Will Oil Stay Soft?

With expected disruptions so far absent and U.S. consumers cutting down on consumption, some experts think lower prices will stick

For the last few years, being an OPEC oil minister has been one of the world's easiest jobs. With prices rising and the money rolling in, the ministers might as well have spent their time at the beach. Now, as they gathered on Sept. 11 in the cozy hotels of Vienna for one of their frequent conferences, OPEC oil ministers had something to worry about. After hitting $77 per barrel earlier in the summer, prices have fallen sharply. That drop continued on Sept. 11, when prices fell by another $1.19 per barrel to $65.06.

A temporary softening? Maybe not. Although many oil experts insist high oil prices are here to stay, some respected analysts are making a persuasive case as they call the end of the eight year bull market that drove prices up roughly fivefold since 1998. "The big picture is that the fundamentals are shifting now," says Eric Chaney, Chief European Economist of Morgan Stanley, "We were very close to $80 in July, and that was the peak."

Chaney thinks high oil prices are at last having an impact on consumption in the U.S. and Europe, the capital intensive economies, as drivers leave their gas guzzlers in their garage and companies switch to more energy efficient operations. "In the U.S., energy consumption per unit of real GDP has declined faster in 2005 and 2006 than in previous years, a pattern similar to the post 1979-80 oil price shock," he writes in a recent study with U.S. counterpart Richard Berner.


  The big drop in oil consumption after that earlier oil shock wound up inflicting deep pain on OPEC nations as oil prices fell to the $10 per barrel range. Chaney and Berner forecast that prices will ease to around $60 per barrel by the end of next year and to $50 by the end of 2008. They say that if the U.S. and China, where oil consumption is growing fast, experienced sharp economic downturns, prices could fall to the $20 per barrel range.

Of course, they also concede that supply disruptions could make a mockery of such forecasts, taking oil over $100 per barrel if Iranian exports are suspended. Indeed, most oil specialists still think that high prices will be with us for the foreseeable future thanks to strong growth in consumption across the developing world, limited increases in new supply, and continued political tensions in the Middle East and elsewhere.

Some analysts also say OPEC has far more power in drawing a floor under prices than in heading off upward spikes. "The bears are forgetting the power of OPEC to control markets on the downside," says Paul Horsnell, an analyst at Barclays Capital in London. He thinks OPEC will defend prices of around $55 per barrel.


  While OPEC didn't announce production cuts on Sept. 11, it "is already penciling-in cuts" for next year, says Saad Rahim, an analyst at PFC Energy in Washington. Rahim says OPEC may already have unofficially trimmed around 500,000 barrels per day in production.

"There's no need to cut now, but if there's a deterioration in the global economy and prices fall quickly, then we will need a meeting before December [when the next OPEC meeting is scheduled]," said Algeria's Oil Minister, Chakib Khalil, in a Reuters report. OPEC, analysts say, wants to give the situation more time to see if prices rise in the fourth quarter, as they usually do when demand for heating oil kicks in.

No one is arguing that gradual shifts in demand are directly responsible for the rapid price drops of recent weeks. In mid-summer, oil prices were sent skyward by several anticipated events—the war in Lebanon, worry over the confrontation between Iran and the U.S., the loss of production from Prudhoe Bay in Alaska, and the approach of the hurricane season in the U.S.

Now prices are falling because the most dire predictions didn't pan out, and some fears proved exaggerated. The Mideast War, with all its problems, didn't affect oil supplies. Fewer hurricanes have appeared than expected, and none has so far ventured into the Gulf of Mexico, where the heart of the U.S. oil industry lies. Full production at Prudhoe Bay could be restored as early as next month. And the standoff with Iran, while still dangerous, looks unlikely to interrupt oil flows soon.


  Traders, who had taken positions in hopes of profiting from hurricane disruptions, are now hastily reversing them, and every bit of news seems to produce a volatile reaction. "The market is very nervous," says Goran Trapp, managing director in oil trading at Morgan Stanley in London.

One reason for such nervousness could be a growing realization that the fundamentals may not justify ever-higher prices. With OPEC pumping strongly, inventories of crude and products have built up, so that they're at the high end of their five year averages, according to Adam Sieminski, an analyst at DeutscheBank in New York.

Sieminski also anticipates a rise in OPEC spare capacity, the amount of spare oil production that could quickly be put back into the market, to around 3 million barrels per day in 2007, compared to roughly half that in 2005. That should further ease price pressure. Sieminski, whose forecasts have been bearish in recent years, thinks prices will average $62 per barrel for U.S. light, sweet crude in 2007.

Such levels would be higher than the $56.70 average for 2005 but less than the $67.10 average for the first half of 2006. That won't be a huge break for consumers and industry, but it would be a relief.

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