Oil will fall below $100 a barrel

Predicting oil prices is a mug’s game. Yet I will stick my neck out and forecast that oil will fall from today’s $135/barrel to under $100/barrel by the end of 2008.

Usually, when prices go up, demand falls. But world demand for oil has kept rising for five years even though the price of oil has quadrupled in this period. Why should the trend not continue?

The short answer is that demand has indeed fallen in countries where consumers have borne the full brunt of higher prices. In the US, petrol has crossed $4/gallon, so consumption is falling. Demand for energy-guzzling vehicles has evaporated.

Oil demand has stayed high in Asia, where demand has been rising fastest. Why? Because most Asian governments have rigid price controls on petroleum products. Although global prices have skyrocketed, domestic prices have risen very little, thanks to implicit government subsidies of trillions of dollars.

These subsidies have spared the consumer pain. But in the absence of any pain, consumers have, very rationally, kept consuming. The International Energy Authority estimated in January 2008 that consumption in China, India and the Middle East would rise by 1.2 million barrels/day, even as it fell in rich OECD countries by 0.44 million b/day. This was partly because of faster growth of Asian nations, and partly because of price controls.

The good news is that Asian governments have decided to bite the bullet. China, the fastest-growing consumer in the world, is raising the prices of petrol and diesel by 18% and of jet fuel by 25%. Oil producers are typically reluctant to raise domestic prices, but two of them – Malaysia and Indonesia – just have. Malaysia has increased prices by 41%, while Indonesia has raised the price of petrol by 33%, and of diesel and kerosene by 25%.

Pakistan has announced that consumer prices will be raised rapidly from July onward so that subsidies for oil – which cost $2.4 billion last year – will be phased out completely by the end of 2008. Bangladesh’s oil subsidy is projected to hit an unsustainable $2.5 billion, so it is only a matter of time till the government raises prices.

India has made petrol costlier by Rs 5/litre and diesel by Rs 3/litre. These are timid, insufficient increases. Yet they should encourage conservation in coming months.

In sum, many big Asian consumers, who earlier kept demand booming through price controls, are finally changing course. That should cool demand in the second half of 2008.

What about supply? Saudi Arabia has started pumping an additional 0.3 mb/day from its new Khursaniyah field, and this should rise to 0.5 mb/day next year. Brazil hopes to expand production by 0.54 mb/day in 2008. Azerbaijan, Russia, Kazakhstan and Canada will also increase production.

These increases will largely be offset by declining production from several old fields – the North Sea, Alaska and Mexico. Even so, total global production should pick up in the second half of 2008, just as higher Asian consumer prices begin to slow consumption.

Saudi Arabia has long argued that increasing Opec’s production is pointless because the additional production would be of sour, heavy crude oil, for which the world lacks refining capacity. Many old refineries are designed to refine light, low-sulphur crude, whose production has been declining fast.

The good news here is that Reliance will soon be commissioning its new Jamnagar refinery which can process 28 million tonnes/year of the heaviest, sourest crudes. Refiners in other countries have also been increasing their ability to process low-grade crudes. Production at some new fields — like Saudi Arabia’s Khursaniyah — will be of light oil. This improving match between production and refining capacity should help cool prices.

Hopefully, Reliance Industries will also start producing gas from its giant Krishna-Godavari field in the second half of 2008, though the dispute with Anil Ambani may cause delays. This gas will substitute oil in fertilizer and power production, and increased gas-based electricity should reduce the use of diesel gensets.

Finally, ethanol production is rising. US production of corn-based ethanol is projected to rise from 0.42 mb/day in 2007 to 0.58 mb/day this year and 0.64 mb/day in 2009. Brazil’s production is expected to cross 0.35 mb/day. So, ethanol production is heading for a million barrels/day, reducing petrol demand correspondingly. Corn-based ethanol has been criticized for raising food prices, but it also dampens petrol prices.

For these reasons, i predict a modest rise in the production of and modest cooling of the demand for oil in the second half of 2008. That should suffice to bring the price down to $100/barrel. That is not exactly low. And it may go up again if the world economy grows strongly in 2009. But let us be thankful for any decline, even a temporary one.

My prediction could be wrong for several reasons – a US/Israeli attack on Iran, terrorist attacks on US oil installations, hurricanes in the Gulf of Mexico that destroy oil platforms. But let me not take refuge in ifs and buts. Let me stick my neck out and shout, “Oil at $100/barrel.”

What do you think?