The decline in crude oil prices in recent weeks is a major relief for the global economy. But is this only a correction before oil resumes its up trend?

Prices of crude oil and other fuels have declined substantially recently and has claimed a major causality in hedge fund Amaranth Advisors, which lost $6 billion in natural gas futures trading. Most of the oil analysts who were predicting crude oil prices of $100 and even $200 per barrel have suddenly lapsed in to silence.

Lower oil prices have come as a very welcome relief for the global economy, which was showing early signs of a slowdown. This decline in fuel prices has considerably reduced the possibility of a sharp decline in growth for major economies like the US.

Are lower oil prices likely to sustain, or is this just a sharp correction in a long term rally? Is the world fast running out of oil and other fossil fuels?

Fundamentals of the oil surge
Over the last few years, oil prices have come a long way from around $20 per barrel in early 2002 to an all-time high of over $78 per barrel for light sweet crude on the NYMEX. There were periodic corrections, but the overall trend was clearly upward.

The primary driver of oil prices in recent years has been the high rates of economic growth across the globe, which drove up demand – especially from large emerging economies like China and India. Demand in mature economies like US – by far the biggest consumer of petroleum – also picked up as the economy recovered and expanded at a fast pace.

Sustained low crude prices for many years had led to huge under-investment by the oil industry in exploration and production activities. The industry cannot be fully blamed as most of the light crude reserves, which are easy and less costly to refine, were already discovered and exploring for heavy crude was not very attractive in a weak market. Most of the unexplored areas which held potential were difficult to explore - like deep water offshore blocks - and would have required much higher investments, which the industry was unwilling to commit.

Absence of new discoveries and rising demand led to a narrowing of surplus production capacity – the gap between total global demand and total existing production capacity. This left oil prices very vulnerable to supply shocks or developments which could disturb production.

Another factor which led to the rally in oil prices was the lack of surplus refining capacity. Low oil prices in the last decade also resulted in underinvestment in new refining capacities. Most of the older refineries can only process light grades of crude while much of the production from newly discovered fields is of the heavy variety. Tight refining market led to higher refining margins which in turn pushed up prices of refined products.

Thus the situation was ripe for investors and speculators to move in. The last few years have seen a significant rise in money flows from financial investors into commodity markets. Crude oil is one of the more liquid – widely traded – commodities and the fundamentals of the oil market made it a very attractive destination for financial investors.

As the early investors who caught the market bottom in 2001 and early 2002 made very attractive returns, others moved in droves. Some of the largest global fund managers became very active in crude oil and energy funds mushroomed.

Oil prices became highly volatile, dependent on even minor news flows from the major producing regions. Oil analysts grew at a fast clip and predictions of oil reserves drying up became a favourite pastime. Some of the large investment banks, who are the most active traders in oil, came out with self-serving 'authoritative' analyst reports which talked about impending 'super-spikes' in oil prices.

Industry analysts believe that more than 20 per cent of the price of crude oil at its recent peak was 'speculation premium' because of higher inflows from financial investors.

Significant developments like terrorist attacks and violence in the Middle East, hurricane damages to oil rigs and refineries in the US east coast, militant attacks against oil installations in Nigeria, the stand-off over the Iranian nuclear programme and damages to oil pipelines in Alaska led to concerns of supply disruptions and shortages, and pushed up oil prices further.

All this while, there were no physical shortages of crude oil. Though the prices were high, sufficient oil was available to buyers who could afford it. Sustained global economic growth ensured that consumers could afford higher fuel costs and demand remained high despite the substantial rise in prices.

Behind the decline
For the first time in the last few years, there are serious doubts now about the sustainability of global economic growth. Higher fuel prices have contributed to a rise in global inflation which resulted in rising interest rates. This has started affecting consumer demand and growth rate projections for the medium term are now more moderate.

Demand growth for crude oil has also eased, though there is no decline in demand as yet. Both the International Energy Agency (IEA) and the oil exporters' cartel OPEC have lowered their demand forecasts for the current year and next year. OPEC has not so far reduced its production in response to slowing demand growth and is not expected to do so, at least for the rest of this year.

