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High crude prices: Will they last?

Jun 16, 2008

The crude price levels are hovering around the US$135 per barrel level, causing headaches for governments and central bankers around the globe. Even Saudi Arabia, the OPEC's most important member, has recently announced an increase in daily production by half a million barrels to protect the goose that lays the golden eggs. Let us examine if the current crude oil prices are sustainable. Yes, they will last
Incremental demand from China and India: China and India are experiencing high growth rates in their economies which translates into massive amounts of fuel guzzling. Moreover, the government subsidizes petroleum products thereby dampening the price signals, which could reduce demand. Demand from these countries is unlikely to slow down in a hurry and they will continue to drive the growth in consumption figures in the years ahead.

Supply hindered by political and geological factors: Most of the world's proven oil reserves now reside in politically stubborn regions. They have no love lost for the first world. Hence, pleas for greater supplies generally fall on deaf ears. The recent move by Saudi Arabia is only because US$ 135 a barrel of crude might have worried them that things have gone a bit too far and threaten the trillion dollar bounty that the oil producing nations now expect in revenues from oil.

  • Saudis' nervous on oil spike

    Geology is also not helping matters. The oil fields available in the first world are maturing at a fast clip. There have been very few lucrative finds over the past many years. So the oil majors from the developed nations are forced to concentrate on the marginal and expensive off shore projects.

    No, they will not last
    Actual commodity vs. the financial derivative: While the financial derivative for crude oil is consistently touching ever-higher prices, the actual commodity might not be selling at those prices. According to Bloomberg, Iran had at least 14 very large oil tankers idling in the Persian Gulf around June 02, 2008. This might be an indication that the OPEC's second largest oil supplier is not able to clear the commodity at the current prices. The demand (and the price) for the derivative seems to have run away much faster than the demand (and the price) for the actual commodity.

    Alternate sources of energy: Alternate sources of energy- ultra deep oil fields, Canadian tar sands, nuclear energy etc.- become viable at high crude oil prices. According to some estimates, the threshold price for the Canadian sands is US$ 60 to 70 per barrel. These alternate sources should indeed attract investments if the current crude prices remain at the current stratospheric levels. And such news should act as the safety valve in the pressure cooker like crude oil markets.

    France produces around 75% of its electricity from nuclear energy. Most of the French nuclear power plants were built after the oil shock in the 1970s. The world might rethink the nuclear option on a much larger scale this time around.

    Crude oil remains the most important source of compact energy. But the question is whether the fundamentals warrant the price. George Soros has recently said, "The answer is that the bubble is super-imposed on an upward trend in oil prices that has a strong foundation in reality."

    A bubble can form in any market- equities, housing, currencies or commodities. Mr. Soros has explained in his book, 'The Alchemy of Finance', that bubbles arise from fundamental factors, which the market overestimates in a positive reinforcing loop thus taking it far away from reality. Given the absolute levels of the crude prices and rapidity of increase, this looks like a bubble to us.

    Just as in the equity markets, bubbles in the commodity prices must eventually burst. As to when the crude oil bubble will burst- timing is as, if not more, difficult in commodities as it is in equities.

  • Applying 'Game Theory' in a bubble situation

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