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Predicting Crude Oil Prices

Dec 2, 2011

Indian investors' are often interested where the overall economy is going, and as an indicator, they ask about the direction of crude oil prices. Before speculating on the future, it is instructive to understand how crude oil prices have behaved in the past.

A Perspective on Historical Crude Oil Prices

Pre 1970s: During the mid twentieth century, while new applications for oil were being discovered, the demand for oil was small relative to the large supply available. Until 1950, the price for crude oil was in the range of $5 to $10 per barrel. Given these relatively low oil prices, nations with rich crude oil reserves (e.g. Middle East) could not exert much power on global prices.

However, between 1950 and 1970, there was a significant increase in demand. This along with the supply shocks led to a dramatic increase in prices. Demand for industrial oil spiked up due to World War II and the Arab-Israeli war. On the supply side, attempts to nationalize oil assets by some Middle Eastern countries, and the creation of OPEC contributed to the supply side constraints. During these twenty years, the price of crude oil grew nearly five-fold to $48 per barrel in 1970.

Between 1970 and 2008: With massive global industrialization, the demand for oil rose even more significantly. This period marked the shift of bargaining power from the buyers' to the suppliers. By then, most of the Middle Eastern countries had nationalized their oil related assets. Previously these assets had been assigned to International Oil Companies (IOC). While oil production in the US also increased, it peaked. Clearly the power had shifted to Middle Ease National Oil Companies (NOCs).

Till 2008, oil prices rose every year with a few exceptions. Per barrel crude oil prices increased from $63 per barrel in 1980, to $77 per barrel in 2003, and peaked at $150 in 2008. One notable exception was in 1998, when the price fell for a brief period due to the Asian crisis. However, the Iraq War in 2003, and strong demand from emerging markets such as China and India continued the upward price momentum. At the same time, the new discoveries were slowing and the cost of production also increased.

However, after the financial market bubble burst in 2008 and large financial institutions collapsed, the unjustifiable peak price of $150 per barrel cracked.

Post 2008: After the global financial crisis and corresponding recessionary fears and liquidity crunch, the oil price touched a low of $33 per barrel, and then stabilized near $70. Since then it has increased slowly and is hovering near the $100 per barrel mark in 2011.

So, while oil prices increased form the 1950s to a high of $ 150 per barrel in 1980, they dropped to a low of $33 per barrel, and now is around $ 100 per barrel.

This peek into how oil prices have historically behaved tells us that it is nearly impossible to predict volatile oil prices. Philosopher, Lao Tzu's words to a great extent summarizes the attempt to predict oil prices. "Those who have knowledge don't predict. Those who predict, don't have knowledge"

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