Why $100 isn't the right price for oil

Brandon Snow's picture

We are often asked for an oil price forecast and while we don't have a specific number, we always respond that the appropriate price is "lower." Most commentary in recent years has been focused on the supply of crude and the thought that even if it is growing in North America, OPEC will keep global supplies tight. But what about distortions to demand for oil? The Wall Street Journal had some interesting insights into Venezuela that shines light on this issue.

In Venezuela, the cost of gasoline is 6.5 cents per gallon, and if you use the informal exchange rate (what most transactions are based on), the cost is closer to 1.5 cents a gallon. Because of the subsidy, the cost to fill your tank with gas is less than the price of a small cup of coffee and the per capita usage of gasoline is seven times that of neighbouring Colombia, which uses global prices.

This is all fine and good while government finances are flush, oil production is growing and the price is going up. However, today in Venezuela, the government runs double-digit fiscal deficits due to the subsidies as well as other social programs financed by oil money. In fact, current subsidies are calculated to cost nearly 9% of GDP. So what happens to demand if the country increases domestic energy prices to only half of global averages? Domestic demand would drop and incremental supply would be sent into the international markets. While Venezuela is at the extreme, subsidies are high across OPEC nations:

Source: The Economist

Subsidies are not restricted to OPEC either, with China, Mexico and India supplying fossil fuels below world prices. In fact, the International Energy Agency estimated in 2011 that global fossil fuel subsidies totalled $523 billion! (Click here for global subsidies: http://www.iea.org/subsidy/index.html.) When you see these numbers, it is clear the demand side of the oil equation is distorted by subsidies, just as supply is restricted by the OPEC cartel.

In 2012, with Brent oil averaging US$111 per barrel, Venezuela, Iran, Kuwait and Algeria were running deficits. Today, the price is $100. As the price falls and finances worsen, there is more incentive for individual members of OPEC to cheat on production, and/or reduce subsidies, both of which would put further pressure on the price. Only if this happens, will we know the real price of oil.

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