Some coming attractions that will impact the price of oil are predictable:

   1. OPEC will cut production - or at least announce that they will cut production - probably by 1 - 2 mb/d

   2. The unfreezing of the credit system should proceed apace over the next month accompanied by a reduction in LIBOR, the unfreezing of shipping, and maybe an uptick for the Baltic Dry Index.

   3. The coming recession will be nasty: maybe 9% - 11% U.S. unemployment; weakness in Europe; substantial deceleration of growth in Asia and oil exporting nations.  It will be impelled by further U.S. credit contractions in terms of credit card lending, automobile lending, and mortgage lending.  And the headlines will include a bunch of corporate bankruptcies including probably G.M. and Ford.   As the recession proceeds, state and local governments will be under great pressure to cut spending thus adding to recessionary forces.

   4. To counter all these deflationary trends the federal government will try its best to reflate the economy through spending programs on infrastructure, grants to states, and growth in military personnel.  Chances are this effort will be too little and too late.

   5.  Oil consumption will decline with the OECD economies’ weakness; in oil exporting countries as their cash flows dry up (remember the growth of oil consumption in the oil exporting countries has been fueling half the increase in consumption globally) and there will be  much less growth of oil consumption in Asia.   Over-all we could see a drop in oil consumption of 500 - 1,000 kb/d in 2009 compared with 2008, which itself should turn out to be flat vs. 2007.

   6. The U.S. federal budget deficit will expand to never-before-contemplated levels which will come on top of the wild expansion of U.S. federal debt resulting from various mistaken Bush policies on spending and revenue.  The ultimate risk of this period may well be a possible run on the U.S. dollar as people begin to realize that with social security and medicare deficits fast approaching the U.S. federal government no longer has the ability to tax its economy sufficiently to pay for its growing obligations. 

What we do not know is the timing.  How fast will the economy unwind?  How long will the unwinding go on?  Will it feed on itself to be a virulent depression?  When will governmental reflation efforts - in many countries - begin to bite?  When will currency re-alignments happen?

Without knowing the timing it is hard to predict the sequence of price changes for oil, for the dollar, for gold or for stocks.  But I think of all the unknowns, the most predictable is oil.   Here’s why:  all the above known future developments are bearish for the oil price - they all tend to depress demand - except for two.  The first is the cutback in production by OPEC.  The second is a possible fall in the value of the U.S. dollar.  Of these two, I doubt that the OPEC cutback will have OPEC’s desired effect of stopping the oil price fall because each barrel of oil OPEC decides not to produce is one more barrel of oil added to OPEC’s reserve capacity.  In my view, the price of oil is not only determined by immediate supply and demand.  It is also a matter of how much reserve capacity the market can see.  One reason for the early 2008 oil price spike was a clear lack of reserve capacity.  But as new Saudi production has come on stream and global demand has softened, reserve capacity has been built.  So a cutback by OPEC, I think, even if its members adhere to it (which is less than 100% certain) will have a limited ability to push up the price of oil. 

The second factor, a fall in the U.S. dollar is hard to predict.   I rather suspect that will not happen until the deflationary tendencies of the recession are overtaken eventually by inflationary tendencies caused by Treasury pumping out dollars as fast as they can.   During a deflation the dollar becomes inherently more valuable, it seems to me.  By definition, in a deflation each dollar buys more goods and services.  Unless that is happening in other currencies at a faster rate, the dollar should stay strong while U.S. deflation is happening.  The deflation has begun as we are now experiencing asset deflation in stocks and housing.  We are also seeing deflation in commodity prices. The final stage is deflation in the prices of goods and services, which we could see in 2009.   In that environment, people will not be trying to get rid of their dollars; rather they will want to hold onto their dollars.   So I would expect that such a trend would also tend to depress the price of oil as expressed in dollars.  Similarly gold should be headed lower before it starts its next bull move, probably to record breaking ground.

For all of these reasons I now expect that by year end we will see oil priced below $70.  It may have a short term move up due perhaps to technical forces of the market being oversold by speculators recently.  But once weak shorts have covered - perhaps with the announcement of a cutback by OPEC - I expect oil prices to begin heading back down.

I doubt that an oil price much under $70 will be an equilibrium price - one that can stand for many months - because it will cause supply destruction based on higher marginal production costs.   But in the short term oil can stay down there or even go into the $50’s as some major firms are now predicting.  

Tags: peak oil energy investments

This entry was posted on Sunday, October 19th, 2008 at 7:19 pm and is filed under Investment Ideas, Predictions, Price of oil, The Economy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.