Where is oil going? We have seen predictions of $200 per barrel from Goldman Sachs analyst Arjun Murti (he was the guy who was right about $100 oil last year when it was $50) and recently Alexey Miller of Gazprom said they see oil going to $250 per barrel by this time next year.

I am going to go against these great minds and instead predict a fall off in crude oil prices. Why? Simply put, I believe that a global downturn and the end of fuel subsidies in many Asian nations will all converge to give an overhang, and this, combined with an OPEC vision of a world bound to oil will bring about the fall.

It’s important to expand on these points, firstly, Asian nations are all talking about ending fuel subsidies, in many countries subsidies account for up to 25% of governments budget in Indonesia and a whopping 50% of the budget in Malaysia! Prices in Malaysia rose overnight by 41%.

Fuel is being subsidised at the expense of human life, this is insanity and has to end, of course it’s not popular, cessation of fuel subsidies is what ultimately deposed Suharto in Indonesia in 1998. However, fuel at the expense of education, health, and infrastructure it is lunacy and it will end not because we want it to but because it has to, the fallout from ignoring the growing needs of a population in the areas of food security and health outweigh that of keeping fuel cheap. Recent G8 meetings have focused heavily on food prices.

In Australia the government lead by Kevin Rudd is trying to put pressure on Asian nations to end fuel subsidies because they feel that subsidies are causing the increases in fuel price. There have been big price hikes in China, Indonesia, Malaysia, India and Taiwan in order to stem shortages. The IMF report on fuel subsidies can be found here.

African nations are following suit by cutting fuel subsidies, most recently Guinea cut the subsidy meaning that prices rose by 60% overnight! Many claim that subsidies encourage irresponsible consumption and that is likely true, if fuel is artificially cheap then where is the incentive to invest in more efficient engines? If governments in many nations really want to help they will need to look at the place we have found ourselves, a land where fuel and food is expensive, and in this case the default strategy must always be in favour of human life, so food subsidies would be far better for the stability and health of a nation than fuel subsidies would. Meanwhile countries such as Yemen continue spending more on fuel subsidies than they do on health and education combined.

Food shortages are no joke, people are dying right now (every 1.7 seconds) because of them, bread shortages in Egypt lead to riots in April and in them a young boy was killed, 11 people have died of exhaustion in long queues, and two people have been stabbed to death, that’s just Egypt, there have been food riots in over 3o countries this year, this is all before we consider the 13 to 18 million who will die this year due to starvation. The effect of an overnight hike in fuel prices as we are seeing in many nations is going to have a very fast effect of pushing down demand in those countries, developing nations where fuel demand was increasing the fastest.

Another aspect of oil is that OPEC won’t want to see meaningful investment by the west in alternative fuels, in May part of the solution being put forward by the House of Representatives in the USA was to ‘sue’ OPEC! Meanwhile OPEC are saying there is ‘no shortage of oil‘ and that price hikes are all down to ‘speculators’. However, drilling for new oil in areas such as the Arctic National Wildlife Reserve is not necessarily the answer because it takes a long time in order for that supply to come on stream and in the end it wouldn’t make much of a difference, and then there is the infrastructure outlay to consider in order to realise that new supply.

So we know that oil dependence will only end one way, with the western world being totally reliant on OPEC nations for energy, that is quickly being realised as being a future that is not viable for stability so there has been massive investment in alternative energy (in fact this may one day be the next asset bubble), and then of course there are ‘oil bullies’ such as Hugo Chavez (whom I don’t believe is as bad as the press make him out to be) threatening to cut supply to any nation – the recent target was the EU – that act in any ways that are unpalatable to him.

However, a move away from oil would be disastrous for OPEC, and that is why the Saudi’s are eager to ramp up production by whatever they can (naturally being ‘onside’ also allows them to continue to run their dictatorship without retribution). At the same time we see Libya talking about ‘ceasing production‘… Now why, during peak prices would you want to do that?

Look at it like this, if they keep supplying the market then the blatant overhang in supply that is coming will only be bigger. What is the ‘overhang’ we are talking about? It’s basically the effect of what happens when demand pull inflation reaches a point beyond where its point of balance. An easy way of mapping this out is: Asian and African nations are removing fuel subsidies, people in those countries will start to use less oil rapidly, demand there drops, but production is still in full swing, as demand continues to drop due to unaffordablity an ‘overhang’ develops where supply outstrips demand and at that point we see the crash in oil prices. We’ll continue to look at other aspects that will help create this ‘overhang’

SVO conversions, this stands for ‘Straight Vegetable Oil‘ and its a rapidly growing area of fuel research, whereby people turn diesel vehicles into vehicles that will run on the same kind of vegetable oil that you use to fry food in, creating ‘frybrid‘ vehicles. Can a car really run on other oils? In short ‘yes they can’, when Rudolph Diesel invented the engine which bears his namesake they didn’t have a ready source of refined diesel (the kind you buy at the petrol station) in fact almost all of the early motors operated on oil alone, Herbert Akroyd Stuart invented a cold start oil engine, these engines rely on compression rather than ‘spark’ to ignite the fuel. My own dad was a big fan of cars and he had a Model T Ford from 1926, he used to run it on paraffin oil. Had we gone more heavily into vapourizing oil engines from the start perhaps world history would be much more different than it is today.

