As the price of crude oil flirts again with its $100/bbl threshold, the question naturally arises: How high can the price go? But brush away the superficialities, and market changes give reason to wonder how low the price might sink.
Demand for oil can’t rise as fast as it did during 2004-07 indefinitely. Yes, populous countries like China and India are industrializing, craving oil and other energy. Yes, the global population is growing. Yes, these changes expand the energy market structurally.
But supply struggles to keep up. Part of the reason is geologic: The global petroleum resource, however defined, whatever its size, has reached a stage of development at which new supply tends to be difficult to find and expensive to produce. Much oil remains—more than anyone at any given time can attest. But it isn’t cheap. And the world continues to need growing amounts of it.
Main constraints
Geology, however, is far from the main constraint of the moment. Limits on capital, labor, materials, and availability of exploration and development opportunities curb supply growth even more. Since 2003, the world has needed 1-1.5 million b/d of new oil supply each year—more than that in 2004. Production capacity, despite strong natural declines in mature areas like the US and UK North Sea, has grown. But it hasn’t grown fast enough to prevent a strong increase in prices.
The trend can’t last. As demand pressure builds against limits on supply growth, and as prices therefore rise, the market inevitably responds by shedding demand and, to the extent it can, boosting supply. It’s doing so now.
In their monthly market reports for February, two important reporting agencies note an important turn in the oil market. Citing the global economic chill, the International Energy Agency trimmed by 200,000 b/d its forecast for average 2008 oil demand from the projection it made in January. “Just as the demand shock of 2004 shaped the oil market for the next 3 years,” IEA says, “so too could the pending [economic] slowdown.” And capacity additions this year and next will lift spare capacity, a vital source of surge supply that for several years has been perilously low.
The US Energy Information Administration, while lower in its 2008 demand forecast than IEA, sees a similar change. “Higher production outside the Organization of Petroleum Exporting Countries and planned additions to OPEC capacity should more than offset expected moderate world oil demand and relieve some of the tightness in the market,” it says. EIA projects a doubling of global spare production capacity to 4 million b/d by the end of 2009.
Rising supply and moderating demand growth mean lower prices, of course. No one should be stunned by this news. Nor should anyone think that last week’s price spurt, the result more of news events than of market fundamentals, changes the outlook. The ingredients for an inevitable softening of the market are in place.
So how far might the price of crude oil—absent a supply cataclysm—fall? The answer depends partly on how far the global economy falls, if that’s what it’s destined to do. Pointing to tight oil supplies in the developing world and rising service costs, IEA says corporate analysts are “suggesting companies are preparing for a sustained $60-80/bbl world.”
The floor
The practical floor price of crude oil may lie near the low end of that range. It’s the level at which Saudi Arabia feels enough financial pressure to lower oil production in support of the crude price. In its Global Oil Report, the Centre for Global Energy Studies analyzes the published Saudi budget for 2008 and concludes that the kingdom, to meet spending plans and retire debt at the 2007 rate, needs an OPEC basket price of $62/bbl. CGES calls that “the oil price floor for 2008, below which it is unlikely the oil price will stay for long.”
As always, the oil price can fall as well as rise—but perhaps not as far as it has in the past.
