How Low Can Oil Go?

A drop of $13 a barrel since early August is sweet music to the U.S. economy. The question is how long OPEC will stand pat

Oil prices have been dropping like a stone. Their decline from nosebleed heights since early August has been stunning -- a plunge of $13 a barrel, to below $64 on Sept. 13 on the New York Mercantile Exchange. Behind the fall is a dramatic narrowing of the ``fear premium'' buyers were paying for oil, as summer worries over supply disruptions from hurricanes and Mideast turmoil have eased. All of a sudden, cheaper oil is giving consumers more spending money and easing inflation.

So how much lower can oil prices go? That's the big question everywhere from the Arabian oil sheikdoms to the boardrooms of airlines and automakers. Are we seeing a temporary softening, or have the fundamentals of the oil market started to swing around, bringing an end to the seven-year run-up of prices? If so, what's the impact on the economy?

One thing is certain: Crude oil is a highly volatile commodity. Prices could swing wildly in either direction for myriad reasons -- war, weather, the whims of OPEC, you name it. For now, the markets are indicating that high oil prices will stick around for awhile. Futures traders on NYMEX are pricing oil at around $70 a barrel this winter and through early 2008 and then back to the mid-$60s by the end of the decade.

Some, though, think prices have more room to fall now. Morgan Stanley (MS ) economists Eric Chaney and Richard Berner argue that conservation and increased supplies mean prices probably peaked this summer, and they're forecasting $60 per barrel at the end of 2007 and $50 by the end of 2008. Adam Sieminski of Deutsche Bank (DB ) adds that oil inventories are about as high as they have been anytime in the past five years and that increasing spare production capacity ``points to oil in the $50-per-barrel range.'' Don Casturo, head of oil trading at Goldman, Sachs & Co. in London, says oil could fall an additional 5% to 10% before hitting bottom.

Of course, all the experts concede that their projections could be far off the mark. The Morgan Stanley team offers a range of scenarios all the way from a ``hot'' $103 in 2007 to ``super cool'' -- $43 in 2007 and $22 in 2008. The hot scenario assumes a big disruption in the supply of oil from Iran, while the supercool one would result from economic slowdowns in the U.S. and China coupled with a rapid expansion of heavy crude refining capacity.


For now, though, the trend is clearly down, and that's nothing but good news for the U.S. economy. Motorists save more than $40 million a day from each dime decrease in the price of gasoline. Easing prices are helping to offset the chilling effect of the housing slowdown and solidify the likelihood that the U.S. Federal Reserve will keep further rate increases on hold through the fall. The Fed was worried that high energy prices would feed inflation by raising business costs. Now that's looking like less of a problem.

Longer term, it would take a much more significant decrease in the price of oil to make a big difference to the economy. A $10-a-barrel decrease in the price of crude tends to boost the gross domestic product by about 0.2% in the first year, according to economic forecaster Global Insight Inc. After three years, the economy is only about 0.5% bigger than it would have been with the higher oil price, the group estimates.


Still, given the punishing run-up in prices in recent years, any downward trend is a welcome development. The main beneficiaries of cheaper oil are motorists, airlines, truckers, and other big petroleum-product users such as farmers and chemical companies. For the auto industry, the decline has been too brief to make much difference. Automakers were caught flat-footed by $3 gasoline, and they realize prices could easily shoot back up, so they're not going to change plans because of the recent drop, says Standard & Poor's (MHP ) equity analyst Efraim Levy. As for drivers, he says, gasoline would have to stay cheaper for a long time before they would warm up to gas-guzzling SUVs and pickups again.

Whether prices go much lower depends a lot on what OPEC does in the coming months. Its power to force up prices by withholding production has been largely irrelevant in recent years. That's because demand was so strong that OPEC members were given the O.K. to produce as much oil as they could, regardless of quotas. Now, though, some slack is appearing in the system.

Pushed and pulled by their own conflicting views of the direction of prices, OPEC oil ministers met on Sept. 11 in Vienna to puzzle out a plan. They agreed that the market was ``oversupplied,'' which ordinarily is code for, ``we're cutting production.'' But the cartel would be uncomfortable with prices of $70 per barrel or more, worrying that stratospheric prices will cause a backlash among consuming nations and stimulate non-OPEC production, cutting into its market share. So with time to run in the hurricane season and the Iran-U.S. standoff simmering, OPEC isn't cutting back yet.

If prices continue to plunge, though, OPEC won't stand by forever. Top oil analysts think it is readying a plan of action. Most believe that prices much below $60 per barrel would trigger an announcement of output cuts to restore what OPEC thinks is a sensible balance between supply and demand. To minimize political heat from an abrupt, public production cut, the Saudis have already quietly reduced heavy crude sales by about 300,000 barrels per day by overpricing the less desirable grades. Saad Rahim of PFC Energy in Washington thinks the Saudis are mulling another cut of about 1 million barrels per day next year. The Saudis, now producing around 9 million barrels daily, would likely get help in curbing production from Kuwait and the United Arab Emirates. These are all rich countries whose budgets could weather some loss in revenue.


For OPEC, the tricky thing will be if ministers conclude that bigger cuts are needed. Then, countries such as Iran and Venezuela, which are currently pumping less than their quotas because of technical problems, may be asked to cut back still more -- which they may well be reluctant to do. On the other hand, continuing to overproduce would be worse. Ministers remember the precarious financial situation they got into after prices tumbled into the teens in the late 1990s. ``I think OPEC will try to defend [$60 per barrel] and will likely be successful, and then run into trouble again when we have a recession in the U.S. and a GDP slowdown in China,'' says Deutsche Bank's Sieminski. Yes, $60 oil isn't exactly cheap, but it sure beats $80.

By Stanley Reed and Peter Coy

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