How long will the oil crisis last? - Views on News from Equitymaster

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How long will the oil crisis last?

Mar 17, 2011

Ever since oil prices gave crude shock of US$ 100 per barrel this year, the question on everyone's mind is if the trend is sustainable at all. Until the earthquake and tsunami shock in Japan concurrent with China's announcement of a dismal fiscal deficit, nothing could pull oil prices down. Even now, they are at much high level than what fundamentals support.

The oil price scare has given a good talking point to many commodity experts including the likes of Jim Rogers who expects oil to reach US$ 150 per barrel. And then there are some who predict the level up to US$ 200.

Yes, oil is selling higher than it should. But how much of this is based on demand supply dynamics and how much is just an outcome of fear trade. While some premium for uncertainty is justified, we believe that a level above US$ 100 per barrel is way too much and unsustainable. The fundamentals have been ignored to make place for speculations. Every new event - big or small, is jumped upon and made a cause for rise in oil prices.

The unrest in Middle East and North Africa are real. But we also need to understand that such disruptions to oil supply are short term. There is no shortage of oil supply. OPEC is sitting at a spare oil capacity which is higher than late 2008 when oil prices were at all time high. So what is this panic about? Some believe that the crisis may spread to other Middle East oil producers like Saudi Arabia, leading to high prices. We don't think so. And the reason is that this is not new for us. Back in year 2008, oil prices touched historical peak of $145 per barrel. Within three months, the prices were restored to level supported by fundamentals. Do we have a lesson from this event? Yes. The unusually high prices can destruct demand thus turning tables on oil exporting countries. Since most of the Middle East economies rest on oil prices, no internal crisis that threatens oil demand can last for long for the lack of funds. Also, as effects of quantitative measures settle down and rolled back, the dollar should gain strength thus limiting speculative money into commodities like oil.

And that is just one of the factors for restoring parity on oil prices front. As shale gas has entered the energy landscape, oil is no more the single main source of energy. Within last decade, shale gas has managed to raise its share from 0% to 20% of huge gas streams in the US. And this development is important since this energy source has decoupled gas prices from oil prices. In fact, if oil prices rise, it will only speed up developments in non conventional and renewable energy sector. Backhome, the players like ONGC and Reliance have already forayed into such ventures. Unlike oil reserves, which are likely to last barely six to eight decades more, shale gas reserves in India are expected to meet India's requirements for many more years. The shale gas prices have reduced gas prices in US from US$13 per mmbtu to just US$ 4 per mmbtu within four years. This implies a price of US$ 22.2 per barrel of oil equivalent, a level we can hardly ever expect to see for oil (US$ 34.6 per barrel has been the minimum oil prices since 2005).

To conclude, we believe that current levels of oil prices lack the support from fundamentals . It should not be very long before oil prices are restored to normal levels.

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