Why oil is headed for $100 a barrel -- or lower

Jay Bryan, Canwest News Service Published: Friday, August 15, 2008

Leon Neal/AFP/Getty

Shell sign: even some in the oil industry have been a little unnerved by oil's price spike.

In the 11 months ending early last month, the price of oil nearly doubled, reaching more than US$147 a barrel. Even some in the oil industry were a little unnerved by this trend, since it raised the eventual prospect of a severe global economic slump.

But there would be no help for consumers or businesses hurt by high oil prices, some analysts argued. Even as rich countries cut consumption modestly, fast-growing new industrial powers like China would use much more oil, squeezing limited global supplies and leading to US$200 oil within the next few years.

Maybe, but then again, maybe not.

Instead, the laws of supply and demand seem to be working -- as a number of other forecasters had predicted. Oil consumption has fallen enough to bring prices sharply lower. Oil is currently around US$113 a barrel, down more than 20% from its July peak.

There's no guarantee this decline will continue, since oil's price is driven by such a complex mix of factors -- including shadowy, but massive flows of speculative money -- that forecasting can be "a mug's game," in the opinion of Aron Gampel, deputy chief economist at the Bank of Nova Scotia.

Nevertheless, there are many economists who have long believed that prices well above US$100 a barrel were far higher than could be sustained by global supply and demand. It seems they had a point.

Forecasters at the National Bank of Canada expect oil to head toward an equilibrium somewhere between US$75 and US$80 a barrel over the coming year, a level that should be sustainable over the long run, says assistant chief economist Stefane Marion.

A new forecast published this week by the Economist Intelligence Unit predicts that oil will fall as low as US$85 late next year, averaging US$91 in 2009. This report foresees a moderate rise in following years.

At the Toronto-Dominion Bank, a June forecast was that oil ought to settle near US$100 next year.

A common feature of these relatively optimistic predictions is that they assumed consumers and industries would do the logical thing: use less fuel as it became more expensive.

Now we all know that evidence of such logic isn't always obvious. Just look at the number of people who kept buying large, energy-inefficient cars and homes over the past few years, even though it was already becoming more costly to buy gas and heating oil.

But there seems to be a tipping point where people who are in denial finally face the music. Looking back, it appears that this point arrived this year in late spring or early summer, as the price of oil shot past US$120.

Even before this, growth in oil consumption was tapering off, but in recent months, the will to economize went into overdrive, with oil consumption falling sharply in the U.S. and most other rich countries.

It's true that demand is still rising in fast-growing economies like those of China and India. But fuel subsidies that shielded consumers and businesses in those countries from the true cost of their behaviour have become so costly that they are being phased out. It's not unreasonable to believe that these countries might respond over the coming months by tapering off their growth in oil consumption.

If this happens, it's possible that oil will, indeed, drop below US$100 and stay there, at least for a while. This would be good for the global economy in some important ways, Marion points out.

First, it would reverse the drag on global economic growth brought by this year's skyrocketing cost of oil.

That would be particularly welcome in the U.S., where consumers are already shell-shocked by a meltdown in housing prices and a rise in unemployment. And any relief of economic pressure in the U.S. can only help the manufacturers of Ontario and Quebec, now suffering from the slump in their key market.

Second, lower oil prices would slash the inflationary pressure that's preventing central banks from stimulating growth in slowing economies all over the industrialized world. If oil starts dampening inflation instead of fuelling it, interest rates can come down as much as necessary.