We expect the average oil price over the year 2006 to be lower than during 2005 and in 2007 to be lower than in 2006. There are several reasons for that. The main reason is that the high oil price over the last years tends to increase supply and to decrease demand. Both happens with a time lag as investment in new production facilities takes time and the switch to other energy supplies to avoid oil takes time, too. But even if it takes time, there is no doubt that it will happen. Also it is important to remember that during the last couple of years, during which the oil price kept rising, there has not been a supply shortage. The stockpiles in the USA have increased even during price peaks, signifying that even during those time periods supply was greater than demand. The free production capacity in the world was low and still is low at around 2,0 million bpd, but it is not zero. That means that production could and could have increased any day, which would cause oversupply and a sharp drop in oil prices. This of course the OPEC does not want, but still it is what it could do.
Definitely the threat of terrorist attacks remain, or the politically motivated reduction of production by one of the supplier countries. Following the argument above, a terrorist attack destroying less than the free production capacity of 2.0 million bpd should in theory have only a moderate effect on the overall price level. Of course the risk premium would increase for a while, but not permanently. Even the destruction of production capacity of more than 2.0 million bpd could be absorbed temporarily by the stockpiles in the industrialized countries. Therefore, only a terrorist attack destroying more than 2.0 million bpd production capacity, which can not be rebuild within a reasonable time period, would put the world oil supply below demand and send prices to new highs. This is possible but not likely.
A politically motivated reduction of production levels significantly below demand is also possible but not likely either. It would send prices extremely high and isolate the country, which reduced output, in the world community. A slight reduction of production to put pressure on consumer counties is more likely, (but not probable) but would only be temporary. Still, it could send prices up to maybe 80 US$ per barrel. Even at this price level we do not predict a recession in Europe or the USA. We do not expect this scenario. In our opinion oil prices peak this year around 70 US$ and will be lower on average next year.
One factor contributing to high oil prices is the growing demand from China. This demand grew faster than GDP during 2004 and 2005 so far. Some analysts make the mistake and assume that demand will continue to grow at those rates. This is unlikely as there are some factors, which lead to the high demand, which will probably not persist in the future. As Chinas GDP has expanded at a rate of about 10.0% and its industrial production expanded at a rate of about 15.0%, companies had to use gasoline powered generators to meet their electricity needs. China has been busy to build new power plants and continues to do so, which will lead to a substitution of the gasoline powered generators by mainly coal fired power plants. This will result in at least a sharply reduced growth rate of oil demand for China and maybe even a stagnation for some time.
Another important aspect for the oil market are the portfolio investors. Long and short positions in the oil market have mainly been used for producers and consumers to hedge their positions in the real world. But more and more with the continued increase in oil prices (and other commodities) these commodities have been used for investment. Contrary to bonds, which pay interest and contrary to shares, which pay dividends, oil and other commodities bring their investors only a profit if prices keep rising. And in fact the continued inflow of funds for investment purposes has contributed to the price increases as they mainly go into long positions. Then follows the simple fact that prices can not keep rising for ever. No matter if they peak at 70, 80 or 90 US$, they will definitely peak. From that point on they will not bring a profit to the investors any more and they will tend to leave the market. In an already falling market, this will lead to sharp price reductions. Therefore once the peak has been established we expect sharply lower oil prices.