Are oil prices dangerously low?

As the immortal Larry King would say, "This, we don't need."

One of the few benefits of the recession has been the drop in oil prices. Global oil markets are flush with crude now, primarily due to massively decreased demand, and prices have plunged to around $50 per barrel. But all that could change in a hurry, says one veteran oil industry analyst.

Matt Simmons, founder of Simmons & Co., a Houston-based investment bank, argues that aging oil fields and the credit crunch are likely to lead to a spike in prices that could exceed last year's highs, and sooner than we think, Reuters reported Thursday. In the summer of 2008, oil hit a record $147.27 per barrel amid the leveraging bubble.

Why today's low oil prices could be bad

"We are three, six, maybe nine months away from a price shock. We are not talking about three to five years away -- it will be much sooner," Simmons told Reuters. "These prices now are dangerously low. The lower prices fall, the less oil will be produced and the greater the chance of an oil spike."

It should be noted that Simmons supports the "peak oil" theory, which argues that world oil output is approaching an irreversible decline.

In his 2005 book Twilight in the Dessert, Simmons argued that output from Saudi Arabia, holder of the world's largest proven reserves, is reaching an apex and will soon diminish. The resulting realization first of a topping out in production and then of emerging scarcities will forever end the era of cheap oil, Simmons argues.

In this scenario, low oil prices will continue to take oil fields out of production and reduce exploration. Then once prices recover, companies will have trouble gearing back up due to the credit crunch, resulting in production increase delays.

"Unless oil demand falls by 10 or 15 percent per annum, which it is not going to do, then we don't need to wait for oil demand to come back before we have a supply crunch," Simmons said.

But maybe not as bad as some think

It should be noted the Kingdom of Saudi Arabia has strongly disputed that its fields, including the massive Ghawar oil field, is approaching a production peak. Saudi Arabia does not publish production and reserve results for individual oil fields, but U.S. officials have taken the Kingdom at its word -- and I'm inclined to agree with them. It's not in Saudi Arabia's interest to "spring" any scarcities on the U.S. that could lead to dramatic run-ups in prices. Ignoring for the moment the large Canadian oil sands reserves that would be marketable with oil prices above $80 per barrel, any sudden recognition of a Ghawar peak would most likely also propel sudden, and irreversible, changes in U.S. energy policy.

The decrease in gasoline and oil demand from the recession led some industry watchers to conclude that OPEC would try to prop up prices by cutting production at its most recent meeting in March. However, with prices hovering in the $50-range, OPEC ordered no such cut, and if Simmons' analysis is correct, OPEC will soon need to increase production, not decrease it. True, a weaker U.S. dollar could help put a floor under oil prices, but recently the dollar been holding its own despite more than $5 trillion in federal fiscal and monetary stimulus over the past 15 months.

Additionally, comments Sunday by Quatar's Oil Minister Abdullah Bin Hamad Al-Attiyah suggest OPEC is aware that the cartel's spare capacity may be critical to keeping a handle on prices after the recovery starts, given the relative ease with which OPEC can increase production compared to other suppliers.

"We believe growth in the international economy is still very weak -- it doesn't mean we are going to cut production in May," Al-Attiyah told Bloomberg News Sunday. "The [recession] has not reached the bottom so we have to be very careful."

Economic Analysis: While the view from here does not necessarily agree with Simmons on peak oil, his point that the world is dangerously under-producing oil should be heeded by policy makers and citizens. Given the speed at which oil demand can increase as global GDP growth resumes, it's easy to see how oil prices could quickly rise to the $70-range and beyond, if not the $150+ levels the doomsayers predict.

Bottom Line:
Even if Simmons' is wrong about peak oil, this period of low oil prices will be short, which points to the need for the U.S. to develop a comprehensive long-term national energy policy, and for consumers to choose a vehicle that makes economical sense with oil above $70, because that's where we're headed, eventually.
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