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Well, I like to answer your question as any good engineer would -- it depends.

If the economy continues to grow and does not tank, I don't think prices are going to go much lower than were they have been in the past year. In other words they would probably range between $55 and $65.

Spare capacity this year has on paper grown by about 1.5 million barrels per day, mostly as a result of expansions from OPEC. Non-Opec production expansion has been about 650 thousand barrels per day over the production in 2005, and that is barely equal to the approximately 700 thousand barrels per day of demand increase in 2006.

While spare capacity is higher than last year-- on paper, and estimated at about 2.4 million barrels per day, that is NOT net of some of the set backs in actual production that have occurred in Nigeria and in Iraq. As some of you may know, Shell has been unable to restore to full capacity a lot of the production that got interrupted due to gerrilla attacks back about 11 months ago.

In addition one has to examine the role of OPEC. OPEC has been somewhat successful at managing its output. It has been able to cut back according to the latest statistics about 700 kb per day since November. So to the extent that OPEC is able to show supply output restraint, one would expect that a collapse of prices, especially if the world economies hold at about the level of where they are today, is highly unlikely.

Then of course you have China and India, and developing ASIA. Growth in these countries and areas have been well above 5%, and world output is barely keeping up.

You also have the geopolitical situation. Unless somebody assures me that Iraq is going to be stabilized within this year, and that exports from there can be maintained steadily at over 1.5 million, one could construct a scenario whereby the markets would then perceive the possibility of higher output from there down the road, and maybe, and only maybe can I imagine a positive psychological factor that could push prices down a bit-- in other words a reduction of the "risk" premium.

And then of course you have Iran as a big question mark. We don't know what is going to happen there. And the possibilities for a confrontation and some supply disruption cannot be discounted.

The Nigerian elections are comming up in May 2007 as another disruptive geopolitical event of significance. So expect increasing violence there until this event comes to pass which will likey continue to affect output, and nerves.

Even with some improvements today, the supply situation is not very clear to me for the medium term (3 to 5 years from now). While it is true that Non-Opec supplies are expected to expand by about 1.7 million barrels per day this year, something that has not happened I think in 30 years, one really has to wonder how long will this level of output increase be sustainable? Then we have to factor whether other events may not neutralize this apparently positive output picture. Let's look around.

Venezuela's oil production, especially that managed by the State, has been declining ever since Chavez assumed power. And he was reelected for another 6-year term. And now that he has won the elections I don't expect much improvement in that sector despite the many claims to the contrary. But even if the gov't is successful at attracting some foreign companies like Repsol and/or total, the biggies such as Shell, Exxon and BP are not going to pour the precious capital into a country where the rules of the games are changed at whim.

In Iran, I expect production to fall off as many western companies stay the hell away from there for fear of a confrontation with the U.S. and Europe. So unless there is a serious political turnaround there, something I much doubt, expect Iranian output to continue sinking.

The Saudis and the Kuwaitis, and probably the UAE are some of the countries in OPEC where capacity could be meaningfully expanded. But my suspicion is that the Saudis are going to be mighty cautious as to when and how they bring that spare capacity addition on line. I think they are going to manage it in a way to avoid a collapse of prices.

memo: There is a low price scenario that was brought recently to my attention regarding the Saudis which suggests that if the U.S. pulls out of Iraq too soon with the Iranian filling in the power vaccuum, the Saudis have told the U.S. that they will move in to support the Sunnis.-- In one scenario Saudis intervene to stop the chaos but in the meantime the production in Iraq drops, but to prevent sustainable high prices, the Saudis begin pumping like mad to collapse the price of crude and deny Iran the revenues it would need to sustain an armed conflict there. But while possible, this is to surgically precise for me to accept. In fact, I argue that if chaos breaks out in Iraq with the intervention of the Saudis, prices will go through the roof.

Russia is another question mark.

Putin and his thugs are certainly doing a very good job of scaring away investments in the energy sector from companies like Shell, Exxon, BP Chevron and COP. STATOIL was basically told Nyet -- take a walk, we don't need you and we will develop our own resources --that was the basic message. And the Saihalin affair with Shell, and to some extent with Exxon, and in other related matters with BP is a signal that Russia is not a friendly place to invest. So the operative word there is "caution". This does not suggest to me that we are going to be developing resources at the pace we once thought possible.

Angola is going to join OPEC -- that is not good. And other West African countries may do likewise.

With these developments, especially in Russia, I am not sure how eager these companies are going to be to accelerate the pace of development for new projects, especially while they are publicly being slapped around. And in the case of Shell, the outcome has not been good. It has been basically forced to sell a good share of its Sakhalin project --after it took all the risk. In addition consider that Russia's export infrastructure, while being improved, is still deficient, so one has to wonder how much will Russia be able to contribute to future increases in output.

I think the only bright spot in the supply equation is West Africa and Canada, but then you have the countervailing drop in production in the North Sea, Alaska, and Mexico, Iran as well as in other places.

My point is that while I have not doubt that anything is possible, when you weigh the supply scenarios scene sets, I believe there are more chances that prices will again resume their upward climb by the summer than there is for prices to sink further through the year.

Longer term, prices I believe will ineluctably continue to move up over the years, even if we have temporary dips like the ones we observe today. For prices to sustainably remain low for a while the geopolitical situation would need to be drastically improved and spare capacity would need to grow dramatically and sustainably to handle some of these geopolitical disruptions, and the enormous growth in demand expected from China, India and developing Asia.

As somewhat wrote back in 2004:

... "oil, viewed on an historic basis, is not exceptionally expensive. When measured in inflation-adjusted terms using 2004 as the base year, the price of oil is far from its all-time peak of just over $100 reached in November 1979.

From 1970 to present the average inflation-adjusted price for a barrel of oil has averaged $34. And while higher oil prices will depress demand, the price of oil had to average an inflation- adjusted $60 per barrel before oil consumption/production actually declined year over year."

Well, actually oil prices have averaged well above $60/B in 2006 and there has yet to be a decline in demand year over year. In fact, the IEA is predicting that next year's growth is going to approach 1.6 million barrels per day on a worldwide basis, almost 1 million barrels per day gain from this year's growth of 0.7 MBD.

Therefore, I find it hard to subscribe to the gloom and doom on oil prices. I see this year as more or less a replay of 2006 without some of the panic that propelled prices to $78. But I do see on average prices sustaining above $60/B by the summer, or even higher if one of the major producers gets hit hard by some political event that disrupt the flow of oil.

There is a difference between a softness in prices and a collapse. Softness can occur at times to bring inventories and supplies in line with demand. But those are temporary events. What is important are the structural macro factors, and frakly they don't point to much lower prices than where they are today -- the mid-fifties, and with the possibilities of much higher in the near to longer term.

Madame Butterfly
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