The price of crude oil on international markets dominates financial news headlines for good reason: crude oil is the world’s most traded commodity. With a multitude of complex and dynamic factors at play, there is a great deal of uncertainty surrounding oil prices, both in the short term and the longer term, but some general trends and possibilities can be identified.
It is useful first to put oil prices in historical context. Between 1986 and 2003, the nominal price of crude fluctuated between $10/bl and $30/bl, aside from a brief spike in 1990, following Saddam Hussein’s invasion of Kuwait. But from 2004, the price started climbing every year to 2008, when it averaged $97/bl. In 2009, it fell to $62/lb, but rose again to reach $111/bl in 2011 and remained at that level last year.
Looking forward to the rest of this year, the main factors driving oil prices will be economics and geopolitics.
The economic fundamentals are, of course, demand and supply. On the demand side, there are three main drivers to watch: how severe the eurozone recession becomes, whether the US is able to dodge a threaten- ing double dip or is mired in its budget and debt quagmire, and what happens to Chinese demand for oil – itself heavily influenced by conditions in China’s Western export markets.
On the supply side, one of the key questions is whether the recent impressive gains in US tight oil production can be extended, as the International Energy Agency (IEA) predicts.
Geopolitics has always been integral to oil price gyrations, with a centre of gravity in the conflict-prone – and oil-rich – Middle East and North Africa region.
The key risk for now is that the ongoing civil war in Syria could spill over into neighbouring countries and destabilise the region’s oil exports. The impasse between the West and Iran over its nuclear enrichment programme is still simmering, although the war rhetoric has been toned down considerably in recent months. The recent gains in Iraqi oil output are under increasing threat as the Shiite, Sunni and Kurdish factions battle for power.
Besides these usual suspects, there are possible wild-card price drivers – such as extreme weather events that disrupt production, such as hurricanes in the Gulf of Mexico, or another financial system implosion. But even if there is another price collapse, similar to what happened in late 2008, it would not last for long. The Organisation of the Petroleum Exporting Countries would likely take action to ensure that oil prices remain in triple- digit territory, since most of its members depend on these levels to balance their budgets.
Longer-term scenarios for oil prices are all over the map.
In its ‘World Energy Outlook 2012’, the IEA projects that the price of crude oil could rise to $125/bl (in today’s money) by 2035. The agency sees growth in emerging- market demand being offset by vehicle fuel efficiency gains in the US and fuel switching to alternatives like natural gas.
But the IEA’s relatively sanguine scenario of future oil prices is contradicted by analyses published in two working papers written last year by researchers at the International Monetary Fund (IMF).
The first paper, by Jaromir Benes and colleagues, examined the interaction of rising demand and geological supply constraints, and warned that the price of oil could double to $200/bl (measured in 2012 dollars) by 2020.
In a second paper, Michael Kumhof and Dirk Muir model a range of scenarios for oil prices and their impact on global growth. In their relatively optimistic baseline scenario, which assumes that oil supply growth is constrained to one percentage point below the 1.8% average attained between 1981 and 2005, but that there is a high degree of substitutability of other energy sources for oil, the price of oil, nevertheless, rises (in real terms) by 100% by 2020 and by 200% after 20 years.
If it proved difficult to substitute for oil, or world oil supply were to decline by 2% yearly, the oil price would climb off the charts – by up to 800% after 20 years. The authors do not regard these sorts of price spikes as feasible – the economy would simply not withstand them.
The IEA’s record of price predictions over the past decade does not inspire a great deal of confidence: its ‘2004 Reference Scenario’ assumed the price of crude would stay close to $33/bl (in today’s money) to 2030.
While the upside and downside forces in the oil market seem to be fairly well balanced for now, there is always the possibility of an event that pushes them much higher or much lower – temporarily.
For the longer term, the relentless force of depletion means that the costs of oil production are on an upward trajectory as companies scour increasingly remote areas in their efforts to satisfy increasing thirst for the black liquid.