Oil futures are contracts whereby parties commit to buy or sell oil at a pre-agreed price at a given date in the future. The graph shows at what price levels futures traded last Friday, on the first day of this year and a year ago (ie, the most recent futures indicate that markets expect prices to slowly go down from their current level above $100 per barrel to stable prices in the high 90s - and stay there for the next several years: in effect, market are betting on almost constant $100 oil over the foreseeable future).
The most striking thing about these graphs is that markets have no clue whatsoever as to where prices will be in the future.
In the past, it used to be simple: whatever the short term price, future prices would be around $20, ie markets expected prices to be stable in the long run, whetever the short term variations. Today, they are in effect still clinging to the same formula, ie that prices will go back to some stable level from where they are today - but given that prices keep on increasing, that target can obviously no longer be $20, and given that they have not been stable at any level in the recent past, they are just taking last month's prices as a "safe" bet.
Which simply means that they have no clue.
As I've been promising for a while to create a new target for the successor of the "Countdown to $100 oil" series, this has left me in a quandary as to what new target to select - if the markets have no idea, it's not that controversial to say anything (well, except if I did end up with a $1000 target, but that would probably be a bet on US hyperinflation than on the oil market, today).
So what are the factors driving oil prices in the near and medium term?
- Supply and demand.
The main driver behind the price increases of the past few years has been the continued tightness of the market, with demand growing rapidly and supply struggling to keep up - the result being much reduced spare capacity and a much higher sensitivity of the market to any and every disruption (weather events, accidents, incidents, strikes or other).
Much of the demand has been coming from oil-producing countries themselves, and, as they are booming - and subsidizing domestic energy prices - this is unlikely to change. China and India are also providing major contributions as large swathes of their population reach the income standard where car ownership becomes widespread, and slowing growth would still mean growth... As to the US and Europe, the margest markets, they have largely been stagnant in recent years (having borne most of the impact of higher prices, given how price controls distort demand elsewhere), and even in a recession demand is unlikely to be reduced much, from existing precedent (most of the demand destruction in the 70s was in the power generation sector and by industry). So global demand is likely to keep on growing.
Supply, on the other hand, is highly uncertain, given the lack of information about decline rates in existing fields. The Oil Megaproject database started by my Oil Drum colleagues suggests that a number of projects are expected online this year and the next,and thus that supply should be able to increase, but there is debate as to whether these new capacities are sufficient to do more than compensate for declining production in mature fields. The fact that Russia, which provided most of the boost in production of the past decade, is now expected to see its production decline this year, is symptomatic of these contradictory trends.
Even in the optimistic scenario, with increasing overall production and moderate demand growth, market tensions are unlikely to abate. In the medium to longer term, the question of peak oil looms large and will also keep an upwards pressure on oil prices.
- Investors rushing in the commodity sector
Speculation has been blamed widely for the high oil price levels - but then again this has been the case since at least 2005. Financial investors have indeed become a lot more present in the oil market, but it's hard to say what their influence has been. They do not appear to be present only on the buying side of the market; and while speculators can accelerate underlying trends, and can sometimes overshhot, they cannot create trends. Oil price increases have objective reasons, as noted above.
What is true is that commodities are now seen as a haven against inflation and against dollar weakness, and thus increased oil prices reflect dollar weakness as well as pure oil market fundamentals. But that weakness is just as real as the oil demand-supply tensions, and betting on goods that protect oneself against that wekaness is quite rational.
Given the still wide trade deficit of the US (which oil price increases continue to boost), and given the expectation of more monetary boosts by the Fed to try to limit the credit crisis and the economic meltdown, inflationary expectations are on the rise, and thus expecting the dollar to go down, and oil to go up is logical, even if not very politic.
- geopolitical factors
The other factor influencing oil prices is the "risk premium", ie the fact that potential events in international politics could have a huge impact on the oil market, and that oil prices are therefore boosted by the likelihood that these might happen - and the premium is proportional to the perceived probability of such events and to the expected price impact of the event should it happen.
With the Bush administration still stuck in Iraq, still tempted by military action against Iran, and still confrontational towards Russia, the premium is high, but might be expected to go down with a new president. However, McCain is as bellicose, if not more, than the current administration, and the odds of him winning have gone up somewhat lately. And even a Democratic president is unlikely to eliminate all Middle East tensions quickly - in fact, a period of withdrawal could easily be an unstable, or at least a very uncertain, one from the oil marjet's perspective.
All of that suggests that the balance is towards oil prices going higher rather than down, even in the (quite likely) case of a sharp economic downturn in the US. And it also suggests that how the financial crisis plays out will have a strong role in the short term.
Which points towards the logical goal to have in mind: 100 euros. However, as I've been arguing that the oil market would stick to the US dollar for a while, I'l try to be consistent, and propose a new target still expressed in dollars: $200, which should be met at about the same time as the €100 one...