How high could oil go? (2)

January 25, 2011 | 00:00

How high could oil go?

Oil prices have risen quickly since Bernanke's Jackson Hole speech last August, reflecting strong fundamentals and easy money.

At current prices, we estimate that total global energy consumption as a share of GDP sits at 7.9%, up by1.2 percentage points from last year. This figure varies by region, of course. In EMs (emerging markets), the size of energy demand is presently at 13%, more than double that of the OECD where it sits at 6%. As a reference point, the share of energy demand inglobal GDP scratched 9% in 1980 during the 2nd oil crisis. The global energy sector also averaged 9% of GDP in 2008, briefly jumping to 12% as oil spiked above $145/bbl. How high can oil go before the world economy starts to struggle again?

Oil above $115/bbl could put the global economy at risk

We have long argued that oil would break through $100/bbl in 2011. But with higher global economic growth and inflation expectations for 2011, our analysis now suggests that Brent crude oil prices would have to average about $115/bbl this year, and $130/bbl next year to bring global energy demand to 9% of GDP. Among the factors that are pushing this "oil threshold" higher is: (1) much lower US natural gas prices, (2) lower refining margins, and (3) a rapidly expanding global nominal GDP in USD, a function of real economic growth, global inflation and FX moves.

Several countries appear vulnerable to rising oil prices

As oil prices continue to look for a demand rationing point, the sensitivity of different countries varies. Combining a quantitative filter and qualitative discussions with our economists, we believe that Turkey, peripheral Europe, India, Korea, and even Indonesia could start to suffer if global oil prices averaged $100-120/bbl this year. If oil instead broke unexpectedly to a $120-130/bbl range, pretty much every other net energy importer, including Germany, Japan, China and other parts of Asia, would be hurt.

Perhaps surprisingly, the US is somewhat less vulnerable. We estimate that the energy sector now represents 5.4% of the US economy, relative to 7.6% in 2008 and 10.6% in 1980 thanks to efficiency improvements and low domestic nat gas and coal prices.

An oil spike is unlikely as OPEC spare capacity is ample

Based on our estimates, global oil demand growth will ease to an average of 1.5 million b/d in 2011, down from 2.7 million b/d in 2010, suggesting OPEC will have to add at least 300 thousand b/d to current output to prevent prices from rising further. Real interest rates remain very negative, central banks seem reluctant to tighten monetary policy, and OPEC will have to add barrels to the market to prevent further price gains in 2011. Still, with inventory levels at, or near, 5-year seasonal highs, more Iraqi crude on the way, and OPEC spare capacity sitting at 5.4million b/d at present, compared to about 2 million b/d in 2008, we believe a sharp spike in oil prices above $115/bbl this year remains an unlikely possibility.

To read the full report with important disclosures, click here.

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