Reasons for a Sweeter Scenario in 2007

Sweet scenario, no? Lower oil prices keep economic growth higher than expected, keep the Federal Reserve on the sidelines and push up stock prices in 2007.

Of course, right now all we've got is a bunch of economists projecting lower oil prices for 2007.

Hard Evidence

Certainly, before I'd put any money behind a scenario like this, I'd like to see just a little bit of hard evidence. So here's why I think we're due for a pause in 2007 in the long-term run-up of global oil prices.

• Lower U.S. growth for the next few quarters and European economic growth that falls below expectations will lower demand for oil. In the developed economies, oil consumption isn't that sensitive to economic growth anymore -- oil demand grows only about one-third as fast as GDP, according to the investment researchers at Sanford Bernstein -- but with demand and supply in such tight balance currently, even a slight drop in oil consumption due to slower economic growth will make a difference.
• Substitution of coal for oil in power generation in China. In the short run, only oil could offer China a way to meet its huge surge in demand for electrical power in 2004-2005. That produced a huge surge in China's demand for oil, up 14% in 2004. (The winter of 2004 was colder than normal in the Northern Hemisphere, and that added to the big jump in oil demand that year.)

  The country has abundant supplies of cheaper and environmentally dirtier coal, but China's transportation system simply wasn't capable in the short term of getting the coal to power plants. Since the worst days of the crisis, China has upgraded its transportation and utility systems, and the country is using less oil and more coal to generate electricity. China's demand for oil isn't going fall; it just isn't going to climb as fast as it did in 2004 and 2005 and will most likely match its growth in GDP going forward.

• The continued European shift from gasoline to more efficient vehicles burning diesel fuels and the recent market shift in the U.S. toward slightly more fuel-efficient cars instead of SUVs and trucks will reduce global oil consumption marginally.
• A gradual increase in global oil production will be sufficient to gradually put a little breathing room between supply and demand. Part of the huge run-up in oil prices was due to the lack of any global spare-production capacity. Any increase in demand increased fears that some customers would have to go without. And those fears led customers to be willing to pay larger and larger premiums to assure themselves of supply. The lack of global spare-production capacity was a result of underinvestment in the oil industry in the 1990s.

The higher prices of recent years have reversed that trend, and oil companies increased their capital budgets. Many of the new projects are relatively small, high-cost efforts that are only viable with oil north of $40 a barrel. But they should be enough, estimates Sanford Bernstein, to restore spare capacity to something like a normal 3% to 4% of demand instead of the recent crisis levels of 1% to 2%.

None of this, mind you, will be enough to take oil prices back to anything like the 20-year average of $27 a barrel. Prices north of $40 a barrel are here to stay. And I think that it's likely that in a decade we will all look back with nostalgia at the good old days of $50-a-barrel oil.