How High Will Global Oil Prices Rise?

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Frederic J. Brown / AFP / Getty Images

Prices posted at a gas station where the fuel is selling for over five dollars a gallon on March 16, 2012 in downtown Los Angeles, California.

If you’re watching global oil markets and getting a sickening feeling in your stomach, you’re in good company. Oil prices have spiked precipitously in recent weeks, with the U.S. benchmark price at over $107 and Brent rising to $125. Those increases are already being felt at the pump. Gas prices in the U.S. are creeping towards a wallet-busting $4 a gallon. How much higher will oil prices go?

It is a critical question. Just like in 2011, when hopes of an economic rebound were squelched, in part, by rising energy costs, high oil prices could again dampen a global economy that looks more promising but is still struggling to climb out of the Great Recession. With consumers paying more to drive to work each morning, they have less money left over to buy TV sets or take vacations, curtailing global consumer spending and dragging down growth. Goldman Sachs figures that a persistent 10% increase in oil prices shaves two-tenths of a percentage point off growth over one year. The European Central Bank a few days ago lowered its growth forecast for the euro zone, to a possible small contraction in 2012, and at the same time hiked its expectations for inflation, due in part to rising oil prices. Even robust emerging markets would feel the pinch. By adding to inflationary pressures, policymakers could be forced to hike interest rates and reduce growth rates. Here’s what HSBC economist Frederic Neumann said on the impact of lofty oil prices on Asia in a recent report:

Oil drifting higher poses two seemingly contradictory challenges for Asia. First, it may knock down export growth to Western markets, which are far more sensitive, at least in the current environment, to swings in the price of crude. Second, it will – not now, but ultimately – push up Asian inflation. This isn’t simply because of energy costs. The problem is much broader: across the region, food prices tend to rise with a lag in response to oil. And food matters hugely for regional inflation. We need crude to come down.

But will oil markets cooperate? Well, that depends on two key questions.

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First, will we see a sharp disruption in oil supplies? Part of the spike in crude prices has been a reaction to growing tensions between the West and Iran, and the possibility that the conflict might escalate and cause a sudden curtailment of supply. Iran is one of the world’s major oil exporters, and if its crude suddenly stopped flowing, we could see a very destabilizing surge in global prices. Research firm Capital Economics  figures that in the event of an all-out war that closes the Strait of Hormuz, through which 35% of the world’s seaborne oil is shipped, crude prices could double. Merely jitters about a supply disruption, Capital estimates, are probably responsible for about $10 of the recent increase in Brent prices.

Commodities analyst extraordinaire Soozhana Choi at Deutsche Bank offers an even more alarming view of the supply situation. She says that Iran is only one of a myriad of potential geopolitical threats to supply, from Libya to South Sudan, that will keep oil markets nervous, and potentially, prices high. A combination of events could add up to a big problem because, Choi says, OPEC (read: Saudi Arabia) might not be able to boost production enough to cover losses elsewhere. Here’s Choi, from a February report:

The world faces oil supply risks from a multitude of sources, not only in the Middle East but also in Africa. In our view, not since the late 1970s/early 1980s has there been such a serious threat to oil supply…OPEC spare capacity is sufficient to offset the loss of Iranian exports or a combination of smaller losses but not the totality of the potential disruptions, though we acknowledge that this is a low probability.

Choi studied historical examples of how supply disruptions impacted crude prices and came up with a rough peak of Brent at $150 a barrel.

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The second big question facing oil markets is: What will happen to the global economic recovery? Part of the recent price increase has been caused by optimism over a stronger world economy, especially an encouraging rebound in the U.S. Faster growth means bigger demand for oil, which means higher prices. If you believe in the strength of the global recovery, then you should be ready for oil prices to remain elevated. Here’s more from HSBC’s Neumann:

The cost of oil keeps drifting higher. It’s easy to blame Iran. But more may be going on here:…Asian demand appears to be coming back, and the region is now the biggest consumer of crude. Global car sales are currently running at a record level, largely thanks to Asian drivers. Also, with Japan having shut off all but two of its 54 nuclear power plants, which in normal times provide some 30% of electricity, the country is importing coal, gas, and oil galore…The crude rally may have legs.

However, the global recovery is anything but secure. The euro zone debt crisis, despite a recent improvement of sentiment, is far from over, while growth in major emerging markets like China and India has been slowing. So there are enough threats to global growth to make some oil watchers believe demand pressures could ease. So what we see coming for oil prices depends on how we add up all of these very uncertain factors. Do you believe in high global growth and shocks to supply? Or a continued anemic global recovery and no serious supply shocks?

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The folks at Capital Economics are taking the latter view:

Oil prices are likely to fall as fears over Iran ease and the economic recovery disappoints…Prices could quickly drop by up to $10 if Iran gives some ground on its nuclear programme and tensions ease…The recovery is still fragile and from a low base. The US appears on a sounder footing than in 2011, but China’s economy is slowing, and the worst of the crisis in the euro-zone may still lie ahead. We therefore continue to expect oil prices to fall back…Prices (for Brent) should still end the year below $100.

Even the more nervous Soozhana Choi believes that, barring another shock to supply, prices may not rise much further, as she told me in an email:

We are bullish on oil prices as a consequence of ongoing supply disruptions, expectations that normalization of output from affected regions will be slow and concerns about OPEC/Saudi spare capacity constraints. That said, I think we’re already seeing some level of demand rationing in response to higher prices so we’ll have to see a material supply-side catalyst to get prices much higher, i.e. another disruption in supply in the Middle East/Africa or marked escalation of tensions with Iran.

So, for now we may not see oil prices spike that much more. How does that impact prices at the pump? Despite the political rhetoric in the U.S., higher crude prices are not the only cause of higher gasoline prices. The heart of the problem is dwindling U.S. refining capacity. Here’s how Choi puts it in a recent report:

Gasoline prices have been the focal point of worry amongst US policy makers as prices at the pump near USD4/gal level. While the gain in crude prices carries much of the blame for such high retail prices, what’s added to the fundamentally bullish US gasoline story has been the closure of US refinery capacity. We show that since 2009, 1.3 mln bbl/day of refinery capacity in the US has and will be permanently shuttered, of which nearly 90% is located in the East Coast. This means the mothballing of half of US East Coast/PADD I refinery capacity this year alone, which increases the region’s gasoline deficit and its dependence on imported gasoline supply, either from surplus regions in the US…or foreign sources. Gasoline futures have rallied more than 20% since the start of this year, while crude oil futures (referencing Brent)…rallied by 15%.

That’s bad news for the U.S. consumer, and the U.S. economy. And the global economy.

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