The sharp drop in oil prices in the past few weeks confirms the oil price forecast that I published back in May 2013, when West Texas crude sold for $94.50:
“Oil prices are headed down, and I mean down at least $20 a barrel. The key reason is that prices have been high. It's not a paradox, but a result of the long time lags in oil production.”
Before going into the forecast, it's worth mentioning that price can change faster than the fundamentals of supply and demand. In a recent 30-day period the price of oil fell by 20 percent. There was no change in the demand or supply over that month to justify such a large change. What happened is that commodity traders look at expected future prices, based on long-term supply and long-term demand. When the traders' expectations change, they buy or sell and the price changes. Traders' expectations can change due to moods, “animal spirits,” fear, greed, drugs, family strife or lack of coffee. Or too much coffee. Thus, short-term price changes can happen quickly. My own guess is that hundreds of very influential traders suddenly slapped their foreheads and said, “That Bill Conerly is right.” Which triggered a large drop in oil prices.
The fundamentals of demand are straightforward. Demand is moves up or down as the global economy moves up or down, but with a pronounced trend toward less energy use per dollar of economic production. The chart tells the story well.
Economists have been slowly lowering their projections for global economic growth in the coming years, triggering lower expectations for oil demand.
On the supply side, think of three distinct steps involved in getting oil to market: exploration, development, and production. Exploration is very sensitive to projected prices of crude oil. The price of oil had seemed stuck at $20 for many years, from roughly 1986 through 1997. Then prices started to rise, breaking through $60 in 2005. The price break, plus maybe talk about peak oil, lead to a surge in exploration around the world. With prices now dropping, new exploration activity will decline.
