Is Crude Oil a One-Way Bet? - Outside View

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Is Crude Oil a One-Way Bet?
Aug 9, 2010

Whether we realize it or not, crude oil plays a significant role in all our lives. Oil is used to generate electricity and fuel, both of which we all use on a daily basis. More importantly, we are all impacted by the price of oil. Anyone who lives in a country that is a net importer of oil will be financially worse off if oil prices go up. Let's examine the long term demand and supply conditions for oil. Most of the arguments support the view that in the long run, oil must go up.

Looking at the supply side first, oil is a fossil fuel meaning that its global supply is fixed. We can't create more oil. We can discover new sources of oil that will increase supply temporarily, but in the long term oil from any new sources will eventually run out as well. Oil supply also depends on its price. There is plenty of oil available that is expensive to drill, and would only be financially viable to produce if the price was high enough. The bottom line is that the supply side of the equation leans toward higher future oil prices.

On the demand side, oil demand can fluctuate over the short term (as global economies go in and out of recession) but steadily rises in the long term. With emerging markets like India and China growing at such high rates, even a slowdown in developed economies will probably mean that global demand will still keep rising. Again, the bottom line is that the demand side also leans toward higher future oil prices.

Looks like a simple equation to me. Oil will go up over the long term. Before we all rush to purchase oil for ourselves, let's examine some of the issues that could put a dent in this argument. In fact, what we should be asking ourselves is not whether oil will go up in the long term, but rather how high can it go? Recently, we had oil prices that reached nearly US$1 50/barrel, so this range can certainly be revisited. US$200/barrel seems possible in the near future as well. Beyond that, it is more difficult to say. Could we have US$ 500 or US$ 1,000 oil?

Let's start with the supply side. The first issue relates to what I mentioned earlier. At higher prices, it becomes feasible to drill deeper to extract oil. We don't really know how much of this expensive oil is out there, but it could be sizeable enough that it puts a ceiling on prices, at least for a while. The next issue is substitutes. For example, natural gas is much cheaper than oil (for the same quantity of energy). If oil goes up, we can substitute to natural gas to a greater degree which would also put a ceiling on oil prices. The same logic would apply to any other forms of energy, and especially so with renewable energy sources.

On the demand side, we are continually getting more energy efficient. A car produced today will use much less fuel than a car produced ten years ago. A car produced ten years from now will be more fuel efficient than a car produced today. The same applies to all forms of transport. So as our economies grow, our demand for crude oil could grow at a much lower rate as we become more energy efficient. In fact, higher prices will encourage us to be more efficient.

The point of this article is to demonstrate the crude oil is certainly not a one way bet. There is no guarantee that prices will skyrocket, even though in the near term demand growth will exceed supply growth. In the short term, it is difficult for economies to substitute oil for other energy sources. It is also difficult to increase energy efficiency in the short run. In the long run, anything can happen. It could be the case that over time we'll use less crude oil due to advances in technology.

I have read numerous articles on doomsday scenarios if the price of crude oil were to reach astronomical levels. People talk about how there' be hardly any oil left; and we will be back to the stone-age. This of course is nonsense. In fact, a higher crude oil price (which will hurt us financially in the short term), will be a blessing in disguise over the long term. Why is this? A higher crude oil price will mean societies will shift to alternative forms of energy which are more likely to be renewable and more sustainable. A higher crude oil price also means we have a greater incentive to become more energy and fuel efficient. I doubt for example that we would have created the hybrid car if fuel prices were very low. The best way to reduce oil consumption is simply to let the price rise too high for our liking.

Going back to our original question of whether oil is a one way bet. At current prices, demand growth exceeds supply growth which supports higher prices. But the real issue here is whether in the long run, if prices are high enough, will demand for oil fall significantly? If so, oil may not end up at the astronomical levels that many are predicting. This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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