Oily Promises

Story Highlights:

• Oil prices are hovering around low- to mid-$40 a barrel—a precipitous price drop considering oil's brief flirtation with $140 a barrel just this July.
• In an attempt to drive prices higher, OPEC announced on Wednesday a pledge to cut oil production levels by 2.2 million barrels per day, effective January.
• Analysts recently lowered forecasts for oil prices, but these forecasts are too often fickle, and commodity prices can be extremely volatile.
• Sound investing decisions about commodities require long-term views. Global demand for oil is weak today due to the global economic slowdown, but in the medium to long term, fundamentals support higher prices.

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Suddenly, it seems safe to dust off the SUV. After all, oil prices are now hovering around low- to mid-$40 a barrel—a precipitous price drop considering oil's brief flirtation with $140 a barrel just this July.

But if you're thinking of a joyride, better make it quick. OPEC, a cartel of 12 oil exporting countries responsible for producing 40% of the world's oil, is understandably upset about the new oil price trajectory. (The higher the price of crude, the more money they make.) In an attempt to drive prices back towards the $70 –$80 a barrel range, OPEC announced on Wednesday a pledge to cut oil production levels by 2.2 million barrels per day, effective January.

OPEC's statement yesterday augments two previously announced production cuts since September. Including this new cut, OPEC production levels are slated to fall 4.2 million barrels per day in 2009. OPEC is also encouraging oil exporters outside the cartel to cut production to help put a floor under falling prices and trim excess commercial oil inventories worldwide.

The announcement marks the largest production cut in OPEC's history and is the biggest in decades, but whether that reduced level is reached is tenuous upon its members' compliance. OPEC members have a notorious history of pumping more oil than agreed-upon quotas permit—governments are reluctant to curb production and lose revenues. But this lack of compliance also creates skepticism in oil markets and partly explains why oil prices continued to drop despite previously announced cuts.

Let's be clear: OPEC is a cartel in the pejorative sense. There is no "appropriate" price of oil other than its equilibrium price relative to supply and demand in the world. That this "group" of nations manipulates markets to their will is a pure market externality and in itself a reason to anticipate higher prices in the longer term. The short-term jiggering they do with the oil market is also probably a reason for its price volatility over the years— though geopolitical issues are always part of the commodities game.

Wary of OPEC's broken pledges and dour over the global economy's outlook, some analysts recently lowered forecasts for oil prices. The same Goldman Sachs team that predicted $200 a barrel oil in the summer now forecasts oil to average $45 a barrel for 2009, with prices dipping to $30 in the first quarter. However, these forecasts are based on today's price trends, and commodity prices can be extremely volatile—the huge range of forecasts over the last couple years tells us as much.

Believing current declines in oil prices will lead to ever-lower future prices is the same ill-conceived logic as believing this summer's rising prices meant oil would rise and stay high at length—something that obviously did not occur. This is a common cognitive error. Oil prices, like any commodity price, can experience extreme gyrations in the short term. This is why decisions regarding commodity-based market sectors must be made with a longer view.

It's true global demand for oil is weakened by current global economic slowdowns, but in medium to long term, fundamentals still support higher prices. There's every reason to believe emerging markets will continue their drive for development and industrialization when the global economy recovers—and this process relies heavily on oil, pumping up marginal demand all the time. There is no viable, economical substitute for oil, and as long as this is true, demand will continue to grow over the years. Further, despite current excess commercial oil inventories, oil supply is still largely fixed due to the constraints of technology, delivery, production, capital, investments, and resources.

The road ahead for oil won't be smooth—it never is. But, it will be lengthy.