Tuesday, June 21, 2005

Oil gone wild

It’s rather remarkable how the markets have reacted to oil at nearly 60 dollars per barrel, just four weeks after dropping to 47 dollars per barrel: stock prices have risen on average and bond yields have stayed put.

The good news is that high and rising oil prices are usually a sign of strong growth in the world economy, which of course is most welcome.

The bad news is that we’re entering dangerous territory and no one seems to know what’s really going on.

Some analysts, such as Andy Xie over at Morgan Stanley, explain away the jump in oil prices as the consequence of rampant “speculation”. They argue that slower growth and the rising output of petroleum substitutes will cause a dramatic collapse in oil prices in the near future.

Obviously, “speculation” is an oft misused and abused word, but there’s some evidence to back this point of view. For one, it’s hard to reconcile oil at record price levels with inventories at 5-year highs in the U.S.. And let’s not forget that neither the demand or supply outlook has changed over the last few weeks.

Yet, the fact remains that spare capacity is low and demand in the U.S. and the Asia Pacific region is still very strong. (By the way, I don’t buy the capacity-constraints-at-refineries argument: heavy crudes have risen as much in value as light crudes).

Things get even weirder at a more fundamental level. While many insist that oil production will keep on rising for quite a while, the “peak oil” movement loudly argues otherwise.

Regardless of who’s right, one has to wonder what impact energy prices at this level will have on the world economy. Sure, it’s dodged the bullet so far, but it’s possible if that the price of oil crosses-a certain threshold—obviously unknown—the impact will be severe.

Where does that leave mere mortals like me? Well, if I have to trust anyone, it’d be the price mechanism, which is signaling strong demand and high prices for the foreseeable future. However, for investment purposes, I’d use fairly conservative assumptions: my long-term guess is that oil will average around 40 dollars per barrel over the next few years. And, yes, high prices will take their toll on output over the next few months.