Seven Questions: The Return of Cheap Oil?

David McNew/Getty Images Barreling downward: Oil prices are down to their lowest levels in nearly three months.

Foreign Policy: Energy analysts talk a lot about the fundamentals. What are the fundamental factors driving the oil markets today?

Edward Morse: The oil markets have been exceptionally tight, as have other commodity markets, since the earlier part of this decade, and that tightness has been a function of a generation of underinvestment in all aspects of the oil chain, the gas chain, and most other commodity chains. As a result, demand caught up with supply, and the result was what always happensa price response. Theres a short-term supply response, mostly out of OPEC countries, which is bringing more supply into the market. Were having an investment response in the refining sector, which is making product markets more competitive. And were having a very rapid impact on global product demand. As a result of those three elements, were seeing markets soften considerably for the first time really since 2002 to 2003.

FP: As youve pointed out in recent news articles and interviews, oil markets have historically been cyclical. But people have of course been panicking this year about oil prices. What made this year so special?

EM: The big change that really did happen last year and this year is that now for the first time in a generation, incremental supply is coming from OPEC countries that are not as transparent. Secondly, we now have the largest share of incremental demand growth coming from emerging markets, rather than from OECD countries. And again, what happens is opacity, rather than transparency. So the market has been spooked by not knowing how much demand there is and assuming that the pace of demand from the emerging markets is relentlessly positive and at a growing rate. Theyre not seeing the supply fulfilling that demand because the supply coming out of Mexico, the North Sea, and the north slope of Alaska is declining, and the market isnt perceiving that decline being made up by OPEC countries that dont provide a lot of data and transparency to the market.

FP: Youve forecast oil dropping below $100 a barrel by this coming winter. Oil prices are now at a 12-week low at just over $120 a barrel. Why have oil prices declined from where they were several weeks ago, when they were at record highs?

EM: I think the market has responded to the signs that inventories are growing, and growing very rapidly. And it is responding to clearer and clearer evidence that demand has been destroyedI use the term demand demolitionand people are now just beginning to understand that after the Olympics, China may not come roaring back with the demand it had during the first five months of the year. And that demand, in my mind, was mostly import, or apparent, demand, and we dont really know how much of that is in the form of inventory build, as opposed to meeting final demand.

FP: Do you think prices will be significantly lower by the U.S. presidential election in November? How low will they go?

EM: I originally thought wed see double-digit prices in the fourth quarter [of this year]. I then shifted to the latter part of the winter, in the first quarter [of next year], but I would not be surprised if prices were under $100 in November.

Two major factors could make prices go significantly higher: We are in what is said to be a more active than normal hurricane season, and we cant predict what will happen on the Gulf Coast, either on the supply side or on the refining side. Secondly, we have a relatively dangerous world. When you have Israel, Iran, Iraq, Saudi Arabia, and Nigeria all with different points of vulnerability, from terrorism to interstate warfare to domestic violence, its very hard to predict when such acts will occur.

FP: What effect would an attack on Iran have on your projections?

EM: It really depends on what the attack was and what happened in the aftermath. One of the uncertainties is: Does Iran have a capability of setting up devices to detonate in the Strait of Hormuz? The strait is 32 kilometers wide, and we have the U.S. 7th Fleet there. I personally would bet on a disruption of supplies through the Strait of Hormuz as not lasting more than a very short period of time, but if Im wrong on that, then that would have an impact, and theres nothing that can quite replace the 17 million barrels a day that flows through the Strait of Hormuz.

FP: As the security situation continues to improve in Iraq, are you expecting a major uptick in supply?

EM: Weve already had a major uptick in supply. Iraq is now consistently producing nearly half a million barrels a day more than it was a year ago. I think markets ignored that, and I would not be surprised to see another surge of three or 400,000 barrels a day coming out of Iraq, with heightened security.

FP: What effect will lower prices have on renewable and alternative energy? Is there a tipping point that could doom alternatives like ethanol or plug-in hybrids?

EM: I see a period of two or three years with relatively lower prices, in the high $90s. But we dont know what the response will be on the conventional side, going out three or four or five years. And certainly with the power requirements of the world, something really needs to be done to improve overall efficiency in a dramatic way across all energy uses, and something needs to be done to encourage, in the marketplace, the use of as many renewables as possible. One of the dangers of lower prices is that it will again lull governments and consumers into thinking that there is no problem at hand, and that would be in my judgment a false sign of hope.

Edward L. Morse is the chief energy economist at Lehman Brothers.