Pump to the Future

Oil appears on a roll. How high can it go?

Over the past four months oil prices have rallied from $75 per barrel to about $90. Prices are headed higher now, linked to concerns about the Middle East and the Suez Canal. I think that both the US and Egypt are unlikely to repeat the errors of the ‘70s: the US is unlikely to alienate tens of millions of Egyptians; Egypt is unlikely to cut off its nose to spite its face and close the canal, through which much of Europe’s oil and about 10% of the world’s trade flows.

Now the risks of supply disruptions have increased, so the price of crude has risen to about $4 to reflect them. This seems rational. But we should remember that the marginal price of producing oil hasn’t changed much. It costs about $75 to get the next barrel of oil from an undiscovered reservoir to the refinery. When prices rise above that level, developers have a tremendous incentive to find new reserves and expand existing production.

That’s why the energy sector grew from about 6% of the world’s equity markets in 1995 to about 15% in 2008. In the course of the global recession it pulled back to 8% or so, but now it has expanded again to 12% as employment and investment in the sector increase–as they did 30 years ago.

Oil prices have limits. Instead of peak supply, producers are facing peak demand as much of the world develops alternatives. This cycle will continue as long as there markets.

Douglas R. Tengdin, CFA
Chief Investment Officer
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