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4 August 2008

Is the crude oil bull dead?
NYMEX crude oil futures have dropped some $25 off the high near US$147/barrel, to just below US$122/barrel. This is the largest fall in history (we believe) in absolute terms.

Still, the recent fall in crude oil has many asking if the bull market in crude oil is over. We doubt it, but it may well have cooled in the short-term.

The supply side
In our view, the supply side has been constrained by a lack of investment in exploration and refining capacity around the world. OPEC has also constrained supply over the years in order to keep prices firm.

There are also signs that higher prices are increasing production. The International Energy Agency has world production rising in 2009. This should lead to a greater build-up in world supplies, which in turn, should pressure prices.

The demand side
The IEA expects global oil demand to reach 87.7 million barrels per day in 2009 – up about 1%. Demand in OECD countries is expected to drop 1.2%. Non-OECD demand is expected to increase by 3.8%.

Still, the outlook for global growth is mixed and a significant downturn could see world demand fall further, pressuring prices. The largest expected drop in demand will come in North America, largely due to decreased motor vehicle usage, with gasoline prices in the US above US$4/gallon.

What do we think?
We think the western world is now very sensitive to high oil prices and while the economies can absorb high prices for a short period of time, the duration and sheer magnitude of the price rise means demand growth will slow and demand could potentially fall significantly.

If the economists who predict stagflation are correct, economic activity will fall. This last occurred back in the late 70s and early 80s and it took years for the world to recover. Back then, crude oil in current US$ terms from below US$20/barrel in 1972 to a little over US$100/barrel in late 1979.  By late 1980, US interest rates rose over 20%, the US$ rose and crude oil began to tumble.

We are unsure about whether or not we buy the stagflation view but we believe that current oil prices are having a significant impact on confidence, and demand will fall when increased supply becomes available, leading to lower prices. When taken over the longer-term (i.e., 10-20 years), this expected drop in crude prices will simply be a correction in a longer-term bull market.

Oil takes millions of years to make and we pump it out significantly faster. Crude oil prices will rise over the long-term and hence, the bull market will continue to live.