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Business News/ Opinion / Online-views/  Oil Prices: Are we at a multi-decade bottom?
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Oil Prices: Are we at a multi-decade bottom?

Oil Prices: Are we at a multi-decade bottom?

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Oil has been one of the predominant stories for 2008. Characterizing the first half with its meteoric rise and capturing the second with a spectacular free fall, market chatter has swung from talk of $150 per barrel of crude to $35 per barrel in the span of a few months.

In the first half of 2008, demand for India and China was forecast to grow by around 10%. The high estimates argued that these countries would exhibit price inelasticity in their blistering path of growth, leading to fears of spare capacity exhaustion. Spare capacity as a percentage of demand has been coming off its peak of 14% in 1987 to an anaemic 3% in 2007. Hoarding by select nations added to the general level of panic, causing markets to bid oil contracts higher.

Through the summer the US saw a decline in demand—highway miles driven fell for the first time in 29 years, toll booth receipts dropped and several airlines grounded fleets. With the biggest consumer weaning off its addiction, oil started faltering. The final blow was dealt with worse-than-expected numbers coming out of China. While part of the price decline was funds flowing out of the commodity spectrum and the US dollar strengthening in a recessionary environment—in line with prior recessions—the crux of the matter is a fixation with the near-term demand.

Also Read Rajeshree Varangaonkar and Bharat Indurkar’s earlier columns

In earlier recessions, developed nations would largely contribute to the growth in oil demand at the cusp of a recovery. However, over time, developed nations have lost share to emerging nations and hence any recovery in oil demand will now be led by these countries.

Estimates assume acceleration in demand growth in the second half of 2009. That might prove overly optimistic, with China’s economic growth undoubtedly set to slow further.

China’s reliance on exports and any prosperity thereof feeds into oil consumption.

Exports to developed countries have dramatically slowed and are hardly a self-starter in light of the severe downturns in these countries. While internal domestic growth could be a driver, we have severe doubts about China’s announced fiscal pump-priming.

Incremental demand was also registered from West Asia. With large infrastructure and development projects being rolled out, these cash-rich nations were once touted as self-sustaining and hence consumption-based economies. But as this levered story came unhinged, any incremental demand in oil from these nations is now suspect.

While in the near term the pull back in consumption is more than certain, we believe this will lead to an overcorrection in the price of oil.

The Organization of Petroleum Exporting Countries (Opec) faces one of the largest drops in global oil demand since the 1980s and will aggressively cut production. As demand overcorrects, so will supply.

A pull back in the price of oil will also put new projects on hold as it is no longer as profitable to spend capital in generating a commodity that can’t seem to bottom.

New expensive upstream projects such as oil sands and deep-water exploration will likely be delayed, thereby postponing any incremental supply additions.

Turning to existing supply, the picture is bleak. Mature oil fields are seeing accelerating decline rates, and outside of Opec, the supply is characterized mainly by mature fields. New discoveries are yielding much smaller fields, not to mention some fields trapped in geopolitical strife.

All this will eventually contribute in setting a floor to the price of oil. Additionally, China has pledged to build strategic reserves to service 180 days, demand over the next decade. As oil gets cheaper, nations will strengthen their strategic reserves, bringing natural buyers to the market.

The world will be weaned off oil only in the face of a major technological shift towards, say, battery cars or biofuels, or an increase in supply. However, the former will take a long time to become mainstream and the latter is highly unlikely.

Although oil prices have plummeted, the prospect of an economic recovery at some point in the future isn’t unreasonable. Neither is it unreasonable to consider the pressures of rising population on a shrinking natural resource.

As oil pulls back, we are likely sitting on a multi-decade bottom.

Rajeshree Varangaonkar and Bharat Indurkar have day jobs with US-based hedge funds. They write every other Thursday. Send your comments to globalbeat@livemint.com

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Published: 20 Nov 2008, 10:56 PM IST
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