High Oil Prices – How Worried Should Investors Be?

Are you worrying about high oil prices that translate to higher prices at the pump because you, like myself drive a condo on wheels? Are you considering changes to your summer holiday so that it includes less driving?

With crude prices recently trading at over $40 US/bbl, the price of oil has approached levels seen during oil shocks of the past, including the early: 70s, 80s and 90s. Conspiracy theorists have had a field day, claiming that OPEC, led by the Saudis, has cut back on oil production to punish George W. Bush for meddling in the Middle East. Other analysts point to the boom in China and other emerging markets as the force behind rising demand for resources across the board. Still others are pointing to the rise in oil prices as evidence that a long-awaited peak in global oil production has arrived, with shocking increases in oil prices lurking around the corner.

Peak Oil Theory

The latter theory has been around a very long time and would be the only one of concern for the longer term effect on oil prices. Proponents of the “peak oil” theory have grown in the last few years and have published a number of books with ominous titles. They feel that the world could see radical increases in oil prices during the 1st 2 decades of the 21st century unless alternative sources of energy are developed. These proponents warn of a permanent oil shortage, beginning right now. In the next few years, they believe the world’s productive capacity of oil will reach its geological limit and fall behind increasing demand. These predictions lead to a scenario of gas prices in the US of $6 to $7 /gallon or higher later this decade, making today’s average price of $1.85 seem like a real bargain. Nor surprisingly, the consequences of such scenarios could be grim news for fin’l markets.

Running Out?

energy economists argue that the “peakists” have overstated the case for imminent oil shortages. Fear of running out of oil has always haunted this industry. Way back in the 1880s the head of Standard Oil Trust began to sell his shares in the company because oil engineers told him that America’s days as an oil producer were numbered. Projections of shortages often fail because of two main factors: The openings of territories to exploration by companies faced with ongoing demand to replaces existing reserves; and the impressive impact of new technologies for finding oil or getting it out of the ground more efficiently. I.e. The development of deep offshore oil fields in the 90s… this was inconceivable during the crisis of the 70s. There are many pessimists who feel that Persian Gulf countries overstate current reserves, yet there are many optimists that say reserves are underestimated in Russia, the Caspian Sea and the deepwater Gulf of Mexico & that a greater % of oil will be extracted from current projects.

Few energy experts doubt that a peak in oil output will eventually be reached and that the world will need to develop new sources of energy, but the debate is whether the shortage is imminent or whether it is more likely to be delayed much further into the future. Most agree that even if global oil demand increases by 20% over the next decade, led by demand from nations like China and India, that supplies will rise to meet that demand.

When to Worry?

This lack of agreement leaves us to have to follow oil prices to decide what will happen. Despite the hysterics about oil and gas prices among the media and politicians, we owe it to ourselves to consider the current price of oil within our current economic environment. Yes, the price of oil has recently traded close to record levels. However, if we look at the price of oil after adjusting for inflation, we are nowhere close to the peak prices recorded during other energy price spikes. For example, in the early 80s, the price rose to over $80/ bbl in today’s dollars. Likewise, the price of oil rose to nearly $55/bbl in today’s dollars ahead of the first Gulf War in 1990 (see chart). This is similar to the price of a loaf of break when compared to 25 years ago, much of the price is inflation related.

Another important perspective on how oil prices affect the economy is to consider not just ht level of prices but also the rate of changes. If prices rise slowly, we have time to adjust, thus no shock. But when prices rise rapidly (as they did during the 1973 embargo), the huge and sudden drain on purchasing power could trigger economic weakness.

Going Down?

can take comfort in OPEC curtailing production because its members are actually worried about the potential for a price crash when the seasonal demand for oils slows this fall. Whatever the long-term outlook, oil inventories have been on the rise in recent months. It is also well known that most OPEC countries lie about their production and produce much more than their allocations. History suggests that there is likely quite a bit of oil currently in reserves.

Oil is critical to the world economy and world fin’l markets. In fact, most investment strategists follow 3 signs: price of money, price of credit & price of oil. Currently, the price of money and the price of credit are well behaved and trends in the price of oil have not been as alarming as some media commentary would suggest.