The R Word and the Oil Markets –
A Perspective on the Debate.

By Bruce Bullock, Director of the Maguire Energy Institute at SMU Cox.

In recent weeks, we have seen significant turmoil in financial markets, housing markets, and credit markets. Many analysts indicate that the United States is either in a recession or near one. At the same time, short-term oil prices have trended downward on fears or reduced demand for oil in the U.S. as a result of reduced economic activity. In the news media, we see wild predictions on oil prices, some towards an overall continued upward direction and others towards a continued slide. What are some of the factors impacting these forecasts? Who is to be believed?

The Bulls argue that we are in a dip on the way up. At $89 per barrel, prices are up significantly from prices in the low $60s a year ago. The Bulls focus on a number of economic factors. The Federal Reserve continues to lower interest rates and push more liquidity into the financial system. OPEC continues to produce at near capacity and is hinting at a potential production cut in March. Political turmoil continues in the Middle East. West Africa's political environment is uncertain at best, especially in Nigeria and Congo. Refining capacity remains constrained. Major oil companies are reporting year-end results yet are showing little if any increase in overall production. Recession fears are confined to the U.S. with demand in China and India continuing to grow.

The Bears focus mainly on the demand side and the possibility of a U.S. recession. They point to a slowing of demand increases and point out that historically demand has declined during periods of low economic growth such as the Asian financial crisis and the recession of the early 90s. They see U.S. consumers with little available disposable income and maxed out credit cards. Thus, they argue the U.S. consumer must drive less and buy less.

However, much of this debate lacks the longer-term perspective that is more relevant than day-to-day swings. Day-to-day, week-to-week and even month-to-month, the oil markets react largely to sentiment and not to the forces of supply and demand. However, longer-term prices are dictated by supply and demand. In this debate, price volatility is being confused with overall price direction, both on the upside and the downside. Most investor forecasts are predicting an average oil price in the mid 70s for 2008. While that's a drop from the near $100 per barrel price, it's about a 20% increase over the average 2007 price. Longer-term, most forecasts show a increase in demand but a smaller increase in supply – which points to higher prices. However, fears of sustained prices over $100 per barrel on the upside or $50 per barrel on the downside are probably exaggerated – we will always see peaks and valleys in commodity prices even though the general trend is upward.