The world oil market has been a constant source of frustration for economic forecasters of late. Have the laws of economics been rescinded?
The short answer is no.
The basic facts are straightforward. After plunging to a valley of $10 US per barrel during the global financial crises of the late 1990s, oil recovered to average around $30 during much of the 2000-03 period, except for a brief downward blip in late 2001. Then in 2004, prices began a steady upward trek, passing $40, $50, $60 and then $70. The peak earlier this year was $78.
There was never a shortage of explanations for ever-rising prices. World economic growth was running at record levels in 2004-05. China and India emerged as major oil consumers, with their joint share of world consumption rising from five per cent to 11 per cent between 1990 and 2005.
Add a series of supply disruptions in Venezuela, Nigeria, Russia, Iraq and the U.S., plus the ongoing geopolitical stresses in the Middle East, and analysts had grounds for forecasts of $100 oil, or higher.
In the background was also the so-called peak oil theory, which postulates that global productive capacity has peaked. Even the peak oil adherents, though, would agree that the main impetus for higher prices today is not a true shortage of oil, but a shortage of spare capacity that left the system vulnerable to temporary supply shocks. Having been burned by unexpectedly low prices in the past, oil companies were using conservative price forecasts when developing their exploration and investment plans, and the level of spare capacity had shrunk steadily over time.
And then there is the emergence of the acquisitive national oil company. Nations have always seen oil as a strategic resource. But the high prices of the past two years have strengthened governments' resolve not to fall short of oil in future, and have motivated a lot of government purchases of oil assets - transactions in which price matters far less than energy security.
Despite all this, it is becoming clear that the laws of economics still apply to the world oil market. High prices should reduce demand and encourage new investment in supply capacity, and we can see that happening.
There is already evidence of a shift to smaller cars and less travel by North American consumers. Oil companies are re-examining their investment plans, boosting recovery rates in existing fields, raising output from the oilsands and announcing exciting deep-water offshore discoveries. Moreover, the high price of oil is contributing to an emerging slowdown in world economic growth, which also will mean slower growth in oil demand.
Accordingly, economic forces point to further declines in oil pricing in the next couple of years - a reasonable forecast would be for a long-term reference plane of $35-$45, although prices seem likely to fluctuate around the $50-$60 plateau for some time while spare capacity is being rebuilt.
The bottom line? Forecasting the price of oil is still a risky business. With little by way of excess supply at present, any economic, political or climatic disturbance could send prices back into the seventies.
But at least the laws of economics are regaining some traction in the oil marketplace.
(Stephen Poloz is a senior vice-president and chief economist for Export Development Canada. He can be reached at spoloz@edc.ca)