Friday, 9 May 2008

The Cost Of the Black Stuff

With the price of oil pushing through the $120 per barrel level, many are now asking how high the price of oil can go. Whilst oil at $120 per barrel is high in nominal terms, it is by no means clear that the price of oil is that expensive in real terms. The cost of $120 per barrel is in 2008 dollars. If we were to translate cost of oil in the early 1980s (the previous record price of oil) into 2008 dollars, then the cost of 1980s of a barrel of oil in 2008 dollars would be $94 using the producer price index and $118 using the consumer price index.

However, these price indices do not account for the growth in purchasing power since the early 1980s. In 1981, the annual average income in the G7 nations would have bought 318 barrels of oil. Given the annual average income in the G7 nations today, in order to limit the purchase to 318 barrels of oil, the price would have to rise to $134.

Alternatively, in 1980, in the US, 8% of disposable income went on energy. Today it is 6.6%. For the relative cost of energy to increase to 8% of US disposable income today, the price of oil would have to rise to $145 per barrel. Again, in 1980, spending on oil as a percentage of global output was 5.9%. Today it is 3.5%. For the spending on oil as a percentage of global output to reach the level of 1980, the price of oil would have to rise to $150 a barrel.

In nominal terms, the current price of oil looks expensive. In real terms, it is looking about right. And in terms of purchasing power, the current price of oil looks relatively inexpensive. For the future prospect of the price of oil, there are two critical uncertainties – one on the demand side, and one on the supply side.

On the demand side, much depends upon how extensive the downturn in the US economy will be and the extent to which the world economy has decoupled itself from the US economy. If the downturn is hard, and if the global economy is still coupled to the US economy, then the demand for oil is likely to weaken sufficiently to soften the price of oil. If the US downturn is not that severe, or if the world economy is less dependent upon the US, then we can expect demand for oil to remain robust, and to further harden the price of oil.

On the supply side, we need to look at the petro-economies – particularly the ‘low absorbers’ (those economies that do not absorb the oil revenues, but channel them into foreign investment). From the perspective of the low absorbers, the traditional investment routes (bonds, equities, and property) currently appear to have high risk and relatively low returns. A far better investment, given the price elasticity of demand for oil, is to simply leave the oil in the ground. It has a relatively low risk, and is currently yielding far better returns than any other investment.

If this takes hold as a production strategy for oil suppliers, then a restricted supply of oil will add to the pressure for its price to harden. However, there is also an incentive for the high absorbers to increase their oil production because, by definition, they would like to spend their oil revenues rather than invest them. This would act to soften the price of oil as stocks are released into the market. The critical uncertainty on the supply side is whether or not the low absorbers or the high absorbers will gain the upper hand.

In 2006, we came across a US analyst, Stephen Leeb, who was writing about oil at $200, and the economic implications of this. It would appear that Goldman Sachs has recently taken up this thinking, and are now talking of oil between $150 and $200 per barrel by the end of 2008. For this to happen, on the demand side, either the US downturn would turn out to be not too severe, and/or the global economy would have decoupled from the US economy; and on the supply side, the oil producers would have concluded that oil has more value to them in the ground rather than out of it. As we have seen, oil at $150 per barrel is not necessarily expensive in terms of purchasing power. If we take this view, then the price of oil has quite some way to go.

From a longer perspective, do your scenarios consider how your world view might change if oil were to increase in price to, say, $200 per barrel or beyond?

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