This slowdown in demand growth would widen the surplus production and refining capacities available. The oil industry has also started making significant investments in new exploration, developing new production facilities and setting up new refineries which can process heavier grades.

This change in the short to medium term fundamentals of the oil market prompted some of the financial investors to turn bearish. The Middle East conflict involving Israel and militant groups in Lebanon and Palestine came to an end. The Alaska pipeline has been repaired and the US government has given permission to restart production one month earlier than expected.

After last year's hyper-activity, this year's hurricane season in the Gulf of Mexico has started very mildly. Current forecasts indicate that hurricane activity may not pick up substantially, removing another threat to oil supplies.

The only remaining major issue involves Iran's nuclear programme, the second-largest OPEC producer. Though the Iranian leadership continues to resist pressures to stop uranium enrichment, it appears less likely that the situation would worsen to a military conflict.

It is also unlikely that the US, already mired in tough situations in Iraq and Afghanistan, would initiate military action against Iran. Any such attack would lead to a flare up in oil prices and would affect the political fortunes of the Republican Party in the US. Lower oil prices are in their interest, as the next presidential election nears.

Hence it is more likely that the Iranian nuclear dispute would be resolved through diplomatic efforts. There would be much haggling between the two sides and it may take some time, but neither side can afford a military conflict at this point.

As most of the immediate threats to oil supplies subsided, more and more traders and financial investors in the oil market became bearish. This has led to the sustained drop in crude oil prices over the last few weeks. Prices have declined 23 per cent from the lifetime high to around $60 per barrel on the NYMEX yesterday.

What the future holds
In the short term, prices may recover on any new development affecting supplies. The recent decline has been quite steep and over a short period and such falls are often followed by an equally sharp recovery. But it is very unlikely that oil would go straight back to earlier levels, as market fundamentals are uncertain and sentiment has definitely turned negative.

The trigger for such a short-term recovery could be anything ranging from tough posturing by Iran to an unexpected production cut announcement by OPEC. By next month, winter demand in the northern hemisphere would also kick in which may lead to a decline in US oil inventory and upward pressure on prices.

Over the medium term, global economic growth rates would determine oil prices. If growth falters considerably as feared by some, it could affect demand and push oil prices even lower. However if the slowdown is moderate, it is unlikely that there would be any decline in demand and prices may remain at around current levels.

The longer term picture is hazy in the absence of clear data on oil and other potential fuel reserves. There is no consensus on when oil production would peak. Estimates range from as early as 2010 to a much more optimistic 2070. The very wide range of estimates on peak production is because there is no reliable data on discovered reserves of crude oil and other fuels like natural gas.

Pessimists argue that crude oil reserve estimates given by government-owned oil companies of major producing countries are hyped up and reserve estimates of natural gas are even more so. They also believe that all the major oil and natural gas fields have already been discovered and the potential of other sources like shale or tar sands, coal-bed methane, etc, is much lower than projections and would be very costly.

More optimistic analysts reckon that while there may be inaccuracies in reserve estimates, they are not significant enough to cause alarm. There are many unexplored areas across the globe which may hold large reserves and even well-explored areas may contain more reserves. The recent discovery of a large oil reserve in the Gulf of Mexico with potential reserves of billions of barrels lends support to this view.

Higher oil prices would attract more investments into research on reducing fuel consumption and developing alternate energy sources. Modern engines are far more fuel efficient than earlier ones and technological improvements can be expected to improve their efficiency even further in future. Many countries are already turning to alternate fuels like ethanol, bio-diesel, etc.

Hybrid cars, which run on both electricity and petrol, have already become affordable and increasingly popular. Production of cars running on fuel-cells, which do not require any petroleum fuel, at affordable prices is less than a decade away - even by the worst estimates.

Though demand from fast growing economies would continue to rise, technological advances and use of alternate fuels would limit overall global demand growth. Hence it is more likely that longer term average crude oil prices would remain at around the current levels, which makes further exploration and development of alternate sources economically viable.

A super spike in oil prices? Not very likely, unless there is a US-led military move against Iran which develops into a wider conflict involving most of the Middle East.