Our Forecast for Oil Prices Has Risen

The energy sector is no stranger to shocks that push the price of oil well above or below levels that would appear reasonable to someone focused on the long-term economics of the industry, and recent history is no exception. Oil prices have seen sizable gains over the past few years. Emerging and developed economies have boomed simultaneously, lifting demand. On the supply side, political unrest has grown in countries crucial to the world's oil supply while hurricanes struck supplies in the United States.

The only thing that appears certain is that new shocks will continue to batter the price of oil well into the future. Unfortunately, the timing, magnitude, and direction of these forces is often unexpected (otherwise it wouldn't be a shock). So how should an investor value and invest in firms involved in the production of oil? It's clearly not a simple task.

At Morningstar, we've formed an approach that attempts to address some of these challenges, with the goal of generating reasonable fair value estimates for investors. When it comes to constructing our five-year price forecast for oil , we let the first two years more closely reflect current industry conditions, shocks and all. As things sit today, that translates into higher price assumptions in 2006 and 2007 than we expect from 2008 to 2010.

After two years, we rely on our long-run equilibrium oil price assumption to guide our way. This assumption is based on our best ideas about two distinct measures: the long-run average cost of the industry and OPEC's market power. As a team, we estimate what we think the marginal cost of a barrel of oil will be over the next decade and assign a cartel premium to arrive at our long-term assumption. We incorporate the views of analysts who cover a broad set of companies in the oil and gas industry (exploration and production companies, refineries, pipelines, fully integrated firms, drillers and service companies, and other energy-related firms), leveraging the insights they have gleaned from across the energy world.

Why assign a cartel premium to our estimate of the long-run average cost? As mentioned above, we think that shocks will batter the price of oil above and below the long-run economic average. However, if OPEC's members successfully cut supplies when these shocks knock oil prices lower (thereby reducing either the duration or magnitude of negative shocks), the net effect of all shocks (both positive and negative) will be positive. Therefore the presence of a strong cartel should induce a premium in the price of oil relative to the industry's long-run average cost.

Today, we increased our long-run equilibrium oil price assumption. As a result, we're using the following oil prices (per barrel) in our company valuations from today on:

Per-Barrel Oil Price Assumptions
New Prices:
2006	2007	2008	2009	2010
$69	$60	$46	$44	$46
Old Prices:
2006	2007	2008	2009	2010
$69	$57	$40	$38	$39

The case for higher industry costs over the next decade has strengthened, and we expect that OPEC's influence will also continue to improve in the years ahead. In particular, the case for OPEC's increased market power appears especially strong. Much of the incremental supply forecast to come online over the next decade or two is likely to come from OPEC countries. With the call on OPEC supply likely to be large, the cartel's influence should expand in the future.