CRUDE OIL SQUEEZE TO EASE NEXT YEAR
But Era of High Prices Here to Stay

Executive Summary

This year’s dramatic run-up in crude oil prices to above US$65 per barrel for West Texas Intermediate (WTI) has sparked talk of a “new era” of high prices. It would not be the first time that these bold predictions have come to the forefront. Indeed, past periods of skyrocketing prices for crude oil in the early 1970s, 1980s, and 1990s were followed by similar prognostications, but each time, they have failed to materialize. Notably, market mechanisms, such as the lagged impact of high prices on crude oil consumption, investment and output, subsequently kicked in, helping to restore balance in the market and push down prices. As such, the price of crude oil has remained prone to among the largest cyclical swings of any traded commodity.

TD Economics’ 5-year oil price projections

TD Economics’ 5-year crude oil price forecast rests on two convictions. Firstly, we don’t believe that the laws of the oil-price cycle have been repealed. And, next year, the major catalyst for the correction is expected to be a significant slowdown in the U.S. economy. Secondly, we see some merit behind the new-era hypothesis this time around. In other words, the key drivers behind the recent rally are expected to persist to some extent, supporting crude oil prices over the medium- to longer-term. These include:

• Rising global demand – With populous and highly oil-intensive developing economies of China and India projected to continue industrializing at a rapid rate, there is good reason to believe that longer-term demand prospects for crude oil will remain strong. Last year, crude oil consumption in China alone grew by 18 per cent – almost ten times the world average – as the country surpassed Japan as the second largest world consumer after the United States.

• Limited world output growth – Although there has been little compelling evidence that world crude oil supply is soon poised to reach a peak, the outlook for world production increases over the next five years is lacklustre at best. OPEC, the global production powerhouse, is bumping up against its capacity constraints, while weak investment in exploration over the past decade and declining production of existing conventional reservoirs have left output in many of the leading non-OPEC producers growing at a snail’s pace. Even in Canada, significant expansion in oil sands output in Alberta is being offset by declining productivity on the conventional side.

• Alternative energy sources unlikely just around the corner – Although there is likely to be stepped up efforts to develop alternative energy sources, it remains unlikely that crude oil will be displaced as the number one energy transportation fuel worldwide over the foreseeable future.

• Refinery capacity to remain inadequate – There is a severe shortage of capacity available to refine crude output into its useful products. And, the biggest strains are apparent in converting relatively-dense grades of crude oil, and removing sulphur in order to meet steadily-tightening environmental regulations. This crunch is largely the result of low margins – at least until very recently – and long time lags associated with receiving project approval. The lack of refining capacity has increased the demand for West Texas Intermediate, which is a lighter/sweeter crude oil grade and requires less processing.

Fundamental price has increased

Boosted by these structural factors, the longer-term equilibrium or fundamental price of crude oil has probably increased over the past decade. Over the past few decades, US$30 per barrel (in real 2005 dollars) appears to be a level that has been well supported by supply and demand fundamentals. However, given the increasing costs of extracting conventional supplies and the gradual trend towards developing non-conventional crude oil, the fundamental price has probably increased to US$40 per barrel. There is a good case to be made that at least part of the massive US$25-odd gap between existing spot prices and the fundamental price reflects the current tightness of supply-demand conditions within the market. However, a more important component is the “fear” premium, which we believe has ballooned to as high as US$20 per barrel in recent months, as investors increasingly fret about geopolitical risk and other Katrina-style supply disruptions.

Price to fall to US$45 in 2007

While an estimate of the long-term fundamental price provides a benchmark for where the price of crude will converge to over the long term, it may say little about the medium-term direction of spot prices. Indeed, as we reveal in our 5-year projections, crude oil prices are likely to remain above this fundamental price over the next five years. The highlights of the forecast are:

• The direction of crude oil prices over the very short run is a wildcard, especially in the wake of Hurricane Katrina, where temporary damage to U.S. energy infrastructure has added to the substantial jitters about supply that had already been present in the market since the start of 2005. Although we have set a year-end target of US$60 per barrel, we certainly don’t rule out prices moving above US$70 or even US$80 later this year if further unanticipated shocks along the same lines as Katrina sideswipe the crude oil market.

• Next year, the picture will begin to crystallize. More specifically, once the dust from Katrina-related impacts subsides by mid-2006, a significant mid-cycle slowdown in the U.S. economy is likely to be revealed, stoking concerns about the demand picture going forward in the broader global economy. At the same time, the past surge in energy prices is likely to lead to some limited conservation efforts by consumers and businesses in major industrialized countries.

• The prospects for a scaling back of gains in global consumption and for modest supply increases will lead to some further easing in the tight global supply-demand balance in 2006 and 2007, and in turn, a pull back in the massive fear premium currently embedded in crude oil prices. By early- 2007, the price of WTI is expected to head back to US$45 per barrel.

• The extent that prices move up higher later this year would set the stage for a larger percentage correction in prices in 2006-07.

Resumption in tight markets beyond 2007

• In 2008-10, TD Economics’ forecast calls for crude oil prices to bounce back above US$50 per barrel. By then, both the U.S. and world economies are expected to have snapped out of their sub-par period of growth, driving up annual consumption gains closer to the recent trend rate. And, with world production continuing to plod along at a sluggish rate, the supply-demand balance is likely to shift back into a deficit position.

• In this environment, nervousness about supply shortages for crude oil and refined products is likely to move back to the forefront, elevating the level of the risk premium.

• Hence, look for crude oil prices to follow a U-shape over the next half decade. On the plus side, in spite of the increased non-conventional output contribution from Canada and ongoing shortage of refining capacity, according to a study done by CERA (Cambridge Energy Research Associates), most of the incremental oil coming on stream over the next half decade is expected to be light and medium sweet crudes. This should lead to a narrowing in the current lofty price spreads between the different grades.

Implications on gas prices and other conclusions

• In line with the likely path of the price of crude oil, we expect to see some easing in gasoline pump prices over the next 12-18 months to between C$0.70-0.80 per litre from current levels of over $1.00.

• Likewise, we expect natural gas prices to fall back in tandem with those of crude oil. In 2007, we expect natural gas prices to average US$8 per MMBtu from current levels of US$12 per MMBtu.

• This projected profile of crude oil prices in 2006-07 is no doubt likely to temper at least some of the enthusiasm that is currently evident within the crude oil and natural gas sector. For one, not all projects are created equally. And, in a more sustainable environment of US$50 per barrel prices, some lower quality projects are likely to be looked at with increasing scrutiny.

• Above all, the next five years is likely to witness exciting new developments, as significant amounts are poured into exploration and development. And, while crude oil is unlikely to go the way of the dodo bird any time soon, heightened efforts to developing alternative energy sources in response to high prices could bring that day closer.

Derek Burleton, AVP & Senior Economist
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