Vol. 11 - No. 3




Oil Overreaction?


EDC Vice-President and Chief Economist

High oil prices seem to have become a fact of life. Many have grudgingly advised that we had better get used to it, and move on. Analysis repeatedly cites insatiable emerging market demand and limited accessible supplies as key factors. Itís tough, if not impossible to refute these arguments, but similar reasoning in the early 1970s led to wacky forecasts. Are todayís triple-digit projections reasonable?

A strange fact of modern analysis is that familiarity can breed complacency. If a price, or any other data point persists for awhile, sometimes months, weeks, or even days, it seems to be quickly embraced as the new reality, one of the family. Until the next shift, that is. A quick update of the analysis, and we have yet another new reality. Over the past 20 years or more, this has been repeated, both on upside and downside movements for a variety of economic indicators.

Crude oil prices have shown that they can drift from fundamentals for awhile and convince even seasoned, specialized analysts that the world has indeed changed, redefining fundamental levels. Witness the price plunge to $10 per barrel in late 1998, when respected analysts pondered the industryís future when prices reached $5 per barrel. Laughable now, but serious chatter then. Ten years later it was the polar opposite: predictions of $200-plus oil and the end of globalisation.

What can we make of this? History shows that out-of-range prices actually set in motion their own undoing. Simple demand and supply fundamentals kick in, moving prices back toward reality. If prices are too low, overconsumption creates supply pressures, driving prices up. High prices undermine the economy, slowing aggregate demand, and prices generally follow. Are these forces currently at work?

Apparently so. Recent triple-digit crude prices occurred in a context of weak world demand, low confidence and inventories at 20-year highs. Persistence and a pervasive belief in constrained long-run fundamentals seemed to convince markets that pricing was reasonable, in spite of the soft near-term conditions. In contrast, analysts are now acknowledging that high prices have undermined economic momentum, and in response are recoiling.

The International Energy Agency agrees. Its monthly report, released last week, describes slower-than-expected growth of world oil demand, citing the dual and related effects of high crude prices and weakened global growth. True, prices were pushed higher by Mideast political turmoil, which temporarily constrained supplies. But prices had been riding higher in advance of the turmoil.

The nascent price plunge that has taken WTI crude to the $80 range suggests an overdue reality-check. Excessive stranded liquidity in the world market likely fed price increases for some time, creating a sustained speculation that suggested to market watchers a new fundamental level. The current disruption is a challenge to that notion. It is possible that, while the broader market is likely overreacting to various fears, oil markets are being jolted back to more reasonable metrics.

The bottom line? Now is a noisy time for markets, and it is difficult for any analyst to sort out or define what is reasonable. But when the present decibel count drops, donít be surprised if crude oil prices settle at new, lower levels.

The views expressed here are those of the author, and not necessarily of Export Development Canada.


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