The recent increase in the price of crude oil can be characterized as nothing less then explosive. In January 2002 a barrel of WTI was priced as less then USD 20. The same barrel now trades at close to USD 140. Where does this price explosion come from and does the current price level imply that we are in bubble territory?
The problem with commodities is that calculating an intrinsic value is practically impossible since there are no future cash flows to base the calculations on as analysts tend to do with pricing equities, bonds and real estate. We can only look at supply and demand factors to get an idea of where the price should be and where it’s going. Unfortunately this is not as simple as it sounds.
Let’s take a look at the big picture. The world economy currently guzzles down 87 million barrels a day. The IEA expects that we will consume 116 million barrels a day by 2030. The additional future demand largely comes from developing economies, with China and India as the most important players, where the standard of living is rising rapidly and with it the demand for energy. So we’ll have to pump up more oil.

Unfortunately, reserve capacity based on current production sites is already at a historic low. And since a lot of large oil fields are already on or over their production peak we can expect production of current fields to decline in the near future. New fields need to be developed and taken into production to sustain current production levels, let alone increase global production to meet the increase in aggregate demand. We know that there is enough oil to meet demand for quite a lot of years to come, however every new field will be more technically challenging and expensive to develop.

New production will have to come from oil sands, deep sea oil fields, oil fields in very challenging environments such as Siberia or the Pole area and fields in politically unstable countries in the Middle East and Africa. This will cause production costs to trend higher and higher as development of these oil fields will require a higher level of technical expertise and machinery. We can also expect increased volatility on the supply side. The technically more challenging projects in rough environments will be more susceptible to operational problems. Also, oil will be used more and more as political leverage: reducing or cutting off the oil supply can be a very convincing argument in the geopolitical arena.
Higher production costs will obviously result in higher oil prices, while increased volatility warrants a risk premium which pushes prices higher.

These fundamental changes in the oil market explain at least part of the current price level. Of course other factors also play a role, I will just mention a few. Both private and institutional investors have found their way to commodities. Large sums of money may have (and probably have) accelerated the increase in oil prices. Also the organization of the supply side of the market, with OPEC as the most influencial party, is a disturbing factor and frustrates the transparency and efficiency of the oil market.

Another factor is the fact that several oil producing countries heavily subsidize the price of oil for domestic use. Demand in these countries is effectively decoupled from the oil price on the global market. And last but certainly not least: the strong depreciation of the US dollar against the other large currencies has pushed up the US-dollar dominated oil price.
We can conclude that there is a strong fundamental case for sustained high oil prices, but several in- and external factors impact the oil price to an unknown degree and for an unknown period.

In 2007 with an oil price of just over USD 70 Goldman Sachs analysts predicted that the oil price would break the USD 100 barrier in the near future. Their prediction was met with quite some skepticism. Recently Goldman analysts said the oil price may well hit USD 200 within the next 24 months. I didn’t hear anyone laughing.

Rob van Wechem, CFA

Rob van Wechem works as an investment consultant for Oyens & Van Eeghen in Amsterdam. This article expresses his personal views on the financial markets and does not represent the views or opinions of Oyens & Van Eeghen