BMO Financial Group - Outlook 2005(1.1Mb pdf File) - Boardwalk REIT

30
Oil Price Outlook
Supply risk roils oil prices
Oil prices have spiked above the US$50/barrel
mark for US benchmark West Texas
Intermediate (WTI). In current dollar terms, this
is higher than they have ever been.
High oil prices partially reflect rapid growth in
global consumption, particularly in China and
other parts of Asia. Despite a number of
disruptions to supply this year, global
production of oil has more than kept pace with
demand, allowing for a rebuild of inventories
from very low levels at the beginning of the
year. Strong supply growth primarily reflects
continued robust gains in Russia and a
substantial ramping up of production by OPEC.
However, in order to quickly raise output,
OPEC has had to reduce its margin of excess
capacity. This narrowing of OPEC’s cushion to
deal with supply shocks – at a time when
geopolitical and weather-related events have
made such a cushion so important – has
unsettled the global oil market and contributed
to the large risk premium on prices. Thus,
while production is currently adequate to meet
demand and rebuild inventories, high oil prices
reflect the market’s concern about geopolitical
risks to available supply and OPEC’s narrow
margin to deal with risks that actually
materialize.
Looking ahead, some elements of supply risk
are likely to diminish during the next year.
Some have already fallen off the radar screen
and others are likely to follow. Further, markets
do respond to high prices. Both supply and
consumption adjust to changing prices,
although in the oil market this sometimes takes
quite a while. Nevertheless, high prices are
stimulating investment in new oil producing
capacity in OPEC and elsewhere. And, if
sustained, high prices would lead households
and businesses to take steps to reduce
consumption of oil-based products. Newly
emerging risks, such as the possibility of labour
strikes and increasing rebel insurgency in
Nigeria, could push prices even higher during
the next few months, particularly with the
approach of the winter heating season.
However, over the medium- to longer-term, oil
prices are not likely to be sustained at current
levels.
This note examines current oil market
conditions in an historical context and
assesses the likely direction of factors which
have forced prices well above normal.
Oil prices spike well above normal range
Oil prices are at record-high levels in terms of
current dollars. However, adjusted for inflation,
they are well below those prevailing in 1980,
following the revolution in Iran. For instance,
using constant 2004 dollars, oil prices in early
1980 were over US$80/barrel. However,
adjustments on both the demand and supply
sides of the market during the ensuing few
years led to a sharp reduction in oil prices. By
1986, the West Texas Intermediate price fell
back into its ‘normal’ range.
In assessing the equilibrium price for oil and a
normal trading range around that price, oil
markets for 1986-2003 interval were examined.
During that period, the real price of WTI, in
constant 2004 dollars, averaged US$25/barrel.
Its ‘normal’ range, as measured by two
standard deviations on either side of the
average, was US$15-35/barrel during that
period. There have been a few times when
prices moved outside that normal range. At the
time of the first Gulf War at the beginning of the
1990s, oil prices temporarily spiked above
US$40/barrel (in constant 2004 dollars). In
1998, following an up-shift in OPEC production,
which just preceded the economic and financial
crisis in Asia, oil prices fell to around US$10/
barrel. And, currently, they are well above their
normal range and are likely to stay above
longer than they did in the early 1990s.