Diesel engines are more fuel efficient than petrol engines (traditionally they are heavier too), but when Rudolph Diesel invented his engine he planned on using vegetable oil or coal dust to run it, his first engine ran on peanut oil. The diesel we buy today is a byproduct of petroleum production and that has made it easy to come by while we drill for endless oil, but now that crude oil is reaching new heights there is a huge renewed interest in biodiesel and vegetable oil substitutes. Why import fuel when you can grow it? This is becoming a more common theme in many countries and in the press, if we apply this to the theory of an oil crash then we can see that if fuel prices remain high that people will invest in being able to use this technology, the bulk price of vegetable oil is about 20 cent per litre, that’s a fairly hefty savings!

There are also advantages to using hybrid fuels, in Ireland Section 81 of the 2008 Finance Bill specifically states that there are rebates of up to 50% of the VRT charged for ‘flexi-fuel’ cars, the act states ‘ethanol’ but ethanol still has to be distilled and in fact vegetable oil for that reason is more environmentally friendly, so it would be ridiculous of the Revenue to take any view other than considering a vegetable oil converted engine as a hybrid. The revenue website has a table of rebates published as well. SVO kits are not prohibitively expensive (at least not in the light of $140 or more per barrel oil) and you can buy fuel for about 20 cent a litre once installed, that would mean you save about €1.20 per litre, the maths is easily worked out.

Perhaps the most exciting development is ‘Renewable Oil‘ which is created from the waste products of small bugs, sounds insane right? That it does, but it’s also true, then there is the ‘diesel tree‘ which is being planted in Australia (imported from Brazil) and it allows you to tap right in and get functional fuel, you tap the tree the same way people would tap maple trees for syrup or rubber trees for rubber. This can give a yield of 12,000 litres per hectare of trees, imagine that? Not only would you help save the planet by using a biofuel but because these trees could be grown in the areas that they are used thus removing any transportation carbon footprint. We are on the verge of Oil 2.0.

Oil pumped from the ground creates monster profits for the companies involved, Exxon is twice as big as the ensuing three biggest companies in the world combined and a large chunk of it is held by a few choice shareholders, if we rationalised the way that energy is sourced and distributed it would cause a massive redistribution of wealth into working class echelons and that alone is hugely positive prospect.

Another reason oil will crash in 2009 (I fully believe that the 2008 momentum will carry through the end of the year) is the intensive research into cellulosic biofuels. Cellulosic biofuels are a hot bed of research, and the advantage of them over the traditional ethanol based biofuels is that they don’t use human food in their creation which is one of the issues with corn or rice based biofuels, biofuels are being blamed in part for worldwide food prices and shortages, whether this is true or not remains to be seen, growers claim it’s not the cause, commentators say it is, the best solution is to avoid making fuel altogether from foods that humans eat. Once we get anywhere close to finding energy independence there is a strong likelihood that the world will avoid going down the route of reliance on OPEC or anybody else for their energy needs, it just doesn’t make sense.

‘Morally questionable’ is perhaps the best way to describe the politics in any oil exporting nation, almost exclusively you could draw a map of the wars in the world and the oil deposits in the world and you are looking at the same map, oil is therefore not good for the average citizen there, instead it tends to be of benefit only to the dictators or militias controlling the area.

Air cars are becoming a reality, granted you need to burn fuel to compress air but you could use an efficient vegetable oil engine to do this, solar panels or wind could also drive a compressor, the engines in cars are not as efficient as they could be because sacrifices in the areas of weight and size are made.Another reason for the oil overhang will be a falling demand from US consumers, it is reaching the point where it is costing $100 to fill a car up. This will lead many people to re-think commutes, consider car pooling or public transport or even to move jobs if the impact of fuel on income is high enough. SUV plants are closing down, GM closed four of them in June alone, citing that a shift towards fuel efficient vehicles as the reason. Fuel efficient vehicles won’t mean that people will suddenly drive more and use the same amount, it means instead that demand will drop.

