Looking Backward, Analyst Finds Argument Against Coming Oil Price Shock

An oil rig in Breckinridge, Texas, 1920. (image: texasliberal.wordpress.com)

Last week, The HEAT Zone reported on a consensus among many oil price experts that current economic conditions are laying the foundations of an imminent oil “price shock” that could take place as soon as three months from now. Over the weekend, Morgan Stanley asset manager and Newsweek columnist Ruchir Sharma took the opposite position, writing that historical trends show that oil is on the verge of a sustained period of low prices in a column titled “If It’s in the Ground, It Can Only Go Down.”

To be fair, Sharma at least partially agreed with the idea of a price spike, writing, “At some point, of course, commodities will spike again, but only temporarily.” His broader argument looked at oil prices on a longer timeline and predicted that they would remain low and perhaps even decline over the next 20 years or so.

Most strikingly, Sharma took issue with the belief that rapidly growing economies in China and India will rebound from the current downturn with a renewed thirst for crude that will drive up global oil demand. He noted that “as countries get richer, per-capita consumption of commodities decreases,” due to improvements in efficiency and discovery of new resources. He cited the fact that, although the economies of Europe and Japan were growing rapidly during a period of economic expansion in the 1980s, their levels of oil consumption remained flat during that period. He also called China’s affect on oil demand “exaggerated,” and predicted that the Chinese government’s increased emphasis on energy efficiency and shifting to a local consumer-driven economy will cause the nation’s oil consumption to decrease dramatically in coming years. In addition, he argues, China’s current pace of consuming 25 to 50 percent of the world’s industrial commodities while outputting just 10 percent of global GDP is unsustainable anyway.

The backbone of Sharma’s argument is that, since commodities first went into widespread use, their prices (adjusted for inflation) have been steadily declining. He cites a surprising statistic released by Bank Credit Analyst, a Canadian research firm: “major industrial commodity prices are 75 percent below where they were in the year 1800, after adjusting for inflation.” On its surface, this data is not too shocking, as natural resources in 1800 were much more difficult and expensive to find and excavate than they are today, making them more rare and more valuable. It does however, lead to the logical question: if commodities prices are 75 percent cheaper today than they were 200 years ago, will they be 10 percent cheaper 25 years from now? If so, that certainly contradicts the conventional wisdom on oil prices, as evidenced by the fact that the price of oil contracts rise steadily as they stretch into the future. As of this writing, the price of a barrel of crude oil under a May 2009 contract is $49.38, while a barrel under a December 2017 contract is worth $82.15 (an increase of about 66 percent in 8.5 years). According to Sharma, this situation (known as “contango”) is a reversal of the norm that ruled oil markets until 2005. He explains:

[T]he long view died with the commodity price boom of this decade, and it has yet to return. Today investors are still reacting to any sign of health in the global economy by pouring money back into commodities, producing the erratic upward price swings we’ve seen in recent weeks.

Sharma’s emphasis on the long term, downward trend of oil and commodities prices includes a frontal assault on peak oil theory, based on the historical price of oil:

The real price of oil today is now at the same level as in 1976 and, before that, in the 1870s, when oil was first put to mass use in the United States. This long-term price decline is due mainly to the constant discovery of new fields and greater energy efficiency, making nonsense of the idea that the world is rapidly running out of oil.

When analyzing oil and commodities prices, Sharma makes the unique choice of looking at the 200-year chart instead of the 20-year chart. His basic conclusion is that the price of oil, along with the prices of other industrial commodities, is on a gradual and unstoppable decline. Although he did cede that oil prices would spike again “at some point,” according to the concluding argument in his column, that point is 20 years away:

Data from [investment bank Credit Suisse First Boston] shows that the average bull market in oil has lasted from four to nine years, and the average bear market from 11 to 27 years. The bull market that ended last summer saw prices rise tenfold over nine years, mirroring the duration and magnitude of the previous bull market, which ended in 1979. That was followed by a bear market that lasted 20 years. If history is any guide, we’re only at the beginning of another long one.

What does Sharma’s argument prove about oil prices? Nothing. It is no more or less valid than the augment that oil prices will skyrocket in a matter of months. What both arguments prove is that the business of predicting oil prices is so complex that highly educated, well-experienced people can look at the same evidence and draw opposite conclusions.

For our part, we at The HEAT Zone must once again encourage you to conserve to make sure that you get the most out of the heating oil and other energy resources you buy, whatever their prices may be.