Sunday, July 20, 2008

Drowning in a Sea of Oil?

Conventional wisdom tells us that the price of oil has rocketed skyward due to increasing demand from the emerging world, coupled with a slow decline of all the world's oil fields. This is peak oil pessimism, which adds the ominous warning that all the big oil fields have been discovered long ago.

But what if increasing demand has been exaggerated, and the decline in oil fields overstated? What if supplies are growing, demand is slowing, and there are sounds coming from the henhouse suggesting foxes are about? There is a lot more going on than demand from China and India.
Oil prices have increased by 1,400% in the last decade and have now reached a level that is threatening to drag global economy to a grinding halt....The US and other developed countries attributes this rise in oil prices to the fact that the global oil supply by producing nations has not been able to keep pace with ever increasing demand from consuming nations, more so the emerging countries like India and China.

The mainstream media continues to glorify the view that the world oil demand continues to be robust but in reality the world oil demand growth has been slowing over the last four years. The total consumption is expected to grow by only 0.3mbpd this year which will be easily absorbed by the new production coming into the system. Important to note is that the new supply is coming into the system at a time when the global economy is likely to slow down....At current prices the demand for oil, which we normally assumed to be inelastic, may well drop over the long run. Much of the inelasticity stems from the subsidies enjoyed by populations of many countries. However as governments starts aligning prices of oil to market levels, as recently being witnessed in Egypt, China, India, Indonesia, Malaysia, Taiwan and others, the demand will rationalize, consumption will fall and result in an increase of supplies as domestic oil companies capitalize on higher prices.

While the growth of emerging markets is cited as one of the key reason that oil prices will continue to rise in future, ignored is the fact that many countries are witnessing aging populations and many countries will see zero or negative population growth for many years to come. For instance, of the top 15 oil consuming nations, 10 of them will see negative or zero population growth for the next decade. This will severely restrict any significant increase in overall oil consumption...

...Most of the recent speculative activity in commodity prices in the US is being channelled through a relatively unregulated mechanism. Energy futures, which were earlier traded through exchanges such as New York Mercantile Exchange regulated by The Commodity Futures Trading Commission [CFTC] are now traded on the OTC electronic market. They were removed from jurisdiction of the CFTC in 2000. As of the end of last year, the total outstanding contract value on the OTC commodity exchange stood at $9 trillion, up by $1.9 trillion over the previous year. Assuming oil constitutes around 70% of the contracts, the new money being poured into oil contract would be $1.33 trillion. This amount is large enough to justify the theory that speculation could be behind up to 60% of the increase in oil prices in the last 12 months. _SeekingAlpha
How low could oil go, should there be a speculative bubble, which happens to burst? I doubt oil can drop a lot more than $20 from current levels, perhaps $30--to around $100 a barrel. At that level economies and industries that rely heavily on liquid fuel will be able to relax a bit. The inflationary pressure from high oil prices would continue, but at a level easier to absorb.



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