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David Smith: Oil Prices Will Come Down

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August 14, 2005

The oil bubble will burst and interest rates fall...

THE August sun has been beating down and the driving season is in full swing. And, oh yes, oil prices have been hitting record highs again, topping $65 a barrel.

The driving season, usually thought of as an American phenomenon, kicks off on the Memorial Day holiday weekend in late May and lasts until Labor Day in early September, when American motorists take to the highways in large numbers in search of rest and recreation. But it is also a European thing and, judging from my recent experiences on our crowded motorways, one we embrace enthusiastically here, even with petrol at 90p a litre.

Its significance is that it is associated with strong demand for oil, putting pressure on limited refining capacity. Everything, in fact, seems at present to be conspiring to push up oil prices. The driving season gives way to autumn and winter heating demand. If the weather is cold, oil demand increases; if global warming makes it hot, turn up the air conditioning.

Our appetite for oil continues unabated in spite of record prices. The eastward shift of the global economy and rising demand from China, with its 9.5% growth rate, is another seemingly permanent oil-price booster.

I will return to that in a moment. The big domestic economic news this month, however, has been generated by the Bank of England, first by cutting base rate from 4.75% to 4.5% on August 4.

Then last week, Mervyn King, the Bank’s governor, presented a new inflation forecast that offered little encouragement to the interest-rate doves. If the Bank’s forecast turns out to be correct, the monetary policy committee (MPC) will see little need to cut rates further.

There are some serious questions about that forecast. Growth over the past 12 months has been roughly half what the Bank expected last summer, yet it persists in predicting an early bounce-back in activity — from where is not entirely clear.

That was not the only curiosity. King has stressed that the Bank can achieve as much when not cutting rates as when it does, as long as people expect it to do so. The prospect of a succession of cuts could have cheered up households, encouraging more spending, so minimising the need for the MPC actually to make those cuts. Last week’s signals went against that spirit.

The Bank, it should be said, will always have a built-in bias towards saying that the present level of interest rates is right. Otherwise, why not change it immediately? To me, however, the big issue has been oil. Inflation, on the consumer-prices-index measure targeted by the Bank, stood at 2% in June, exactly in line with the target. A year earlier it was 1.6%, three months before that just 1.1%.

What has caused this rise? The Bank offers two competing views. One is that inflation has moved up because of pressure of demand. Firms, in other words, have got back some of their pricing power because of the strength of the economy. The other explanation is oil. In just over two years, oil prices have gone up from the mid-$20s to more than $60 a barrel. Petrol has risen from under 70p a litre to more than 90p. In this context, the surprise is not that inflation has risen but that it has risen so little. At a time when world oil prices have more than doubled, 2% inflation is a minor miracle.

And last week’s inflation report offered no definitive answer on this, something I would want as a priority if sitting on the MPC. Is it really plausible that the strength of demand has pushed up inflation? Not according to retailers, who say consumer demand has been weak.

So we should look to oil, both for its effect on inflation — “core” inflation, excluding energy and seasonal food, is running at only 1.5% — and its impact on growth. Part of the slowdown we have seen in Britain is due to the fact that high oil prices act as a tax on growth. The more people and businesses spend on energy, the less they have for other things.

Petrol prices have yet to reflect the impact of the latest rise in crude oil. Gas and electricity bills will rise further over the winter. As the Bank said, the current inflation rate of 2% is unlikely to represent the peak.

What happens then? While the futures market suggests that oil prices will head gently lower, many market participants are not so sure. Options markets suggest that the chances of a big rise in prices are greater than those of a big fall, with a 1-in-20 chance of prices being $100 a barrel or more in a year.

I’m not so sure. This is a nervy time for the global oil market, but the surge in prices has all the characteristics of a classic bubble. The International Energy Agency, in its latest oil-market report last week, said: “The unfolding statistical picture increasingly reveals that fear of the unknown and the consequent desire to make forward oil purchases is behind oil’s higher price path.”

