Measuring 'extreme' oil prices

March 17, 2008
For seven sessions Mar. 5-13, the front-month crude contract consecutively set record high prices on the New York Mercantile Exchange as the US dollar fell.

Sam Fletcher
Senior Writer

For seven sessions Mar. 5-13, the front-month crude contract consecutively set record high prices on the New York Mercantile Exchange as the US dollar fell to record lows vs. the euro and a 12-year low against the Japanese yen.

Crude climbed to an intraday high of $111/bbl Mar. 13 prior to a record $110.33/bbl closing as the weak dollar prompted investors and speculators to put their money into commodities like oil and gold, which for the first time hit $1,000/oz.

Adam Sieminski, chief energy economist for Deutsche Bank in New York, and Michael Lewis, the bank's head of global commodities research in London, issued a report Mar. 14 outlining several measures to examine how far oil prices would need to rise to represent extreme levels of valuation. "Although oil demand side fundamentals are deteriorating, we expect the oil price will be captivated by a collapsing US dollar, a relationship we hold with deep suspicion. A further 4% decline in the US dollar index would imply oil prices hitting $120/bbl," Sieminski said.

Although crude is at an all-time high in nominal terms, oil prices would have to hit $118/bbl to exceed earlier records in real terms "deflated by US consumer prices," Sieminski said.

Relative to per capita income, crude would have to reach $134/bbl to bring the purchasing power of "an average G7 consumer" from the group of seven industrialized nations—Canada, France, Germany, Italy, Japan, UK, and US—to 1981 levels. "In 1970, back in the days of cheap oil and prior to the 1973 and 1979 oil crises, oil prices were trading at around $3.50/bbl. At the same time the average G7 per capita income was around $3,400 and consequently sufficient to buy just over 1,000 bbl of oil each year," the report said. "Following the two surges in oil prices, purchasing power of an average G7 consumer deteriorated rapidly such that by 1981 an average G7 consumer was only able to buy 318 bbl of oil."

In this decade, the purchasing power of an average G7 consumer has deteriorated as oil prices climbed faster than incomes. "However, the oil price would need to average $134/bbl in 2008 to reduce the purchasing power of an average G7 consumer such that he or she would be able to buy just 318 bbl, or a similar level of purchasing power as prevailed in 1981. As a result, on this measure oil prices are not yet at extreme levels," the report concluded.

"West Texas Intermediate prices would have to rise to $150/bbl for oil as a percent of global gross domestic product to hit the all-time high that prevailed in 1980," the report said. "Crude prices would need to hit $145/bbl to raise energy expenditures as a percent of US disposable income to early 1980s levels."

Ethanol outlook
In a separate report, Sieminski said, "We believe population growth, rising incomes, and increased ethanol production will lead to a doubling in grains demand by 2050." But the major benefactor of that market will be Brazil and probably would require further encroachment on its rain forests. Brazil, Sieminski said, "is the only country in the world that combines 20% of the world's unused arable land, weather patterns which allow two annual harvests, political stability, and close proximity to US markets."

A broad-based market rally has boosted the nominal prices for soft grains—corn, wheat, rice, and soybeans—to record high levels. "However, in real terms prices are still significantly below the highs reached in the early 1970s," Sieminski said.

He said, "The US government has made a key strategic decision to increase the relevance of ethanol in its energy matrix over the next decade. We forecast that global soft grain demand for ethanol production should reach approximately 350 million tonnes by 2010 and 675 million tonnes by 2030. These figures are based on our calculations that US ethanol consumption will reach 13 billion gal by 2010 and 24 billion gal by 2030." Sieminski added, "We estimate that 26% of total growth in soft grains consumption between 2005 and 2050 will be driven by ethanol."

Sieminski said, "We believe that there is plenty of unused arable land available for agricultural purposes. We find that the world has approximately 4 billion hectares of potential arable land, of which 1.6 billion hectares was being used in 2005. If we factor in the increase in global soft grain demand coupled with stable crop yields going forward—an aggressive assumption as yields are likely to continue to rise—the amount of available arable land could decrease to just 600 million hectares by 2050."

(Online Mar. 17, 2008; author's e-mail: [email protected])