Though global economic conditions are at their worst in many decades, oil prices are still higher than they were during any of the previous recessions. That may signal the possibility of yet another price surge when the global economy recovers. By Shivshanker Verma

Arjun Murti must be a very lonely man now. The 39-year old head of energy research at Goldman Sachs was the best known oil analyst until recently. Soothsayer, clairvoyant, Mr Crude Oil monikers for the man who first predicted a 'super-spike' in energy prices and crude oil prices going past $100 per barrel were many. The world watched in disbelief when his prediction came true, dubbing the Oil Oracle of Goldman Sachs.

When oil prices continued to surge, well past the first target, Murti raised the target to $200 per barrel. When he made that call in May this year, it seemed only a matter of time before that target was taken out. Oil prices were rising uncontrollably and politicians were scampering to find a way to ease the burden. Most of them blamed speculators and alternate fuel research was all the rage, matching the crazy days of the internet boom.

Then came the crash. After touching an all-time high of $147 per barrel, oil prices have dropped more than 50 per cent within a few months. Even Murti was forced to retreat. He cut his forecast for 2009 oil prices, first to $110 per barrel and more recently to $75 per barrel. His worst-case scenario for next year is just $50 per barrel, a far cry from his earlier bullish predictions.

No wonder, those who hailed him earlier were quick to dump him as yet another fallen prophet.

But, were the basic premises behind Murti's forecasts all that wrong? True, his price forecasts have been proved spectacularly wrong. That is mostly because the world is going through the worst financial crisis in living memory, something which very few anticipated. Murti himself acknowledges that. The latest report from Goldman Sachs says they underestimated the dramatic demand decline because of the global growth slowdown.

For now, it is all about demand
When oil prices were surging, the focus was more on supplies. Though higher demand from emerging countries was touted as the main reason behind higher prices, the incremental growth in demand was nothing spectacular and it was not that the world was facing any physical shortages. All it did was to reduce the supply buffer and, along with a shortage of refining capacity, made oil prices highly sensitive to even minor supply disruptions. The longer term story was that, if the demand growth continues even at a modest pace, the world will eventually run out of oil and there are no alternative energy sources in place.

Forecasts of Arjun Murti and other oil bulls were based on this premise, which remains very valid. Yes, oil prices went a bit too high, too soon. But, that is how markets behave. Rather than blame the market, suppliers, consumers and policymakers should read such price signals and act accordingly. The absence of alternatives restricts the consumer and the uncertainties of prospecting for oil restricts suppliers to a great extent in this case. But, policymakers should have stepped in much earlier to actively support development of alternate energy sources. If they had been more foresighted, oil prices would not have gone up so sharply in the first place.

Again, market trend has shifted so dramatically and this time it is the suppliers who are doing all the crying. The prospect of a global recession has forced the oil market to refocus on demand, which is evidently declining. Oil imports by the US, which consumes nearly 30 per cent of global output, is down 10 per cent from last year.

That is even before the American economy has formally entered a recession. Most of Europe is facing recessionary conditions while growth has slipped in China and India. So, the demand outlook is definitely weak in the short term and possibly for several years if there is a global recession.

But, even now, no agency is predicting an absolute decline in global oil demand. International Energy Agency has lowered its demand growth forecast for next year by 250,000 barrels a day. Note that it is the not the absolute demand forecast that has been cut, but only the expected incremental growth in demand. The IEA still believes demand will grow by an average 440,000 barrels a day in 2009.

For the oil market, which is focussed on demand in the short term, even the forecast of lower demand growth is significant and leads to sharp price declines. Just as news about minor supply disruptions caused prices to jump when the market was rallying. The focus on demand has become so intense that OPEC's decision to cut production by as much as 1.5 million barrels a day led to further price declines, as the market was expecting bigger reductions. The dollar rally has accentuated the decline in oil prices, just like the currency's fall aided the oil rally earlier.

Politicians who bristled at oil speculators for pushing up prices are surprisingly silent. But the fact is that the same speculators are driving down prices now, maybe even lower than the change in demand-supply scenario warrants! If oil pricing was left to supplier cartels like OPEC and not to an active and liquid market, it is possible that prices would not have declined so sharply. Markets move in both directions and the price excesses can be avoided if all the participants and policymakers act on the price signals.

The downside of cheap oil
Oil markets have seen only a correction of some of the recent excesses, just like most other commodity and asset markets. Since the excesses were way over the top and since oil prices are so widely followed, the correction looks all the more spectacular. Even after this massive correction, oil prices are yet to fall below the levels seen as recently as 2005 when the global economy was enjoying the best ever phase of growth.

Shouldn't our policymakers be worried that oil prices have not fallen more when the global economy is plumbing the depths not seen in nearly eight decades? If the oil price surge that lasted until July this year was just a bubble, not supported by fundamentals, then why are prices still at twice or thrice the levels seen during previous recessions? Those downturns were mild compared to the current one and the financial crisis we are facing now is almost unprecedented. Surely there must be a reason why oil is not trading at all-time lows now.

The reason is, the long-term fundamentals have hardly changed. Demand is still growing, though at a slower pace. Long-term demand projections may be cut by a few million barrels a day, but they are still way above current and forecast supplies. To make it worse, the current price decline will slow down the potential growth in supplies as investments in oil exploration and production are scaled back. Besides, some of the recently discovered large reserves like the deep-water offshore oil field in Brazil will be commercially unviable only  if oil prices decline further.

It is quite likely that development of alternate energy will become less of a priority for governments across the world. Private investments in renewable energy projects have already come down because of the scarcity of funding after the financial crisis. Public funding will also dry up as governments are focussed on more immediate priorities like avoiding a financial meltdown and fighting a recession.
 
Nearly a decade back, we saw another incredible prediction about oil prices go spectacularly wrong. In 1999, when oil prices were slightly above $10 per barrel, it was not one of the self-serving investment bankers who said the world was 'drowning in oil' and forecast prices to go down to $5 per barrel. It was The Economist magazine, probably the most respected publication. The surge since that prediction took oil prices more than 10 times higher in less than a decade.

Soon, we will all forget there ever was a global energy crisis and someone may forecast that oil prices will slip to single digits. Then, the global economy will recover and oil prices will commence yet another surge to scale new lifetime highs.

Then, prophets like Arjun Murti will be back in vogue again.