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Where is oil headed - $300 or $30 a barrel?

In the summer of 2008 the price of a barrel of oil rose to a high of about $130. It then dropped in early 2009 to just below $50 a barrel, and has since risen to today's price of about $90 a barrel. It is or should be of great interest to all of us to figure out where the price will be in one year from now.

A few weeks ago, at a conference called the Innovations Conference on Asphalt and Technology the incoming CEO of Caterpillar, Doug Oberheleman, presented an overview of the current global economy. He noted, among other things, that his company was conducting economic planning based on two possible scenarios. In one (which was assessed as 75% probability of happening) the US economy would grow steadily at between 3 and 4% this year. In the other scenario (25% probability) the economy would go back into recession. While people may quibble with the likelihood of the two scenarios, the general descriptions of them would likely find good support among those who discuss such things.

But where will this put the price of oil? And why has it been changing so much? Basically two things will determine the price of any commodity: the perceived relative supply of that commodity (is there sufficient supply to meet demand, too much demand, or over-supply); and the perceived value of the currency in which the commodity is priced. Thus, if the price of a barrel of oil increases it could be for two reasons. People may believe that the dollar is less valuable than it was, or they may perceive that the supply of oil is becoming less able to meet demand.

In 2008 the run-up in the oil price was due to both of these factors. The economy at that time was booming around the world, and all sorts of commodities (concrete, oil, steel, etc.) were increasing in price because demand exceeded supply. Additionally it seems that a lot of folks thought that growth in traditional investments such as stocks and bonds would be limited in the near future so they put their available money into commodities, like oil, which they thought would increase in value relative to the dollar.

Others at that time got very excited about peak oil - the idea that the world is running out of oil. Such predictions have been made before, about oil and other commodities, and have been proved wrong each and every time. Of course, "this time it will be different," and all that, but it would appear that we are not at peak oil yet.

As the summer of 2008 passed into autumn, the price of a barrel of oil collapsed down to ultimately less than $50 a barrel. What caused this? Well, first of all the world economy cooled off considerably, so the demand for oil diminished rapidly. Then, as the price began to drop, those who had bought oil as an investment recognized they needed to sell it quickly if they were to realize any of their hitherto notional profits, which drove the price down further and faster until it ultimately bottomed out.

And since then, the price of oil has been rising. In part because the global economy has been growing, albeit slowly, and so demand has grown too. But also because confidence in the dollar is not strong at present. The reason for that is because confidence in all the world's economies is not particularly strong either, primarily because most of the developed economies have been borrowing way more than they can afford. People are beginning to worry about whether they will get the bonds they hold in the debt of various countries repaid. Put simply, people have more confidence in oil than in the dollar.

Exhibit A in the current worry is Greece, which is basically broke and unable to fix itself. Simply, for years Greece has been spending more money than they took in as taxes, and making up the difference by borrowing (which sounds distressingly familiar). But now, those who had been lending money to Greece have decided it is not a good deal. If Greece wants to borrow any more money, it will have to do so at ruinously high interest rates. Further, because they are in the Euro currency, they cannot simply inflate their debt into insignificance. To make matters worse, Greece is not the only problem either in Europe, or the world.

Current concerns in Europe are focusing on Spain possibly following Greece into fiscal hell, with additional concerns that Portugal, Italy, and Ireland might follow. But the rot goes further and some are even concerned about the UK being in trouble. And the cause of the trouble in all cases is the same - too much government spending. That trouble of course is one that we share here in the US.

Clearly some people are concerned about all of this, which is why we have the whole Tea Party movement here in the US. Some governments are even doing something about it which is really quite remarkable, and is about the only sign of hope in this regard that I can see. Japanese politicians are calling bureaucrats before them in public meetings and making them defend their budgets, in the hope that the embarrassment would lead to reductions in spending. It appears to be working! To quote the Instapundit - Faster Please!

But what does this have to do with the future price of oil? Well, if the world loses confidence in the dollar, then its value will diminish rapidly and the price of oil (in dollars at least) will rise rapidly. So far this has not happened, but that maybe because most other global currencies are not in very much better shape than the dollar. So, when the treasury auctions off debt, there are still people willing to buy that debt, even at the very low interest rates that hold at present. But if people lose confidence in the dollar (or, more specifically, in the US government) then they either will not buy US debt, or they will demand a much higher interest rate for the debt, neither of which would be good.

Why would people lose confidence in the US government? Because they do not believe that the government is willing to bring spending down to a level that is balanced by tax receipts. In short, if the congress that is elected in November of this year does not propose a budget that is close to balanced (i.e. less than $100 billion deficit) then it appears likely that the world will begin to lose confidence in the dollar. In such circumstances, the price of a barrel of oil will rapidly climb to $300 and quite possibly beyond - which will be one trigger that helps to send us into a second recession deeper and longer than the one we have just started to climb out of.

On the other hand, if the newly elected congress were to show that they could pass a balanced budget (which will involve reductions of at least $1 trillion in spending from this year's budget) then confidence in the dollar will grow rapidly, investment in the US will also grow rapidly, and even though strong economic growth (and thus increased demand for oil) will be happening in the US and throughout the world the price of a barrel of oil will drop to around $30. The question then is not so much what will the price of oil be, but rather, how much courage are the politicians we will elect this November capable of showing? That is not a question that is likely to make any of us feel particularly happy.

Comments

  • dave 4 years ago

    hey peak oil is coming there will be no oil by about 2042 and this estimate was made by the government and wouldn't they want people to think that theres a lot of oil. I think it will be about 2013 that peak oil will be getting really close to happening.

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