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COMMENT: Have oil markets turned the corner?

Oil prices have retreated from record highs, and appear to be heading lower. Was it all a bad dream? Or is this jus...

Oil prices have retreated from record highs, and appear to be heading lower. Was it all a bad dream? Or is this just a short respite before we head to three-digit oil pricing?

The world oil market has been in turmoil for nearly two years. Prices have been driven higher on fears of disruptions to supply we have had military action in the Middle East, political tensions in Venezuela and Nigeria, and hurricanes in the Gulf of Mexico. All of these developments had the potential to knock oil markets on their heels and send prices into a major upward spiral.

The thing is, it didn’t happen. Despite all those problems, both real and feared, not a single supply disruption has been reported. Motorists have been able to fill their tanks without waiting in long lines except, of course, when gasoline has been offered at discount prices, a frequent occurrence that seems like an odd strategy when the gasoline market is supposedly so tight.

Now, after seeing prices approach $60, and after seeing forecasts of oil prices of $100 per barrel or more, markets seem to be relaxing. Prices have fallen to the $50 range, and look poised to go lower. What is going on? Several things at once.

First, the world economy is slowing, as it was forecast to do. In 2004, global economic growth was 5%, far too high to be sustained. This year, growth will be closer to 4%, a much healthier pace, and one which is already taking the pressure off of oil and other commodity markets.

Second, the U.S. dollar appears to be finding its legs, after an almost uninterrupted decline during the past three years. This is cooling commodity prices, which are expressed in U.S. dollars.

Third, the oil supply system is still working. Inventories have been rising steadily, easing the fears of those who see them as too low. Further, the recent performance of the system suggests that suppliers know their business why should they be the only segment of the economy that cannot move closer to just-in-time inventory management? They have, and the system works.

And, finally, there are the forecasts of oil prices of $100 or more. One argument is that consumers will not slow their energy purchases until they are shocked by higher prices. Yet we can already see U.S. consumer confidence and non-energy consumer spending flagging, at much lower prices. Another argument is that it will take time for new investments to produce more oil, leaving prices to skyrocket in the meantime. But the standard industry assumption for future oil prices just a couple of years ago was $20 per barrel this suggests that there are plenty of quicker projects on the shelf that will now be profitable, even if prices fall all the way to $30.

The bottom line? It certainly seems that we have entered an era of higher-priced oil. But suffice to say that oil prices of $100, $50, or even $40 sow the seeds of their own destruction less demand, and more supply. Expect oil prices to remain high, but to keep trickling down.

Stephen Poloz is Senior Vice-President and Chief Economist, Export Development Canada.

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