Crude Oil Could Rise to $120/Barrel by Year's End

When futures options for crude oil predict that prices will rise to $120/barrel by the end of the year, and industry analysts are looking at prices closer to $101/barrel, it’s tough to know whom to believe. The difference is important because a price of around $120 will snip about 0.5% off global GDP compared with a price of around $100.

The World Bank puts 2010 global GDP at about $63 trillion, and the IMF estimates world GDP growth of 4.3% in 2011. That’s a difference of more than $300 billion. That lost growth goes to pay for more transportation fuel, fertilizer, and other products that use petroleum as a feed stock. Essentially the entire $300 billion is divvied up among oil producing nations and private oil companies.

In the US, which uses about a quarter of the world’s crude supply annually, this amounts to a “tax” of about $75 billion. And that’s money that US consumers could be spending on goods and services.

The options market has priced more contracts for December delivery of WTI at $120/barrel than at any other price point, according to Bloomberg.  The next highest number of open interest is at $125/barrel. The two together represent an increase of nearly 30% in open interest over the last month.

Expert analysts typically include demand forecasts as well as other considerations like political stability when they make their predictions. There is little disagreement that supply will be very tight for the rest of this year, especially because Libyan production is essentially completely halted. With 1.6 million barrels/day of Libyan crude unavailable, the issue then is whether or not there is enough spare capacity in the rest of the world to make up the difference.

The answer to that has been pretty well established at “No”. The Saudis, who would like to see prices no higher than $90 or so, could not (or, perhaps, would not) ramp production enough to replace the lost Libyan barrels. The International Energy Agency was forced to withdraw 60 million barrels from strategic reserves in an effort to try to balance the market.

It is true that Saudi Arabia boosted production in June to more than 9.2 million barrels/day, but that was a jump of less than 1%, not enough to offset Libyan barrels. Experts are discounting the price of crude as GDP growth estimates fall because the historical relationship is that when growth slows down so does demand for crude.

Analysts are projecting fourth quarter crude prices at less than $90/barrel. Slow global growth, particularly in the US and China, is the reason. Supplies, if tight, are expected to be adequate.

Traders’ recent experience is that nothing keeps the price of crude down for long, and that December call options at $120/barrel are a good investment. In April, the most popular December option called for oil at $80/barrel. In just two months the sentiment for a 50% hike prevails.

In this case, it is difficult to agree with expert opinion that places crude prices below $90/barrel by the end of this year. Crude prices are rising inexorably, and a safer bet is for higher, not lower, prices. But $120 seems too aggressive. WTI crude is trading at right around $100/barrel today. Barring any additional disruptions, that sounds like a good ceiling for where crude prices will be on December 31st.

Paul Ausick