Calling the Drop in Oil

In the oil market, $50 is the new $100.

Much as oil traders a year ago eagerly eyed the unexplored heights of $100 a barrel, now they are resigned to oil slumping to $50 a barrel or below, as economies around the world, even including China's, slam on the brakes.

An effort to stop the free fall in oil prices -- a decision today by the members of the oil cartel Opec to cut daily production by 1.5 million barrels -- has failed miserably. The benchmark contract for oil is down nearly 5 percent today, at $64.69 a barrel. And options to sell crude oil at $50 by December nearly tripled today.

Last winter, the talk was all about oil surging past $100, even $150 a barrel, spurred by the seemingly insatiable demand from emerging industrial powers like China and India.

Since then, the credit crunch has slowly but surely choked economic growth around the world. Even analysts at Goldman Sachs, who first forecast $100-a-barrel oil in 2005, have become bearish about oil prices, writing earlier this month that "we clearly underestimated the depth and duration of the global financial crisis and its implications on economic growth and commodity demand."

More important, as detailed by John Cassidy in the December issue of Conde Nast Portfolio, was that the seeds of the fall in oil prices were sown in the rally that had begun in 2003.

Once crude oil passed $30 a barrel in 2003, the economics of exploring and producing oil improved, and the energy industry began ramping up capital spending again, Cassidy reported.

Exxon Mobil invested more than $60 billion in exploration and development. Wells that had been mothballed were revived. New offshore projects began.

"With energy supplies expanding and the demand for oil showing signs of faltering, it won't be very long before economic fundamentals reassert themselves," Cassidy wrote.

"If oil were a normal commodity, competition would eventually drive the price down to a level close to the current cost of production, which at the margin is probably somewhere between $20 and $30 a barrel."

It appears that the law of supply and demand has now brutally reasserted itself in the oil market.

Jeffrey Cane

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