Recessionary forces are bringing the oil price back to reality, despite China

Thursday, 4 September 2008

The oil price has taken longer to start falling back to earth than any of us who have long believed commodities to be the next big investment bubble would have thought, but finally the process seems to be under way. Since the peak a couple of months back, the price has already fallen some 25 per cent.
Not that we in Britain are enjoying the benefits of this phenomenon. Oil is universally priced in dollars – one of the reasons the price rose so high is that oil was seen by traders as a hedge against the collapsing dollar. The fall in the pound against the dollar that has occurred over the past few months has therefore cancelled out most of the effect. In sterling terms, we are still paying nearly as much for our oil as we were when the price was above $130 a barrel.
All the same, things are not quite as bad as they were. How low might the price go? One thing seems clear. Despite the now global nature of the downturn, it's not going to go back to previous cyclical lows. In previous cycles, new investment in capacity prompted by high oil prices has tended to come on stream just as demand begins to slow, compounding the subsequent collapse in prices.
What makes things very different this time around is the new ingredient of Chinese and Indian demand, which, even if it slows in the short to medium term, must further out continue to accelerate.
For these fast industrialising societies, the alternatives to hydrocarbons are still very limited, and even where they do exist they tend to have a higher marginal cost than oil even at present elevated prices. Most of the world's cheap reserves of oil are already being tapped. The much higher costs of developing new sources of supply have to be paid for somehow or other.
Even so, as the world economy slows, production and supply may for the first time in years be starting to outstrip demand. This may be only a temporary phenomenon, which will reverse if the Asian supertanker manages to steam through the economic woes afflicting the developed world. But for the time being, if there is more of the black stuff being produced than we actually want to use, then logically the price must fall, whatever the longer-term fundamentals. Already some producer nations, both Opec and non-Opec, are talking about cuts to production to support the price above $100 a barrel.
Neither Hurricane Gustav, which in any case managed to inflict only minor damage on Gulf of Mexico production, nor reports of a fire at a key Middle Eastern installation, have managed to halt the slide in the oil price as economic worries gain the upper hand.
The oil price is not alone. Virtually all commodity prices have been on the slide in the past few months. We must assume that the determination of the developing nations to achieve Western standards of living will put a floor under these prices which is much higher than previous cyclical downturns. Even so, prices may slip quite a bit further than commonly assumed.
There has been extreme speculative activity in these markets as still buoyant levels of worldwide liquidity, burnt by the experience of the sub-prime meltdown, has sought out high-yielding alternative homes. It seems that these days there are no safe havens left, or none that provide a decent return, in any case.