How Low Can you Go?

Yesterday, oil dropped below $50/barrel, its lowest level since May 2005.  In four short months, oil has shed close to a $100 off the per barrel price.  It's a fall that is almost inconceivable.  Even those hawks (few and far between over the summer) who were arguing that $140 was unsustainable and would not last have been dumbfounded by the drop.  In fact, this sudden and severe deflation has gotten folks of every stripe a bit unnerved and few consumers are celebrating as the weight of the economic downturn is playing a larger role in household decision-making than are the fall of gas prices.  Suddenly, talk has turned to the evils of deflation rather than the evils of inflation that was all the rage in the spring and early summer.  Citibank warned in a report released Monday of the fiscal consequences for Persian Gulf oil producers of oil prices averaging in the $50/barrel range.  Citi forecasts that at that level only Kuwait would be able to maintain a surplus.  Speculation has it that Iran is looking for some measure of reconciliation with the US as it begins to feel the vise of lower oil prices and sanctions.  High cost oil producers are being squeezed with supply at risk for being shut in as many of these producers have fairly high break even points.  Several years ago, Wall Street analysts estimated that the break even point for Canadian tar sands was about $50/barrel. Surely that has risen as costs throughout the industry continue to increase.

Are we witnessing a trend that will take us back to 1998 when oil prices fell to $10/barrel?  Speculating on oil prices movements is always a dangerous game but to many people (myself included) it's just too tempting to resist.  So here's my bet: just as markets were overshooting at the beginning of the year and had so far separated themselves from the physical market fundamentals that $140/barrel not only seemed plausible, it was reasonable; so too are markets overshooting the downside risk now.  Again, the market mentality seems stuck.  Until the end of this summer, the market saw no downside risk to prices and prices just kept rising, even in the face of declining demand from the OECD.  Market analysts (many of whom worked for firms that had ties to the trading side) prophesied that even though demand was being met now by adequate supply, soon the world would be short on oil because of growth from non-OECD countries.  $140/barrel was completely justified.  In November, the call is just the opposite: the world is in a deep recession and oil demand is not going to come back.  This even though we still don't have a good handle on where Chinese demand (the big villain during the summer months) is currently.  Chinese consumption has slowed but is still growing.  And the effects of a Chinese stimulus package announced last week are still to be determined.

So where is the "fair" price for oil?  Of course, it's anyone's guess but future contracts point to a range of $80-$85/barrel, suggesting that traders remain bullish on the long term outlook for the oil market.  And, although I reject the notion of a "virtuous" price for oil, $80 seems a bit more reasonable for multiple agendas: low prices contributed to excessive consumption in the US.  A long term sustainable price of $80 would help conservation, the development of energy alternatives, and the long term fiscal health of the oil producers.  Convincing Wall Street of this is another story.