Why Oil Could Be Headed Even Higher

Strong global demand and tight supply will buoy prices for the foreseeable future, analysts say

Oil prices have now been on a bull run for four years. This year alone, they are up nearly 30%—and much of that rise has come in the past few weeks. The U.S. benchmark West Texas Intermediate crude hit an all-time high of $78.77 in intraday trading earlier this week, and closed at $76.86 a barrel on the New York Mercantile Exchange (NMX) on Aug. 2.

Still, it looks like oil prices could be headed even higher. Surging demand coupled with concerns about tight supplies are sending crude prices up, and there’s no relief in sight on either side. In addition, speculators are now betting on further price spikes. “It looks like [oil] is getting ready to do a new leg of height,” says Peter Beutel, president of the energy risk management firm Cameron Hanover. “There is market momentum, and the magic number now is $81. If we hit that, most people believe it’ll head to $91 or higher.” Beutel adds that some technical charts predict prices could hit $110 or $118 by the end of the year. He adds however that such a spike would take a “smoking gun” like Iran blockading the Strait of Hormuz, the key strategic gateway to the Middle East’s oil supply.

Unlike in previous periods, the main driver in the recent price boost is not a war, a hurricane, or the machinations of OPEC, but rather robust global economic growth, say analysts. The U.S. economy has remained solid, despite jitters in the stock market. China and India are surging, while most of Europe is strong.

Even as high oil prices are a symptom of a strong economy, however, they could ultimately put the brakes on economic growth. The darker side of the growth issue is that the price spikes caused by competition for scarce supply could ultimately cause inflation, a recession, and increased geopolitical friction.

Supply Squeeze Ahead

A July 9 report by the Paris-based International Energy Agency (IEA) stated that global spare oil production capacity will shrink after 2010, and because global demand will outpace supply, a “supply crunch” is likely.

Global oil demand is forecast to expand by 2.2% per year on average, the IEA said, led by Asia and the Middle East. Chinese oil demand will reach almost 10 million barrels a day in 2012, and China will only produce 3.9 million barrels domestically. Global oil consumption is expected to reach 86 million barrels a day this year, 1.5 million barrels more than in 2006.

The report said that OPEC’s supply cushion of unused capacity will rise until 2010, but then decline to “uncomfortably low levels.” And while non-OPEC production growth in regions like Brazil and Russia will be strong, it won’t produce enough to quench the thirst of developing and industrialized regions. Further, the biggest increases in non-OPEC production will come from nations that produce heavy oil, which is more expensive to extract and refine than light, sweet crude.

Countries vs. Companies

Other factors keeping oil prices high are the battle for control of existing oil fields between industry and national governments, and more costly penetration of nontraditional sources such as oil sands. The vast majority of world oil supplies are under the control of national governments, and oil companies are venturing into more far-flung areas like Canada’s oil sands and offshore New Zealand in search of more product. Second-quarter profits were flat at ExxonMobil (XOM), which saw a 1% drop in production on an oil-equivalent basis (see BusinessWeek.com, 7/25/07, “ExxonMobil: Poised for a New High”). On July 26, Royal Dutch Shell (RDSA) announced oil and gas production fell 2% for the quarter, partly due to security problems that closed down fields in Nigeria.

Add it up and many analysts see a continued rise in prices. “I think we’re headed toward $85 this year; it’s oil’s technical destiny,” says Phil Flynn, an analyst with Alaron Trading in Chicago. “In the last few years, we’ve added an average of about $10 a year onto the price, and that could continue through the decade. It seems this bull cycle is a long-term trend, barring a change in economic fortunes.”

He thinks that political tensions—between the countries that control oil supplies and those that need them to fuel their economies—are only going to grow in the years ahead. “We also have to look at geopolitical tension in this scramble,” says Flynn. “We’re already starting to see oil used as a political tool, and the power is likely to continue to shift away from consumers and toward producers.”

Herbst is a reporter for BusinessWeek.com in New York. - (by Moira Herbst)

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