RJH, back from holiday, writes...

Financial markets are linear. Except when they are chaotic.

Current energy markets in this light are intriguing. If crude is behaving linearly it theoretically ought to (sooner or later) revert to its mean. That mean since 1970 sits in the $35-$40 per barrel range (real dollars). Excluding the two oil price shocks of the 1970s puts it around $30 per barrel.

So at $70 per barrel the case seems obvious enough that the demand curve has made a non-linear (or chaotic) jump to a higher trend path. Yet the data does not quite fit this hypothesis.

Exhibit 1: Trends in the oil market since 2000. Right click to enlarge.

Exhibit 2: Assorted background data for the hardcore. Right click to view.

Since 2004 global demand has slowed. US demand, 24% of the total, has even declined over the period. Even so, supply has not kept up - most notably crude production (supply includes other elements such as natural gas plant liquids). And, above all, refining capacity has trailed demand increases. Until China increased its refining output by 1.6 million barrels per day versus 2005 global refining capacity had lost ground to demand every year since 2000.

Which suggests less a shift of the demand curve than glacial market adjustments to supply.

Yet slow though the process is, crude production and refining capacity (NIMBYism and all) are adjusting as high prices - after 30 odd years of cheap crude - attract capex. Whether this can (ever) come fast enough to match the pace of increasing demand is the long-term key to price levels.

In the shorter tem it is well to recall that oil demand can fall as well as rise. The consensus view is that 2007 will see at least a slowdown in the US economy. That would push down global crude prices.

But peer beyond and the structure of the oil markets remains the same: over 50% of the 10 year consumption growth to 2004 (a per day increase of 14m barrels) comes from 3 nations - the USA (21.8%), India (7.5%) and China (23.4%). That composition is not going to change soon.

Recovery in oil demand from any slowdown will continue to outpace the large investments required in refining and production to balance the market. It may be linear but slow supply equilibrium mechanisms favour the oil sector continuing to reward calm investors.

Data sources: US Dept of Energy's "Energy Information Administration"

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