While it can be conceded that forecasting the price of oil will always remain challenging, several indicators and trends are leading us to believe that the price of this ‘black gold' could well retrace in the medium term. Thus any investor chasing the stratospheric highs reached temporarily last year may well find only "fool's gold" instead.

The oil price is closely watched because it impacts everyone, yet it remains one of the most difficult economic variables to predict. The price chart reflects the proverbial rollercoaster, with oil driven from lows of $10/bbl in 1998 to a peak 10 years later of over $140/bbl, and then crashing back below $40/bbl in the midst of the economic crisis. Prices have since recovered to over $70/bbl.

With these wild swings in price, pity the oil analyst whose only certainty is uncertainty. Future price expectations currently exceed $80/bbl. However, such forecasts reflect an extrapolation of recent trends; implying that oil would be half as affordable as it has been historically into perpetuity. Current price levels ignore fundamentals and I expect a retracement in the price over the medium term.

The persistent rise in prices that has defined the past decade is a symptom of investment lagging above-trend economic growth, exaggerated by speculative demand.   This rising trend has past its zenith, with the downturn partly triggered by an economic crisis, but predominantly due to a delayed step change in fuel efficiency and the coincident restoration of upstream capacity.

Oil is a dense, convenient form of energy, an essential ingredient of the modern economy. Testimony to its importance is the value spent globally on oil, around 3% of global Gross Domestic Product (GDP) on a trend basis. While there are substitutes for oil, these must be traded against their lower energy density and inconvenience. The key linkage therefore is price. By implication if oil ceases to be cheap, at least in a relative sense, its attractiveness is diminished.

Oil cycles tend to be resilient because both supply and demand are inelastic - at least in the short term. With a lead time between discovering oil and producing of just less than a decade, many of the projects we see coming to fruition today were conceived in an environment of sub-$30/bbl oil! Further, usage of oil is so prevalent in modern society that entire manufacturing and infrastructure systems are built to deliver it. The initial response to increased prices is thrift, with secular changes only possible once there is widespread belief that these high prices are sustainable and there is regulatory intervention.

Oil usage is inherently inefficient, especially in transport fuel applications, which account for more than half of global oil demand. Only around 13% of the contained energy in petrol is used to cover the tractive load of a vehicle! While it is impossible to design a perfectly efficient engine, this demonstrates the scale of opportunity in improving efficiency. Oil intensity relative to GDP has declined consistently by around 1.8% a year. Following the two oil crises in the 1970's, oil intensity experienced a step-change relative to GDP. Efficiency gains averaged 5% a year. When affordability reached an extreme 7% of global GDP (see chart). This pattern seems to be repeating, with efficiency gains over the last three years double the trend level.

Over and above the actions of individual consumers, governments have sought to promote efficiency due to environmental concerns and energy security. In the US, the largest oil consumer, we have seen the upward revision in Corporate Average Fuel Efficiency (CAFE) targets under the last two administrations.

The remaining engines of growth are China and the Middle East. China's high income growth and distorted pricing regime resulted in affordability improving, despite record prices! However, the outlook is dampened by a moderation in income growth and fuel price liberalisation. The Middle East demand pattern is pro-cyclical, reflecting high income growth linked directly to oil prices.

Conservation efforts are imperative because oil reserves are finite. We started running out of oil when we started using it, as demand has exceeded the rate of geological formation. ‘Peak oil' theorists believe the diminishing rate of oil discoveries implies peak production is near - or has already been reached. However, the ratio of cumulative production to the estimate of the natural endowment has remained constant at 30%, implying that the rate of resource discovery has so far kept pace with exponential production growth. This is also supported by the reserve-to-production ratio that has remained relatively stable at 40 years.

OPEC's dominant supply position is undisputed, with a 40% share of production and three quarters of reserves. However, its ability to control prices is grossly overstated. OPEC constitutes around 13 countries, of varied geographic location and political persuasion, all heavily reliant on oil revenues. Historically cohesion among OPEC countries has been poor. Discipline is required in desperate times, but is often found wanting in terms of "game theory": seeking to maximise your own volume without jeopardizing the price. In fact, OPEC has only recently restored the absolute level of production to the levels it enjoyed towards the end of the 1970's, a severe hangover from the record prices of that era.

OPEC cannot time investments to match demand. Instead OPEC is relegated to managing inventories, by maintaining an adequate cushion of capacity and by ensuring production restraint. Despite OPEC's frequent statements on "desired price" levels, a simple observation of the price chart reveals that no one is in control of the market. Analysts often point to the oil price level required to balance OPEC countries' budgets, but the cyclicality in their spending suggests that the causality runs the opposite way.

Meanwhile, the current state of oil markets resembles the supply glut leading up to 1998. Spare capacity is twice normal levels on an absolute and proportional basis. OECD inventories exceed 60 days of demand cover, above the normal 55 days cover. OPEC, emboldened by the improvement in price, continues adding to inventories, despite the apparent slack in these variables. OPEC is producing above its quota by approximately 1million barrels per day (mbpd) and that quota is currently 0.5mbpd above the "call on OPEC" production. This makes the implied growth in global inventories an alarming 1.5mbpd!

Consensus forecasts seem conservative in the context of the recent peak above $140/bbl. However, the three-year moving average in the oil price peaked at $80/bbl, meaning that high prices were never sustained for any meaningful length of time.

*Shoiab Vayej is equity analyst and portfolio manager at Sanlam Investment Management.