Oil prices likely near peak; Katrina delays decline

By James Haughey, Director of Economics, RBI -- Logistics Management, 9/1/2005

BOSTON—Until Hurricane Katrina there was nothing in the demand/supply balance in the oil market to push crude oil prices to $70/bbl., sustain that price, or threaten to push prices higher. Unfortunately, that was also true several months ago when oil sold for $45/bbl.

Pricing now depends on Murphy’s Law—anything that can go wrong will go wrong. The shutdown of the oil and gas fields, pipelines, and refineries in the Gulf of Mexico will most likely be painful. World oil demand is now so close to the current immediately available supply that the oil market no longer has the reserve capacity to absorb the inevitable small interruptions in supply—or brief spikes in demand. Each of these disruptions, minor and temporary, now causes a larger and more enduring increase in oil prices.

The list of recent supply disruptions includes oilfield strikes in Norway, Nigeria, and Ecuador; hurricane shutdowns of oil platforms and refineries in the Gulf of Mexico; and refinery breakdowns due to full capacity operation for a long period. Demand surges have come from a hot summer in the US, an overheated investment boom in China, and booming car sales in the developing world.

World oil demand jumped 3.2 percent last year in a booming world economy, especially in Asia. This was too fast for supply additions to keep up. Demand growth has now ebbed to about a 2 percent annual pace and supply growth has accelerated in response to higher prices. As a result, reserve supply capacity will be approximately stable through the winter and then begin to improve slowly.

Three conclusions flow from these facts:

First, tight supplies for the next two years will keep oil prices vulnerable to every minor supply interruption or demand spike

Second, the price trend, while erratic, should be slowly down from September prices. 

Third, the underlying market clearing prices for oil in a world economy growing at an average pace (for example 2003 and likely again in 2007) is probably in the $40’s. This is far below current prices but well above the equilibrium price, and OPEC’s target, in the high $20s—a price that prevailed for many years until recently. 

This abrupt change is because we now have to share the world’s oil with rapidly modernizing Asian countries that use oil much less efficiently than we do.