CIBC, a Canadian investment bank, has published last week a research note (pdf, 6 pages) which provides extremely strong arguments to support the opinion that oil prices will keep on rising.

The jist of it: oil supply is simply not able to follow expected demand, and thus higher prices will be required to tame that demand:

with the following price expectations:

Let’s see how strong this argument is:
The obvious questions are about how realistic the hypotheses for both demand and supply are.

On the supply side, it is actually fairly easy to predict future production, as oil projects have a lag time of (at least) a few years, so most of the oil assets that will come into production between now and 2010 are already known today. The CIBC analysts have examined all the known development projects and came up with the following newq production to come on stream:

You will note that the stright line in that graph is the expected depletion for existing production, i.e. the decrease in their production. The CIBC analysts suggest that depletion will amount to only 1.5% of current production, which appears to be conservative (for instance, it has been suggested that the Cantarell field in Mexico, the second largest producing asset in the world, could see its production drop by half in the newt few years. North Sea production is declining at an accelerating pace). Further improvements in technology and better reservoir management can be expected to slow the decline of many fields, but the CIBC numbers still seem to be very conservative.

Which means that oil production will barely grow in the next few years.

Meanwhile, demand growth has surpassed all expectations, despite the rising prices (remember, oil prices have increased by 60% in one year, and by 400% since their lows in 1999), and has been repeatedly reevaluated, as this graph shows:

Now, it is quite likely that a slowdown in world growth caused by rising oil prices or by other economic imbalances would also bring about a slowdown in such growth, but it is highly unlikely that it would stop the growth altogether, as it is part of a very long term trend, with less developped economies catching up on the West. Note that for Asia, a slowdown means 4-6% growth instead of 7-10%, so it is still growth, and significant chunks of the population in these countries are close to GDP levels where it has been shown repeatedly that car ownership (and thus fuel demand) skyrockets, and this would happen even with an economic slowdown.

Do note that the scales are very different on the two graphs. The room for catching up is stil huge. Note also how demand in the US has been creeping up in the past 20 years – and that’s demand per capita, not absolute demand, which has increased even more as population itself grows

So where does that lead us? Here’s the CIBC estimate:

How much prices have to rise to achieve those demand cuts depends on the price elasticity of demand for crude. Unfortunately, in the short-run there is very low price elasticity, meaning that it takes relatively large price increases to dampen demand. As a rough guide to estimating the price needed to confine demand to available supply, we have used an elasticity of 0.15 for global oil use. (That figure is derived by weighting US Department of Energy estimates of demand in major oil consuming regions by each region’s share of global oil demand.) A 0.15 elasticity means that a 10% rise in crude prices lowers crude demand by only 1.5% taking today’s roughly $55/bbl price as the benchmark, crude prices must rise to an average $61/bbl next year and to an average of $70/bbl by 2007 to achieve the needed demand cuts from trend . As those cuts begin to mushroom after 2007, so too must the price hikes required to bring them about. Crude prices need to rise to an average $80/bbl in 2008 and continue to rise to $101/bbl by 2010.


As a final note, here’s an additional graph that shows that the oil markets do NOT believe that it is only speculation that brings the oil prices up: long term future have gone up as well in an wholly unprecedented manner:

The market expects prices to remain above 50$/bbl all the way to 2010 – and the increase in price expectations for 2010 has been bigger than the price expectation for short term oil.

So get ready for durably more expensive oil. It will get expensive enough to force us to reduce our consumption, so we might as well start right away, before we are forced to.

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