Oil in for a crude awakening

This morning, the price of oil, West Texas Intermediate crude, is around $US86.00 a barrel. That's a hefty 10 per cent lower than where it was at the start of 2012 and 40 per cent down from the 2008 peak. It is no exaggeration to say that a crash in the oil price could be around the corner for good old-fashioned supply and demand reasons.

While no one is suggesting that the oil price will crash to $US10 a barrel – the level that The Economist magazine boldly predicted a little over a decade ago – a sharp fall in oil prices over the next couple of years is compelling.

The reasons are straightforward. There is about to be a boom in energy production capacity and output, which will in time massively increase supply. This, along with the growth in non-oil energy alternatives, will keep downward pressure on oil prices – plain and simple. It is also likely that the US will be self sufficient in energy within a couple of decades, a factor that will inevitably hit oil prices hard (The death of peak oil, February 29).

Before looking at the current oil price outlook, let's turn back the clock to 1999. The heads of oil giants Royal Dutch Shell and BP-Amoco outlined business plans that assumed a $US14-a-barrel oil price for up to the next five years. This was, as it happened, to be around where the spot price was at the time the plan was made.

In a feature article discussing the oil price outlook, The Economist was more pessimistic with a suggestion the price was headed for $10 a barrel. It mused, "US$10 might actually be too optimistic. We may be heading for US$5.” The story went on to say that "a ‘normal' market price might now be in the $US5-10 range. Factor in the current slow growth of the world economy and the normal price drops to the bottom of that range.”

These predictions were extraordinarily wrong, with the price trending to $US30 by 2003, $US60 in 2005 and 2006, skyrocketing above $US140 a barrel in 2008 before it settled in a broad $US80-100 range in the past few years.

The direction of the error may just be timing.

In the last few months, the oil price has settled around $US85 to $US90 a barrel even though the strengthening green shoots of economic recovery in the US and China are ending 2012 on a more positive note. The weak US dollar has also helped to keep the price of oil higher than it would otherwise be.

The oil price should be trending up, not sideways to down, in these circumstances. Indeed, The Economist magazine's error over a decade ago was a failure to anticipate the lift in demand from China but even this positive influence appears to be waning.

The reason for the oil price softness is slowly but surely being revealed. Oil and gas production is booming globally but particularly in the US to the point where just last month, the International Energy Agency projected that "extraordinary growth in oil and natural gas output in the United States will mean that … the United States becomes a net exporter of natural gas by 2020 and is almost self-sufficient in energy, in net terms, by 2035.”

Think of that scenario – the US becoming self sufficient in energy. The implications for non-US oil producers is huge. The disappearance of the world's biggest market can only have one implication for prices and that is down.

There are a couple of ways non-US producers may deal with this problem. To maximise profits and revenue in the short term they can crank up production before US self sufficiency comes into play. Or they could hold back production with the aim to keep a floor under prices, but further out, this would leave excessive reserves when demand tapers off. Either way, it spells a price decline.

That said, there is still a logical floor for oil prices - the cost of production. According to the EIA, the average cost of production is lowest in the Middle East at around $US17 a barrel, with a global average around $US25 a barrel. This suggests the low will be a little above that, barring a demand free-fall. In the US, the cost of production is in the mid $US30 range, all of which suggests a level as low as $US40 is possible.

Add to that the tepid growth phase of the global economy and price trends should be down.

It is prophetic, perhaps, to close on what The Economist was saying in 1999: "Nor is there much chance of prices rebounding… the Saudis may now do what once would have been unthinkable: throw open the taps. That, according to McKinsey, a management consultancy, would certainly herald an era of $5 oil.”