Oil Corrections and Trend

July 17, 2008

Extreme volatility and unpredictability remain a fact of life for oil prices.  Market players have literally seen every kind of oil price movement since 1973 and can conceive of a further upswing toward $200/barrel or a huge correction back to $100 happening within the next six months or so.   To approach the above correction scenario merely requires a replication of the 37% drop from $78.40 in July 2006 to a trough of $49.90 in the following January.  Corrections of slightly more than 25% also occurred between October 2004 and December 2004 and in the six months between March 2003 and September 2003.  Even within a continuing long-term uptrend, a correction seems overdue based on the amount of elapsed time and upward movement since the last significant one in 2H06.  But there is no set rule of thumb for distinguishing a sharp weekly drop from the onset of a basic correction.

2008 will be the seventh straight calendar year in which oil prices in year-average terms record an increase, and the jump is likely to be at least twice as much as any of the previous six advances.  If the average price of oil averages for the balance of 2008 its price of today, the average for full-2008 would be $113.60, 70% greater than last years mean of $72.44.  Average oil prices rose 9.2% in 2007, 16.9% in 2006, 37.0% in 2005, 34.0% in 2004, 18.6% in 2003, and 0.3% in 2002.  A streak of seven straight annual advances is extraordinary and suggests that continuing high volatility is now associated with an upward, rather than flat, long-term trend.  The last two U.S. recessions were associated with oil price upsurges, but neither episode saw more than two consecutive annual increases.  Average yearly prices rose 23.2% in 1989 and 24.4% in 1990 after falling 16.6% in 1988, and they fell anew by 12.2% in 1991.  Likewise, oil prices climbed 32.4% in 1999 and 56.9% in 2000, but those gains were sandwiched between drops of 29.7% in 1998 and 13.6% in 2001. 

The magnitude of the present oil shock exceeds the jump in 2000 and is part of a more profound transformation than occurred during the previous two U.S. recessions.  Oil prices are now dictated by the voracious appetite of emerging markets to a degree not imagined during the two prior episodes cited in this update.  While equity and bond markets are right to react quickly to the kind of down-move seen in oil prices this week because such might herald a downward correction for the next few months, the medium-term reality most likely will embody much higher prices than existed as recently as 1Q08.  Huge adjustments in oil demand and supply lie ahead as a result.


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