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$500 Oil?

July 17th, 2008 · No Comments

Yes, you read that right, some are predicting it, and one very smart economics professor argues it wouldn’t be the chatastrophe one might be inclined to think it is in a first (panick?) reaction.

As regular readers will realize, we have called a top in oil a week or so ago, based on a slowing world economy and prices having risen high enough to start changing behaviour, reducing demand and increasing supply (although the latter will take more time).

However, we did not argue that we would never see even higher oil prices. For that to happen (apart from incidents), the world economy should recover, and no doubt it will. Then the full fundamental forces that were behind the rise in oil to close to $150 a barrel will once again exert themselves to the full.

These forces are that demand is structurally outpacing supply. Increasing demand mainly comes from rising middle classes in (rapidly) developing countries with large populations (and growing industry as well).

Demand is further boosted because in large parts of the world, consumers are not paying the full price of oil, as it is heavily subsidized. Fill up your tank in, say, Venezuela or Saudi Arabia, and your reaction would likely be something like “energy crisis, what energy crisis?”

Supply is constraint as the biggest resources are in countries with regimes that mostly take short-term political advantage of the oil surge. It’s unfortunate that the biggest known reserves are in countries where, for political reason, there is severe underinvestment in the industry, so supplies are constraint.

Now, when the world economy recovers we expect prices to continue to rise. Whether they will reach $500 a barrel is anyone’s guess, but structural forces point to higher prices, we’re fairly sure about that.

Would that be a disaster? Not really, according to Willem Buiter, an extraordinary gifted economist (we had the pleasure of having assisted his lectures once):

  • Even if the U.S. sees $500 oil, income would fall no more than 10 or 11 percent.

It seems that his lectures (a couple of decades ago) has done us good, because his position is rather similar to ours:

  • The solution, he says, is conservation, and that goal will only be accomplished if prices stay high. “The only way to encourage conservation is higher prices for the user, that is, prices that fully reflect the long-run social marginal cost of energy,” he said.
  • “We are just beginning to see more realistic prices for energy, even in parts of the world where low-cost energy is seen as a social entitlement.” Europeans have lived with high oil prices for a long time because of taxes, Buiter points out.
  • Yet, as the world economy continues to slow, commodity prices will decline, he said.

We couldn’t have said it better ourselves.

We have a feeling that our stocktips concerining companies like InterOil and Trina Solar will do rather nice when things resume in a more orderly fashion… Even with a temporary blip in the upward march, energy is still the place to be (unless the world economy really sinks, but that is not likely).

Tags: The Markets