US inflation will also stem demand, the DOW saw an official recession yesterday, and the recession will stem demand, one thing that the US government will try to avoid is letting the inflationary environment in the US finding its way into wages, if that happens they will witness a re-run of the 70’s stagflation, wage inflation is the enemy, everybody knows it. If this happens (companies will also resist raises and the strong Unions of the 70’s don’t exist today) then people will have to live on less, and this will cause a demand drop just as I’m writing this I heard on Bloomberg that oil demand is down 4% this year.

BRIC nations will lower usage as prices rise and global downturn feeds into reduced growth for them especially China. It is important to remember that the ‘new found’ wealth of nations is not being magically invented, it is instead a shift of money from west to east, and when the west faces a recession that flow stops as does the profit that comes with it, inflation in China has lead to riots already, their ‘official’ figure released was c. 11% although many believe it to be much higher, in that kind of environment oil demand will fall.

The economic effects of high oil prices are well known, T. Boone Pickens the internationally known energy billionaire puts the case forward very simply ‘demand is 87 million barrels a day, supply is 85 million barrels a day, when you have 85 serving a demand of 87 the price has to go up’. What happens on the way down though? When the overhang is realised? Simply put, we will see an inverse movement of what we witnessed up until now, and it will be described as a ‘crash’. T. Boone Pickens is synonymous with ‘Oil’ and yet he has just launched a $6 billion investment in wind energy, he has even come up with a ‘Picken’s plan‘ which aims to remove the reliance on oil, specifically foreign oil.

Higher oil prices will reduce economic growth (see the link in the previous paragraph on ‘economic effects’), and most importantly we need to look at history, after the high oil prices of the 70’s oil went into a declining bear market for 20 years. A 10% rise in oil prices can reduce GDP by 0.2% and in the last year we have seen well over a 100% rise! That will cause more recessionary pressures which will lower demand, and another point against high oil prices is that the stock prices of the large oil companies have dropped this year, is that the type of movement to expect from a company that is in the ‘only industry’ this year? Oil stocks are performing too far below the level that would indicate a long term movement towards high oil prices.

Sheik Yamani is a well known figure in oil circles, and he was at the forefront of OPEC during the oil crises in the 70’s, he famously stated that ‘the stone age did not end due to a shortage of stones’ and he predicted the oil crash that followed the peaks of the 70’s he was correct, he has said the same thing again in recent years, although you might sneer at his opinion today you might also remember that its exactly the attitude ‘conventional wisdom’ had about him 30 years ago and he was correct back then.

He also maintained that ‘If we force Western governments to invest heavily in finding alternative sources of energy, they will’ and we are seeing that today, oil in 1981 hit $39.50 a barrel, roughly the equivalent of $100 in 2007/2008 so every point beyond that may be giving increased volatility to the movement oil will take, and again, your authors belief is that it will be a downward trend. Not $20 dollar oil but below $100, the range oil will settle at in 2009 once the overhang is realised will be c. 65-95 dollars a barrel. He has said that ‘history is repeating itself’

Between 1979 and 1983 oil consumption in no-communist countries fell by 6 million barrels a day, and we are likely to see the same thing happen again, if this does happen (and bearing in mind this only has to occur across the EU and US) demand will be 81 million barrels a day and supply will still be at 85 thus creating surplus, the momentum towards alternatives will not just ‘cease’ though, they will continue because the one great thing that is coming out of this oil crisis is education, education about biofuels, and other ways of creating power, and its spreading across a globalised world giving equal opportunity to people in Jakarta to read up on it as it does to somebody in London. And countries like Indonesia and China are also investing heavily in alternative fuels, that critical momentum will drive oil into a ten year bear market, so for the people making money on it today, make hay while the sun shines.

Lastly there are many other oil fields that are not tapped, Africa has oil in Sudan and the DRC (both have serious issues but the oil is there), and with prices being – as a long term trend – over $50 a barrel it makes sense now to tap fields that were untouchable for the previous 25 years when oil was always below $30. It takes time for that supply to come on line but it will come, diluting demand with supply. Again though, it will be the magnitude of people looking to alternatives that will push down oil in the long term.

So the predictions of this post are that oil will continue unabated due to the momentum in the short term, as recessionary figures arrive from the USA and EU it will cause demand to drop, coupled with weaker GDP’s people will spend less on fuel, subsidies ending around the world in favour of food security will reduce demand and alternative energy becoming more popular will be the final nail in the coffin, in fact OPEC will likely realise this and themselves aim to push fuel prices down in order to prevent investment heading towards non-oil alternatives. When all of this comes together it will spell ‘crash’ for oil prices and put that sector of the energy market into a long term bear market, energy on the other hand will likely perform well but it will be other forms of energy that see those gains.