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Though the ride may be bumpy from unsettled political conditions in some major producing regions, oil prices should fall from their current levels to the US$33 - US$38 range in 2005 and the US$28 - US$33 range in 2006, according to Earl Sweet, Assistant Chief Economist, BMO Financial Group.

In a new report from the BMO Financial Group Economics Department, Mr. Sweet stated that current high prices reflect strong growth in global consumption (especially in China), several risks to supply, and much narrower capacity margins with which to deal with disruptions. But despite these issues, he says "…global production of oil has more than kept pace with demand, allowing for a rebuild of inventories from very low levels at the beginning of the year."

Mr. Sweet notes that a steep increase in global production, led by gains in the former Soviet Union, Africa, and OPEC, has resulted in a 4.3 per cent rise in supply - a full percentage point above the increase in global demand. However, in substantially boosting production, OPEC has eaten into its margin of excess capacity, which now stands only at about 1.5 million barrels per day, compared to an average of about 5 million barrels during the past five years.

Mr. Sweet believes that current high price levels are a function of a number of supply side risks concentrated over a short period of time, combined with the low margin of OPEC excess capacity to deal with supply shocks. "All of these risks have made the market very nervous about supply adequacy, adding a very large premium to oil prices," remarked Mr. Sweet.

Notwithstanding concerns emanating from the ongoing turmoil in Iraq, rebel threats in Nigeria, and hurricane damage in the Gulf of Mexico, other risks have begun to move off the radar screen. For instance, the resolution of the presidential recall in Venezuela in favour of the Chavez government has for now reduced the probability of production losses in that country. In addition, the Yukos affair in Russia is likely to be resolved in a manner that does not lead to a significant reduction in production and exports. Further, Saudi Arabia and other major oil exporting countries are taking steps to expand capacity and rebuild their ability to respond to supply shocks.

Mr. Sweet noted a move to lower prices would be beneficial to households and a wide range of businesses, which consume oil products, such as gasoline, diesel, and home-heating fuel. It would ease cost pressures on a wide range of items including primary metals, plastics, chemicals, and transportation.

On the other side of the demand-supply equation, with oil trading in the neighbourhood of $30-$35 per barrel, producers of crude would still see much stronger cash flows emanating from existing projects than they initially anticipated. At that price range, opportunities for new projects should be plentiful and returns very attractive.

The full report can be found at www.bmo.com/economic.

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