What's the Right Price for Oil?

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"We had a wild ride in 2008. And I believe 2009 will give us some new shocks."

We had a wild ride in 2008. And I believe 2009 will give us some new shocks. First, we are seeing significant companies in the domestic gas drilling business scaling back their drilling programs. We will see more reports of operating losses, diminishing reserves, reduced earnings, write-downs and even some shotgun weddings (if not bankruptcies).

We will soon start to see tighter output for both oil and natural gas. In Russia, oil output decreased by a seemingly small - but telling -1% toward the end of 2008. You can expect a larger drop from Russia for 2009. Mexican oil output dropped by about 10% in 2008, and will drop even more in 2009. According to International Energy Agency (IEA) figures, about 58% of world oil output comes from just 800 oil fields. And most of those oil fields are in the "mature" category. They were discovered in the 1950s-70s and are past their respective output peaks. So the macro view is grim, out beyond two years or so.

Markets work, right? But if something doesn't work well, does it still work? A stopped clock tells the correct time twice a day, right? But what if the clock just stops and starts whenever it gets banged around?

Let's try to figure this out. What's the difference between oil at $100 in January 2008, $147 that July, $100 in September and $33 in December? Has global demand been changing all that much? (Hint: Worldwide demand was not rising all that much in the first half of 2008. And demand is down over the past six months, but not by large factors.) Is the current oil price - in the low-$40s - per barrel the "right" price? Can we believe the market?

One key thing that has changed in recent months is the oil market's perception of the future. The marketplace is predicting lower oil usage as the world recession unfolds. But that perception is just plain myopic. Look at both the amount and the composition of the oil for sale. We're seeing falling oil prices in the face of flat (at best) world output.

In the near term, will worldwide economic contraction lower the use of oil? Yes, probably. And in the medium-to-long term, will depletion lower the worldwide output of oil? Yes.

For now, lower oil demand is trumping stagnant supply. Near-term issues are beating out the medium-and-long term issues. But the longer oil prices stay low, the more damage will be inflicted on the world oil and drilling industry. We are setting ourselves up for severe volatility in oil prices. When demand starts to recover, supply falls below some not-yet-defined volume or perceptions change about the future of oil availability. . .prices will take off.

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