Economists unsure how low energy prices will go

Only 37% of the buyers polled seeprice inflation ahead. Economists generally agree, but see stability—not reductions—ahead.

By Tom Stundza -- Purchasing, 11/2/2006

This past spring, 80% of the buyers polled by Purchasing and a majority of the public surveyed by the Pew Research Center reported that energy prices were the nation’s most important problem. Last month, energy prices got near-bottom billing in both polls.

That’s no surprise since the mid-October price of crude oil had dropped 34% off its $78 peak to $58/barrel; market prices of gasoline and diesel had slipped to a 16-month low; natural gas prices at the wellhead had deflated by 52% from a year earlier; and the wholesale price of fuel oil was down 15% from last autumn.

Lower oil and natural gas prices are good news for buyers at manufacturing companies, especially for chemical process companies—from steelmakers to paper makers, from chemicals producers to plastics resins makers—that use massive amounts of oil-based products and natural gas to power their plants. Freight buyers also may see fuel surcharges slide. But, on an annualized basis, crude oil still is pretty costly—the 2005 annual price average for a barrel of West Texas Intermediate is projected at $67. And, debate still rages among economists whether energy prices will fall further or stabilize and then rebound.

Victor Shum, a Singapore-based analyst with international energy consultant Purvin & Gertz, sees crude oil staying under $60 but worries that “as long as there is limited excess-production capacity and limited refinery-conversion capacity, the market will still be prone to periodic price spikes.” Any long-term elevation of energy costs still is seen by economists as bad for global economic growth. That’s why analyst John P. Herrlin Jr. at Merrill Lynch expects there to be “more downs than ups in the near term.”

However, Herrlin also points out that buyers shouldn’t think energy prices are heading back to the $20/barrel crude oil or $2/thousand cubic feet natural gas world of the 1990s. “Yes, prices can spike that low in the short term,” he says, “but those prices simply aren’t economical for long term reserve replenishment.” For now, the pricing bears appear to be holding sway—even though a big petroleum-products buyer in Pennsylvania cautions his purchasing colleagues that “energy costs continue to bear watching.” Still, for now, crude oil and natural gas costs are reacting to:

An Atlantic hurricane season that failed to send a storm into the Gulf of Mexico, a year after storms devastated the nation’s energy production center;

• The summer driving season ended with less consumption than forecast and petroleum inventories described as healthy;

• New forecasts are suggesting that global economic growth will slow in late 2006 and into 2007, reducing the global growth rate for energy use;

• Investors are less worried about the confrontation between the U.S. and its allies with Iran over the Middle Eastern nation’s insistence on continuing its uranium-enrichment program. A ratcheting-up of rhetoric earlier this year contributed to the steady rise in prices through mid-July, but both the oratory and the pricing have cooled in recent weeks;

• A pullback in speculative trading of energy futures has helped deflate market prices.

A market analysis by Barclays Capital suggests an oversupply of energy products in North America and Europe will keep prices down this autumn. This view has been supported by other analyses, which see further price slippage in the fourth quarter from a seasonal slowdown in demand during milder-than-average winter weather. Bear Stearns & Co. analysts forecast a “moderation in oil prices in the coming months,” because of dwindling demand and rising supply. Some expect light, sweet crude oil to be $50/barrel in the fourth quarter, which would bring the 2006 average to $68. That compares with $54 in 2005.

“This is like a lull period,” says John Person, president of NationalFutures.com. “If we have a mild winter, demand for heating oil products will decline, thus giving a chance for refineries to build even more inventories.” That’s why Person expects prices at the pump to fall further over the next few months to a national average around $2.25/gallon for unleaded regular—as compared with a peak $3 weekly average in late July. Even more bearish is oil analyst Tom Kloza at the Oil Price Information Service, who forecasts U.S. retail gasoline prices “will go beneath last year’s autumn-winter low of $2.12 a gallon”—which may occur early in November.

The most basic form of energy trading involves buying and selling shares of investment funds that invest in firms involved in crude oil, natural gas and other energy products and commodities such as electricity and coal. Speculators also buy and sell futures of energy products.

As the price of crude and other energy products climbed in 2004 and 2005, many hedge fund managers and speculators made a killing. Now, with energy market pricing in a freefall, “people are much more cautious about dumping a whole bunch of money into energy hedge funds or futures,” says Tom Lord, president of commodity-markets consultant firm Volatility Managers in Green Mountain Falls, Colo. And the self-fulfilling prophecy is: The less action by investors, the less inflation in the commodity.

Still, not everyone thinks prices will keep freefalling forever. “There is no telling if the huge decline in energy prices will hold,” says Anthony Chan, chief economist at J.P. Morgan Private Client Services in New York. And, while analysts polled by Bloomberg News in late September saw slippage from the 2006 average, they still are expecting average crude oil prices of about $62/barrel next year and $61 in 2008. Interestingly, the government Energy Information Administration has a 2007 crude oil spot price forecast that is somewhat more bullish, projected to average around $66/barrel.