Thoughts on Crude Oil’s Record High Above $88 Per Barrel

I have recently suggested investors consider taking some profits in the crude oil market, but prices in the low 80’s price range has not stopped the commodity from continuing its ascent. Crude oil is hitting new historic highs today above $88 per barrel. The contrarian in me prefers to buy weakness and sell strength, so even though the current rise could continue, I am not going to jump on the momentum train and suggest people pile into crude in the short term. Longer term, though, I think it is worth taking a look at what will ultimately dictate where oil prices go.

To understand oil market dynamics, one can simply boil it down to supply and demand. There is a debate right now among energy watchers as to whether or not we are actually reaching a peak in world oil production. Obviously, if that is indeed the case, and demand continues to rise on the heels of a global economic expansion, higher oil prices are the likely result. However, official projections from various agencies still project that production will increase to meet higher demand, despite evidence in recent years that production gains are easier said than done.

Consider information from the U.S. Energy Information Administration. The EIA’s own data shows that despite a trend of ever-increasing oil demand around the world, production has actually been leveling off. In 2005 and 2006, world oil production was 84.63 and 84.58 million barrels per day, respectively. Estimates for 2007 stand at 84.72 million barrel per day.

As you can see, world oil supplies have been essentially flat for the last 3 years. Interestingly, energy experts have predicted production increases in the past for this period, but such gains have not been realized. This data gives the “peak oil” theorists some ground to stand on.

Once again, the EIA is projecting 2008 oil production worldwide to increase meaningfully, to 87.06 million barrels per day. If this forecast proves true, those suggesting that international oil production has already peaked will be dismissed. However, if production fails to meaningfully rise during 2008 in the face of higher demand (for the fourth consecutive year), chances are the oil markets will reflect this dim supply/demand outlook in the form of higher prices.

The chart below shows the data I have referenced above in graphical form. In my view, this is the trend we should be watching to see where oil prices are headed in the intermediate to longer term. The short term, however, is anyone’s guess.

Source: U.S. Energy Information Administration web site