How High Can Oil Go?

Don't be surprised to see a test of $100 a barrel soon, even though that's far higher than what market fundamentals call for.

By Jim Ostroff, Associate Editor, The Kiplinger Letter

October 30, 2007

This oil price rally is running mostly on fumes, but it definitely has legs. Oil traders and investors are largely reacting to risk factors, not to basic supply and demand. Nevertheless, market jitters are likely to keep oil in the $90-a-barrel range for at least the rest of this year -- and a test of $100 soon can't be ruled out.

The fundamentals simply don't justify current price levels. "By every supply and demand standard, the oil market is nowhere as tight as it was in 2004 [when oil was fetching about $50 a barrel], yet prices are nearly double now," says Tim Evans, an energy analyst at Citigroup Global Markets. One factor contributing to the higher cost of oil is the dollar's ongoing decline. Crude oil producers are able to demand a higher price for dollar-denominated crude to make up for the fact that the currency is worth less. But even with the depreciated dollar, oil prices should really be in a $65- to $70-a-barrel range now, implying a current risk premium of nearly $30.

Investors have bid up oil by about $23 since August. Key events driving the upward trend include Turkish military action in northern Iraq against Kurdish rebels, which may cripple the flow of Iraqi oil if the incursions intensify. Meanwhile, heightened U.S. rhetoric against Iran has raised talk of a possible U.S. military strike on the world's fourth-largest oil producer. If such a conflict were to lead Iran to restrict its exports and perhaps try to prevent other Middle Eastern countries from shipping their crude out of the Persian Gulf, the price of oil could easily shoot up to $150.

But, barring a supply squeeze of this magnitude, super-pricey oil can't continue much beyond the end of this year. John Kilduff, a senior vice president with MF Global, a commodities trading firm, says sticker-shocked oil consumers will soon start cutting back on purchases, which will help to ease prices a bit. Even so, oil prices in the first half of next year will probably hover around $80.

Longer term, oil prices are likely to hit even loftier heights. Oil companies underinvested in oilfield development earlier this decade, which will show up with a lag on the production end. By 2010, spare crude production capacity will have shrunk to a measly 1% of global demand from 3% now. That'll mean even greater price volatility and a bigger danger of sudden price spikes. The nonspike price -- that is, what oil buyers pay in the absence of a supply crisis -- could reach $150 a barrel by early in the next decade.

Congress will take limited action to try to rein in oil demand. Lawmakers will pass an "energy-lite" bill with higher efficiency rules for appliances in homes and industry. But they won't impose new mandates to force more use of wind, solar power and biomass to make electricity. Notably, look for Congress to raise auto fuel efficiency standards to 30 miles per gallon by 2012, from 27.5 now.

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