, he showed how much various commodities have increased or decreased in price over the period January 2008 to July 2008. While some commodities (e.g. gold, lumber, wheat) have gone one up by 12 percent or less or declined in value (e.g. lead, nickel, zinc), crude oil has increased in value by over 50%. Mr. Costello highlighted an article in the Wall Street Journal in June 2008 that showed how the percentage of crude oil holdings has shifted from 37% speculators/63% hedgers in 2000 to 71% speculators/29% hedgers in 2008.
Fear and Greed
Steve Maich, commenting in the Dec. 8 issue of MacLean’s magazine, made the following observations. “There is a fundamental misunderstanding about energy prices, which is exacerbated by analysts and executives who continually insist that prices are driven by supply and demand . . . These days, the price of oil is driven primarily by expectations of future supply and demand months and even years down the line. . . But trying to estimate the future is little more than educated guesswork, subject to the naturally distorting effects of human emotion. That guesswork is further complicated by the fact that global oil supply is routinely manipulated. . . OPEC . . . open and close the spigot arbitrarily, to maximize their own profit, often at the expense of market stability. . . It may be technically true that supply and demand drive the price - - except that demand is estimated, and supply is manipulated.”
Mr. Maich then went on to try to make some sense of the wide fluctuation in price over the past few months. “It’s often said that all markets are driven by the constant war between fear and greed, but the oil market is an exception. It is only driven by fear. Last summer, when oil hit US $150, the fear was of global shortages. . . Now, with oil at US $50, the overriding fear is of a sudden collapse in global trade. The question is no longer whether the world economy is growing too fast, but whether it will grow at all over the next couple of years. Pick your poison: the bulls are all about unstable supply; the bears are obsessed with anemic demand. Right now, the bears are on top, but that’ll change. It always does.”
Alternative Energy Sources and Conservation
This begs the question as to whether alternate fuels could help ease the demand for crude oil. Mr. Costello make the point that all of the vegetable oil in the United States would only satisfy 7% of the country’s trucking industry energy requirements. There is no alternative source of fuel waiting “in the wings” to meet the needs of the North American trucking industry. Hybrid vehicles are only of value in local city P & D operations but are of no use for long haul trucking. The multitude of energy conservation measures (e.g. speed governors, reduced idling time etc.) are all helpful but there is no substitute for diesel fuelled trucks.
Where do we go from here?
As the economy recovers from the current downturn, where are diesel fuel prices likely to go? Perhaps history can teach us a few lessons. Only five years ago, crude oil was $25 a barrel. The laws of (increasing) demand and (decreasing) supplies would suggest that crude oil prices should begin to move upwards in the months ahead. Mr. Costello expressed the view that we can expect to see diesel fuel prices return to $75 to $100 a barrel. Commenting in the November 24 issue of Business Week, Dave O’Reilly, the chairman and CEO of Chevron expressed the view that it was only in 2007 that crude oil exceeded $70 a barrel. In his view, current oil prices are surprisingly healthy.
Another variable is whether President Elect Obama will follow through on his commitment to find alternate sources of energy so as to reduce America’s dependence on foreign oil. It is unlikely that an alternative to diesel fuel will be found for the trucking, rail, marine and airline industries in the next 5 to 10 years. However, over time, there exists the possibility that alternative fuel sources - - solar, nuclear, wind, clean coal, bio fuels etc. - - may be used to power our homes and factories. This could offset the increasing use of diesel fuel in the transportation industry.
However, the world’s economies will be increasing their demands for crude oil. Emerging economies will also serve to increase demand. This would seem to suggest that finding alternate sources of energy may moderate the demand for crude oil but not offset it, certainly not in the short and medium term.
Then there is the issue of fear and speculation. The “wild card” now is how quickly the world economies will take to return to July 2008 levels. As demand begins to increase, will the speculators drive the price to $125 or $150 a barrel or beyond? The current housing crisis/credit crunch can be viewed as an anomaly. But a look back at history would suggest that “irrational exuberance” rears its ugly head every few years. It wasn’t that long ago when thousands of individuals were pouring money into technology stocks with no revenues and no profits. Will the next “gold rush” be the “energy rush” or “energy crusade?’ Will the desire to find alternate sources of energy lead us into a new world of speculation and “irrational exuberance?” Can we search for new energy sources in a pragmatic, rational, methodical way? What if Middle East becomes embroiled in a war and supplies are disrupted?
Nobody could have predicted the “roller coaster ride” that crude oil prices have taken over the past five years. It is impossible to forecast where they go from here and how far and fast they will move. Nevertheless, past history tells us that with supply decreasing and demand increasing, at some point over the next few months or years, crude oil prices are likely to begin their upward ascent again. “Irrational exuberance” about the future coupled with fear of adequate supplies of oil could return at any time, pushing prices back up to mid 2008 levels or beyond.