The Oil Cycle


"If supply can't adjust to meet demand, the only economic factor left to move is price."

Why have we seen so much volatility in prices this year, and where are crude oil prices headed? To understand the factors at work, it's useful to define the broader cycles we're seeing in energy prices and try to determine where we are within those cycles.

My basic thesis remains that energy prices and related stocks are locked in a long-term up-cycle that will last for at least another decade, perhaps longer. But every bull market—no matter how powerful—is punctuated by pullbacks and corrections. Sometimes those corrections are brutal, as is certainly the case with oil prices in 2008. This is exactly what we're seeing in the energy markets today: a cyclical decline within a longer-term uptrend.

The current down-cycle is a function of oil demand. Supply will ultimately re-emerge as a key issue but, for at least the next six months, the path of crude oil prices will remain tightly tied to expectations for global economic growth. Oil demand and global economic growth have historically been closely linked.

I see the nascent breakdown in the GDP/oil relationship over the past three years as a symptom of the supply shock the world has been experiencing. In past economic cycles, faster GDP growth powered higher oil demand and rising crude prices; higher oil, in turn, catalyzed increased drilling activity and growth in global oil supply. Those rising supplies helped keep a lid on crude oil prices.

In this cycle, however, supply growth was limited by geological factors; many of the world's largest oilfields are mature and seeing declining production, while new fields are difficult, expensive and time-consuming to develop. Thus, even with oil prices sky-high and energy firms investing record sums in exploration and development, global oil supply rose only slightly between 2005 and 2007. Non-OPEC production growth has, in particular, come in under expectations.

The bottom line: If supply can't adjust to meet demand, the only economic factor left to move is price. With supply limited and demand rising due to a strong global economy, crude prices had to rise far enough to choke off excess demand. We touched this "demand destruction" price earlier this year.

These factors are behind the broader long-term up-cycle in energy prices. Although constrained, supply is off investors' radar screens right now, it won't be for long.

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