Crude is king when it comes to bull markets in the 21st century. The price of a barrel of oil in New York futures trading has climbed some 280%, as of last night’s close from January 1, 2002. As bull markets go, this one’s been extraordinarily profitable for those who’ve ridden the wave. This year alone, crude’s ascended by more than 30%, based on the near-$80-a-barrel mark set earlier this month. But every wave crashes, eventually, even one that’s driven by a potent supply/demand profile that drives the oil market.
Timing, of course, is everything when it comes to making predictions, and on that score we have no more insight than anyone else. But we do have eyes in our head, which informs our ever-cautious temperament when it comes to money.
Any analysis of where oil prices are headed necessarily starts with a survey of the geopolitical tension, which is also in a bull market. Front and center is the reality that Israel’s locked in a war with the Lebanon-based Hezbollah militia. A month ago it was hard to imagine how the Middle East could become more volatile, but the Israeli invasion of Lebanon has resolved that mystery. Not that there wasn’t already plenty of anxiety harassing the region and raising questions about the ramifications for oil. From Iran’s nuclear ambitions to the chaos that is Iraq, the Middle East had more than its share of worries. Unfortunately, the region’s recently descended down another notch into what is in the running to be its worst case of disorder and confusion in the modern era.
Suffice to say, the madness is deemed sufficient to warrant a fair amount of risk premium on a barrel of oil, perhaps as much as $40 by some estimates.
Human nature being what it is, it’s not impossible to imagine that that the situation in the Middle East could yet go from bad to worse in the coming weeks and months. We certainly don’t minimize that possibility. The United States, as we write, isn’t keen on imposing a ceasefire in the Israeli-Hezbollah fighting, and so it’s a safe bet that a ceasefire isn’t coming in the next few days. Forty-eight hours, we might add, can be an eternity these days in matters of Middle East politics.
The longer the war rolls on, the greater the potential that it could spin out of control and become a regional conflict involving Syria, Iran and other nations. In that case, the ceiling on oil’s price could shoot up dramatically in just one trading session. A hundred bucks a barrel, in other words, could be lurking just around the corner.
But oil prices could fall sharply too. Indeed, a review of the underlying fundamentals suggests as much. Inventories of crude oil in the OECD nations are the highest in 14 years, advises a research report issued yesterday by Bernstein Research (see graph below).
The report, penned by Ben Dell, also predicts a robust rise in global spare oil production capacity for 2006 through 2008, reversing last year’s dramatic drop, as the graph below from the report shows. Historically, the correlation of spare capacity to oil prices has been negative; that is, as spare capacity rises, oil prices tend to fall.
Obviously, that negative correlation has been suspended of late, although one might wonder if it’s due for a return engagement. Based on Bernstein’s analysis, oil prices are now more than $20 higher than the price/spare capacity correlation history implies. If spare capacity increases in the months and years ahead, as Bernstein forecasts, the current price of oil would look even more excessive.