From a day-to-day and month-to-month perspective, a recent drop in crude oil and natural gas prices suggests the period of high energy costs may be coming to a close. Indeed, Global Insight has cut its forecast of crude oil and natural gas prices for 2007. Our October forecast for 2007 and the medium term, however, is appreciably higher than a year ago. Supply and demand forces in the oil and gas market still point to historically elevated energy costs. Consequently, it is too early for consumers and manufacturers to stop worrying about their energy bills and for the oil patch to scale down its investment plans.

Energy prices have moved between extremes over the past year or so. Almost one year ago, hurricanes, geopolitical uncertainty, and a booming global economy had driven the cost of crude oil and natural gas to historical highs. While the uncommonly mild winter in North America depressed natural gas prices soon thereafter, the prices of crude oil continued to reach new highs, with the futures market expecting a peak of US$80 early next year at one point this summer. Fast forward to October, however, and a mild hurricane season, lower geopolitical uncertainty, and a slowing U.S. economy have taken the edge from energy prices. Crude oil has traded below $US60 (WTI, per barrel) and natural gas dropped to US$4 (Henry Hub cash, per million Btu).

After one steps back from the wild price fluctuations, however, a more fundamental picture emerges. Crude oil prices averaged just under US$70 during January–September this year, up from US$56 during the same period in 2005. The lowest spot price this year is still higher than last year's average. While some of the froth has come off the oil market due to the dissipation of fears about Iran's nuclear ambitions and about another bad hurricane season, the tight demand/supply balance is keeping prices high. Spare global capacity remains scarce and the lowest-cost reserves are increasingly being put under the control of governments, many of whom are unproductive at best and politically unstable at worst. Exploration and development of politically stable areas that are accessible to the private sector is expensive and requires high oil prices to secure investment, as exemplified by the Jack find in the deep waters of the Gulf of Mexico and Alberta's oil sands. Consequently, crude oil prices are expected to average more than US$60 over the medium term.

Although natural gas prices are affected by the weather, it is unlikely the coming winter will be as mild as the last one. Moreover, here too, the supply situation is tight, though less due to political factors. North American natural gas production peaked in 2001 and is now declining. It will take several years before new capacity for natural gas imports will come on line. Gas prices are expected to average about US$9 over the medium term.

For Canada's economy, this means the current low energy prices are a temporary phenomenon. Most importantly, investment plans in the oil patch will stay largely unchanged, continuing to drive a wedge between Alberta's economic growth and that of Ontario and Quebec. In the first half of this year, the level of nonresidential construction in Alberta exceeded that of Quebec for the first time in history. Price-sensitive drilling will be affected negatively in the near term, as displayed by the drop in drilling so far this year due to depressed natural gas prices.

Certainly, consumers and many manufacturers will breathe easier for a while. They will do well, however, if they continue looking for ways to improve the energy efficiency of their cars, homes, and operations. The recent rundown of energy prices has also resulted in a slightly weaker Canadian dollar. This relief to Ontario and Quebec exporters to the United States will also be temporary. The anticipated rebound in prices will foster a firmer loonie by the end of next year. Consumer price inflation will dip below 1% year-on-year (y/y) in September from 2.1% in August as a decline in gasoline costs this year will contrast with an increase last year, but a recovery towards 2% is expected over the next few quarters.

The recent fluctuations in energy prices are a mere distraction to consumers, businesses, and policy makers. Plans still need to be made based on elevated energy costs over the medium term. The focus should remain on improving energy efficiency and investing in energy production capacity.

Raul Dary

24 Hartwell Ave.
Lexington, MA 02421, USA
Tel: 781.301.9314
Cel: 857.222.0556
Fax: 781.301.9416
raul.dary@globalinsight.com

http://www.globalinsight.com/ and http://www.wmrc.com/