The oil futures market reminds me of the grim trench warfare in the First World War. The bulls and bears are engaged in a zero sum game. Some win, some are wounded, and many die. At times the front lines move, but the defenses recover strength and launch a counter-attack. There are no prisoners in a never- ending struggle, but each side will claims gains. Oil slipped 32% in October- its biggest ever monthly price fall. It fell as speculators and hedge funds lost dominance in the face of declining American expenditure on fuel. Many market players insist the fall shows weak demand. They expect further falls. My question is: "Is oil demand driven, or supply constrained"?

The argument is important. Deutsche Bank predicts $50 oil as US demand shrinks into a recession. Suppliers are aghast at this prospect and try to limit output. Venezuela and Iran apparently need oil to sell at about $100 to balance their budgets, while Saudi and other OPEC members would like to see prices stabilize at about $80. My point is that output is declining at a great rate, and the world will struggle to make up steep declines in existing fields. Output decline is exacerbated by falling investment as finance dries up because of the credit crunch and lower prices. In consequence, high oil prices will remain. The international energy agency bombshell The Financial Times obtained the Agency's draft annual report which shows that output is declining faster than previously thought. (The Agency is furious at the leak.) The newspaper's version is that: without huge new investment, oil output will decline "at a natural annual rate" of 9.1%. The world will struggle to produce sufficient oil to make up for flagging outputs in existing fields, like those in the North Sea, Russia, and Alaska. Few observers realize that large ongoing investments are necessary to maintain present output. The Agency forecasts that demand requires investments of $US 360 bln each year till 2030 (the period under discussion). It is necessary to provide "a significant increase in future investments just to maintain the current level of production". Supply has been tight this year despite high prices, and lower fuel usage: but prices could languish in the short-term before increasing sharply in the longer term. Much of the projected increase will come from the developing country demand, while demand will fall in the developed countries (partly because of ethanol etc). Falling investment Shell has delayed planned investment in Canada's oil sands in yet another example of business adjusting to tight credit and falling immediate demand. The company will wait for costs to come down before it expands the Athabasca oil sand project. BP is lying off staff, Shell is cutting production. Lukoil of Russia has announced a three-year program of lower capital expenditure. Saudi says it will continue with new projects now but will watch demand. The attitude of the big oil companies is baffling. The companies made huge profits: Exxon made $US 14 bln, the biggest profit ever for an American company in one quarter. Shell made $11 bln in profit. One would expect these companies to realize the advantages of a steady investment program. The smaller companies have already been cut off by the banks, and many projects for off-shore field development have halted especially off Africa and Brazil. The action of the big companies is rational only if a) their credit lines have been severed and/or b) there is tremendous over-capacity in the short-term. Given the profits of the companies, it would appear that they feel they are over-producing. If they are over-producing, the logical conclusion is that there is a demand shock. These companies are long established and have excellent analysts. If production for this market is too high, there must have been a recent, unexpected collapse in demand. Moreover, the implication is that the recession will be deep and long-lasting. My guess is that, as short-term considerations dominate decisions, accountants rather than engineers call the shots. Sharemarkets also put a premium on improving profitability, and the share price would suffer if costs rose through strong capex expenditure while prices were falling. I would have thought the big companies have huge accounting powers which smooth investment expenditure. Markets Business will generally look at market price and then decide which projects are viable and which should be halted. If the price falls into the $50-$60 price band, a lot of production will cease. The Venezuelan Premier Hugo Chavez was quite clear at an auction of oil blocks: "We estimate that at $70 per barrel the point arrives when projects now in visualization or in development begin to be abandoned in a massive way. This is not good for anybody". US oil consumption seems to have fallen 8% year-on-year. OPEC has announced cuts in output but they seem slow to take effect. Inventory will build up unless that winter is very cold in the Northern Hemisphere. Crude has fallen from a record $147 to $66-68 presently. The outlook UBS has slashed its long-term price projection from $105 to $60 now: recovering in 2009 to $75. The respected Global Risk Partners believe prices will hold above $60 this year, average $80 in 2009 and $90 in 2010. The IEA has cut its 2008 demand growth forecast by 250,000 b.p.d. but believes China and India will not sink into severe recession. BP says that supply is tight. It notes that non-OPEC production is much lower than expected, so "supply is failing to respond to market signals", according to BP CEO Tony Hayward.  ============== *Neville Bennett is a long-time Senior Lecturer in History at the University of Canterbury, where he has taught since 1971. His focus is economic history and markets. He is also a columnist for the NBR where a version of this item first appeared.