Jul 31 2006 12:00AM | Permalink | Email this | Comments (0) |
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More oil supply at lower prices is the forecast through 2007 from the Energy Department. If this outlook is correct, prices will fall significantly for diesel fuel, plastics products and asphalt.

Don’t count on it. Some decline is more likely than not but the world oil industry has negligible reserve capacity so all of the price risk is on the upside. World oil demand has recently exceeded supply causing a drawdown of previously very generous inventories. This also adds to the nervousness of oil buyers because the inventory cushion is less able to absorb the next supply shock. Get used to today’s high prices. Optimize your operations to a price level just below what you are paying today. Be sure you distinguish between high prices and high inflation. High prices will persist but the odds strongly favor steady or declining oil prices. That is deflation not inflation.

This means that fixed construction budgets will not be eroded by rising prices for oil based products as they have been recently, especially for taxpayer funded public works. Instead, nominal increases in construction budgets will again result in real increases in the volume of construction work. This will be most significant for civil and institutional building projects where fixed construction budget are set long before the project begins and very hard to change.

The Energy Department has persistently underestimated prices for about two years because they have overestimated supply and underestimated demand. Their current 2.4% estimate of GDP growth in 2007 is below the consensus outlook and probably underestimates oil demand next year. Most of the recent errors were due to hurricanes and to outbreaks of violence near oil production and distribution facilities in remote parts of the world. These events are very difficult to foresee. Right now, $5-10 0f the $75 price for crude oil is a risk premium due to the inability of anyone to accurately foresee the scale of weather and violence interruptions to oil supplies.

What happens to oil prices if supplies lost to weather and violence are “normal”, that is much less than recently. The Energy Department projects these price changes by the end of 2007:

Crude Oil - $7.00/bbl.
Gasoline - $0.50/gal.
Diesel - $0.20/gal.

Energy prices could fall twice this much if the weather is always calm and sunny and there is an outbreak of goodwill in Nigeria, Venezuela, the Amazon headwaters, Iran, Iraq and Mexico. Yes, Mexico. The socialists were poor losers in the early July Presidential election and are threatening violence. Fortunately, most of the oil facilities are in the northern part of the country while the socialists are largely in the South. Still, oil buyers have had to add Mexico to the list of countries where oil supply interruptions are possible.