Only A U.S. Recession Can Lower Oil Price

US$80 a barrel level based on short supply, steady demand

After OPEC agreed to boost production by half a million barrels a day this week, the cartel’s secretary-general, Abdalla el-Badri, came out and said that US$80 oil won’t last because the fundamentals don’t support it.

We’ve heard that one before. Many people made that argument over the last four years as oil made its inexorable climb from US$30 to who-knows-what. In retrospect, they were mostly wrong.
If there is any reason to think differently today, it is the U.S. economy. In its latest survey of global economists, the Wall Street Journal pegged the risk of a U.S. recession at 36% this week, up from 28% a month earlier. No surprise given the subprime havoc and subsequent credit crunch.

A U.S. recession means lower oil prices. But if the recession risk is really that high, it begs an obvious question: how did oil jump from US$70 to US$80 so rapidly in the past month?

“A recession is always a possibility, but that’s not what’s being factored into prices. What’s being factored is global demand outstripping global supply,” says Earl Sweet, an economist that follows the sector at BMO Financial.

So investors are being selective, to say the least. But the demand-supply situation does paint a rosy picture for oil bulls. Before OPEC decided to increase production on Tuesday (or more accurately, before Saudi Arabia decided to) the International Energy Agency numbers suggested global supply would fall short of demand by 1.7 million barrels a day through the end of next year. That would mean a shortfall much larger than America’s entire strategic petroleum reserve by the end of 2008.

Add on the big drop in U.S. inventories this week and refinery shutdowns, and the hedge funds and other financial players had plenty of reason to push oil higher, and discount that 36% chance of recession so that it feels more like 3.6%.

Financial Post (Canada)