Oil is the bad boyfriend of the international economy: we can’t live with it, and we can’t live without it. We complain about the price of gas—which really is crippling middle-class America—and worry about the threat of oil spills and all the greenhouse gases released by the 30 some billion barrels of oil we burn annually, yet oil is still a driving energy source for the economy, from family units all the way to nation-states. And it really has gotten more expensive—this year Brent crude ended up averaging $111 a barrel, the highest price on record, and except for 2008 (in the middle of a global recession), oil prices have closed higher every year for the last decade. With global demand still rising as fast-growing developing nations like China and India continue to fill up at the pump—and global supply growing much more slowly—it’s easy to assume that those prices will just keep climbing.
But the picture is more complex than it seems. As we leave a tumultuous 2011 and enter an uncertain 2012, it certainly looks like oil will get more expensive—perhaps significantly more expensive, if Iran moves to close the Strait of Hormuz as it’s been threatening, potentially blocking off as much as 15 million barrels a day. Even if the U.S. Navy prevents Iran from closing off the Hormuz spigot—as the Fifth Fleet has promised to do—the possibility of armed conflict in the Persian Gulf would surely send oil traders into a panic. Yet there’s also the chance that oil prices could fall—and fall very, very far. There’s just one catch: it would require another global recession.
On one hand, the physical oil market is extremely tight—OECD countries built their total petroleum inventories by only 15.7 million barrels through the first three quarters of 2011, according to a recent report by Goldman Sachs, during which they usually add 76.7 million barrels. Countries have been able to draw on their petroleum inventories through the year to keep prices from rising too high—and they received some help in the summer when the International Energy Agency released 35.5 million barrels of oil from its own strategic stockpile. But those inventories are getting awfully bare, and if demand keeps rising, price will rise as well—one reason why Goldman expects Brent crude prices to average $120 a barrel over 2012.
And that’s assuming all’s well on the supply side. No guarantee there—besides the brewing crisis with Iran, there’s also the risk that internal strife in Iraq following the final departure of U.S. troops could slow production in that country as well. Iraq exports 2.1 million barrels of oil a day, and if the country were to fall into civil conflict—not entirely out of the question given the events of the past couple of weeks—you’d see oil skyrocket. “The strong uptick in sectarian violence across the country is a serious cause for concern as it could set back Iraqi production targets by years,” the oil consultancy JBC Energy reported recently.
The supply side story isn’t all bad. As Libya recovers from its own devastating civil war—which rocked oil markets earlier this year—production should increase. Deepwater drilling—despite the all-too-obvious risks—is growing steadily in the Gulf of Mexico, off Africa and South America. And North America has managed to reverse its long-term decline in oil production, with oil shale in North Dakota and oil sands in Alberta.
But as the long as the global economy keeps growing—and as long as that growth is chiefly fueled by oil, barring a major improvement in efficiency—production will need to keep growing as well to keep prices from rising as well. It’s as if oil producers are on a treadmill that speeds up each year, and even as they run faster, they can’t keep up. That’s a formula for high prices—unless the treadmill were to suddenly slow down or even stop.
That’s what oil analysts refer to as a “downside risk.” If the teetering European economy were to collapse because of the Euro crisis or if China overheats or if the U.S. slips back into a recession, oil demand would likely fall as well, and so would price. That’s what happened at the end of 2008, when the sudden financial crisis and ensuing global economic slowdown reversed the growth in oil demand, causing prices to fall nearly $100 from their record-high peak in the middle of that year.
Will that happen again? It’s impossible to tell, and right now most analysts expect oil to stay above $100 a barrel over the next year. But this is life at the end of 2011: if a geopolitical shock hits oil supplies in the Middle East, we could see prices break records. And if the global economy shifts into reverse again, we could see prices plummet. The best we can hope for in 2012 is steady, boring, triple-digit oil, with all the pain that still brings. But that’s the price of addiction.