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Wednesday, Feb 08, 2006


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Oil fall will translate to higher stocks, lower bonds

S. Balakrishnan

THE bull run in oil has endured for around a year now. Buoyed by rising demand the world over, tensions in West Asia, and the projections of leading investment banks such as Goldman Sachs (which created a sensation last year predicting $100 oil), energy prices have been on a high.

Soaring bills have not dented consumption. China and India are at the forefront of demand growth. High pump prices have not dampened the appetite for gasoline in the US either. The strong global economy has undoubtedly given a fillip to oil demand and its price. Yet the sharp rise in prices has not curbed consumption, as the basic law of supply and demand would suggest. Demand does not seem to be sensitive to price (or is price-inelastic, as economists would say).

Not that production has lagged behind. Barring Iraq, which continues to be beset by insurgency, other oil-rich countries are running their fields flat out, finding enough and more takers for the supply and are seduced by the high price. After all, the last twenty years have seen at least two occasions when prices dropped to single digits. Better to make merry as long as the party lasts.

The oil majors are not beguiled easily. Nor are they convinced that high prices are here to stay. As a result, new investments trail the boom in the industry. Refining capacity is short of crude production and this imbalance has driven up product prices, which, working backwards, have pushed up crude prices.

The prospect of a long-term demand-supply gap and soaring prices has naturally attracted speculators by the hordes to the futures markets. It is difficult to say exactly how much, but of the (today's) spot price of about $65 a barrel, $10-$15 could be attributed to speculative activity.

In absolute terms, crude and product inventories have actually been rising. The fear is that the supply chain from West Asia could be suddenly disrupted, and there is no knowing when it will come back. There is little doubt that, despite the fact of rapidly rising demand, especially from the fast-growing economies of China and India, it is event risk, which is keeping prices high.

The outlook for the long-term could be radically different. Think of a shift away from gas-guzzlers to small cars in the US, ethanol substitutes for gasoline, fuel cells for cars, natural gas, clean coal and nuclear energy for power. Oil will no longer have a fuel monopoly.

Even in the near-term, easing tensions in West Asia will cause a significant fall in the price of oil. That would be a further adrenalin shot for the already strong global economy. In that event, look for stocks to rally and bonds to fall.

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