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Ten Times Ten: What Future for Oil Prices?

May 6, 2008
Ten dollars a barrel. That was the price oil fell to in 1998, just 10 years ago. In 2008, oil has been nine times higher, around $90 a barrel, and briefly skirted with $100 a barrel just a few weeks ago. What was unimaginable 10 years ago has happened. How has it happened, and what does it tell us about the future?

Financial crisis swept Asia and other parts of the world in 1998, bringing an end - as it turned out only temporarily - to a period of great economic expansion.

Oil demand dropped precipitously in what had been the world's most vibrant economic regions. The result was $10 oil. When this happened in 1998 it set off an unprecedented period of consolidation within the oil industry to cope with what was expected to be a long period of low oil prices.

Companies downsized; people left the industry; services and capacity to develop new oil fields shrunk. Investment plans were guided by an expectation of $20 oil - $30 was viewed as unrealistic and, even if it did happen, unsustainable. The world was awash in cheap oil - or so it seemed then.

Slowly, perceptions and market conditions changed. After hitting $30 in 2000, oil prices dropped during the recession of 2001. Then in 2003, the global economy took off on a five-year run of extraordinary expansion.

China's boom led to a shortfall of electricity generation - a deficit offset by burning more oil. In 2004 global oil demand jumped 3 million barrels per day (mbd) - the biggest rise in several decades. As oil prices rose, the economic boom spread to the Middle East, Russia and other major exporters.

Exceptional demand growth sparked the oil price rise, but a series of supply disruptions in Iraq, Venezuela, Nigeria and the U.S. Gulf of Mexico - what Cambridge Energy Research Associates calls the "aggregate disruption" - created an even tighter balance between demand and supply.

Oil prices also led to increasing demand for the people and equipment needed to find and develop new oil reserves. Suddenly an industry that had been shrinking couldn't get rigs and drilling ships and had trouble finding enough skilled personnel.

The cost of developing a new oil field almost doubled between 2004 and 2007. Oil is priced in dollars, and a weakening dollar also pushed oil prices higher - particularly evident in oil's steep ascent with the start of the credit crisis in August, from around $70 a barrel to $90-$100.

In the late 1990s, the idea of $100 oil - or even $80 oil - would have seemed preposterous. Prices for long dated oil futures contracts hovered in the teens and low $20s.

Today, $20 seems quaint, if not ridiculous. To be sure, many of the political and manpower difficulties currently constraining supply growth will not disappear overnight. Also, the desire for higher living standards in China, India, the Middle East, Russia and elsewhere will remain as strong as it was in the United States, Europe and Japan in the years after World War II. Higher living standards mean longer life expectancy, lower infant mortality - and higher energy consumption.

But just when the future seems pre-ordained in the oil market, the unexpected can unfold. It did in the decade following 1998, just as it had several times since 1970. This year will be the stiffest test yet for the new oil price era that dawned several years ago. Economic growth is the single most important determinant of oil demand growth - and the course of the global economy in 2008 is fraught with worries.

Financial innovation and the globalization of securities helped to lubricate the wheels of the world's economy during an extraordinary expansion, but they also created risks that were not - and still are not - fully understood. The U.S. subprime mortgage meltdown is the most current example of misunderstood risk, but is it the last?

Oil prices can remain high during an economic downturn. In the early 1980s, which was the weakest period of economic growth since the Great Depression, oil prices were at very high levels - topping out in April of 1980 at $99.04 per barrel in today's dollars.

The Iran-Iraq war and the attendant loss of supply was the prime driver for high prices. But eventually, the economy and demand catch up - the 1986 oil price collapse was due to a multi-year decline in oil demand.

This year, just as economic worries began to mount, oil prices touched that new record high of $100 per barrel. Although oil prices are only one factor that affects the global economy, they are a significant one. Because the world economy took $70 per barrel in stride does not mean that it would easily absorb $100.

If prices did hover in the mid-90s and a higher range for six months or more, they would begin to have a similar impact on the global economy as the high prices of the early 1980s.

Oil prices are fluctuating in line with the latest economic signals - up and down. This will continue until a clearer view of economic growth materializes. It is difficult to see the boom years of 2003-07 continuing without interruption.

At the same time, barring a very sharp economic downturn, it is likely that oil prices will avoid a collapse. Indeed, a price above $80, on average, appears to be the base case for 2008. But global economic uncertainty is now higher than anytime since the current boom began. Just when the future of the oil market seems clear, that is the time to question it.
About the Author
Daniel Yergin, chairman of CERA, received the Pulitzer Prize for "The Prize: The Epic Quest for Oil, Money & Power" and the United States Energy Award for lifelong achievements in energy and the promotion of international understanding. Vist CERA .
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