It also warned that while the emphasis now was on the risks of higher prices, “as stocks and spare capacity increase, it must not be forgotten that the downside price risks will eventually emerge as well”. It predicts a rise in oil demand of 1.75m barrels a day in 2006, but a bigger increase in supply, split between Opec and non-Opec countries. Opec’s margin of spare capacity, currently a wafer-thin 1m barrels a day, will rise to 3m.

That does not mean oil prices are going to collapse. It does mean they are likely to return gradually to earth — which probably means a sustainable $40 a barrel — when geopolitical worries subside. That, in turn, will expose the fact that Britain’s higher inflation is largely an oil phenomenon, enabling the MPC to reduce rates further. And what if oil prices were to hit $100 a barrel? The Bank would need to cut in those circumstances, too, to prevent an already slow-growing economy sliding into recession. Either way, despite the Bank’s cautious message last week, this month’s rate cut will not be the last.

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While the futures market suggests that oil prices will head gently lower

Err, in which universe? Light, sweet crude oil futures traded on Nymex have futures prices above spot from now until 2006 and beyond, as the longer-dated futures have very little liquidity so the prices beyond that maturity are only indicative.

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I'd like to get paid to write the drivel that these reporters produce.

I can see clearly now why people like Rupert Murdoch are worried about the effect the web is starting to have on their businesses.

I'm getting sick of people who just think that dropping rates and propping up the housing bubble will return the economy to health.

The analogy has been posted before, this is like a junkie thinking that they just need to get another fix, and all will be ok.

Well, it's tough, but this junkie needs to go cold turkey.

Just keep dropping interest rates, that will fix everything. Wow.

Phenomenal insight from the economics editor of the Times.

Edited by BandWagon

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An increase in the supply of crude oil is quite likely if nothing much happens in Iran etc. Likewise an increase in demand is pretty much certain until such time as the wheels fall of the economy.

But increasing supply to the point where we go from ZERO to significant surplus capacity? Only if demand goes down.

And in any event, an increse in the supply of crude oil is of little use if it can't be refined. With practically every refinery already running flat out there's not much change of refining even more oil.

So, it's one of those things that under certain circumstances he could be right. Oil prices COULD fall substantially in the short term if we get a global recession or if there is a sudden outbreak of peace in the Middle East. We are, after all, producing more crude than refineries can process so it's not short at the moment and a slump in demand or outbreak of peace would at least address supply concerns for a couple of years.

But my personal expectation is that we will see $80 before we see $20 oil.

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(I may email this comment to him. Anyone have the email address? Or you can send it for me.)

His e-mail is david.smith@sunday-times.co.uk

I regularly read his column. The guy seems to view the world throw rose tinted spectacles. I seem to remember shortly before christmas he predicted that after christmas oil would come back down to around $30 a barrel. So I take all his predictions with the most enormous rock of salt. I think he has a very selective memory and is also very selective about the data he considers i.e he ignores anything that contradicts his viewpoint i.e he ignores Hometracks dfata because 'they have no track record'.

I get the impression that a number of the Times/ Sunday Times journalists have BTL portfolios to protect, afterall last weeks Times was the only paper that reported Countrywide's disasterous results as 'Countrywide hail truning point in Property Market' !

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David Smith says:

"probably means a sustainable $40 a barrel — when geopolitical worries subside."

"what if oil prices were to hit $100 a barrel? The Bank would need to cut ... this month’s rate cut will not be the last"

Smith's comments are often like flipping a coin.

He gets it wrong, as often as he gets it right.  And I think he is wrong here:

My own view is:

+ Oil prices are not going back to "a sustainable $40",

+ At $100 oil, BoE would be as worried about inflation as it is about a slowing economy.  They would not be in a rush to cut, because if the did, they would be opening the door to hyperinflation.  (BTW, the hyperinflation scenario is the best hope of the Property Bulls.  If it comes, I firmly believ that I will do better with my gold shares than the Bulls do with their Property.)

So is Smith then a "hyper-inflationist", as this article would have me believe?

(I may email this comment to him.  Anyone have the email address?  Or you can send it for me.)

What about the Oil in places like Kazekstan. Once the pipeline is built it should bolster supplies for some time. There is Oil but getting it to its destination will be more dificult.

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