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Thursday, May 29, 2008

Fed Letter: Crude Awakening: Behind the Surge in Oil Prices

by Calculated Risk on 5/29/2008 05:24:00 PM

Here is an economic letter from Stephen P. A. Brown, Raghav Virmani and Richard Alm at the Dallas Fed: Crude Awakening: Behind the Surge in Oil Prices

A good starting point is strong demand, which has pushed world oil markets close to capacity. New supplies haven’t kept up with this demand, fueling expectations that oil markets will remain tight for the foreseeable future. A weakening dollar has put upward pressure on the price of a commodity that trades in the U.S. currency. And because a large share of oil production takes place in politically unstable regions, fears of supply disruptions loom over markets.

These factors have fed the steady, sometimes swift rise of oil prices in recent years. Their persistence suggests the days of relatively cheap oil are over and the global economy faces a future of high energy prices.
See the charts in the economic letter on each of these points. And their conclusion:
At first blush, crude oil demand doesn’t offer much hope for lower prices. It is likely to grow with an expanding world economy. Higher oil prices will prompt some conservation and take some of the edge off prices—but not much.
Geopolitics and exchange rates aside, long-term oil prices will largely be set by supply and demand, which will affect prices directly and influence the expectations that shape futures markets. The key lies in how much new oil reaches markets. Four scenarios for conventional oil resources show a range of outcomes and impacts for the trajectory of prices:
  • Oil production reaches a plateau or peak—prices likely to rise further.
  • Oil nationalism continues to slow the development of new resources—prices likely to remain relatively high.
  • In a shift of strategy, OPEC increases its output sharply—prices likely to fall.
  • Aggressive exploration activities pay off with the quick development of significant new resources—prices likely to fall.
  • ... International Strategy and Investment, an energy consulting business, has documented a substantial number of projects under way that would boost world oil supplies. The development of these resources could undermine the expectations underlying the higher oil price scenarios—even those of oil nationalism.

    Supplies could be bolstered by nonconventional oil sources—tar sands, oil shale, coal-to-liquids. ... The substantial development of these nonconventional oil resources could mean downward pressure on crude oil prices in future years....

    What’s the bottom line? Absent supply disruptions, it will be difficult to sustain oil prices above $100 (in 2008 dollars) over the next 10 years.
    After reading the letter, their conclusion was a bit of a surprise!